In October 2008, a number of Wall Street institutions were “bailed out” by the United States government. Public outrage ran high as bailed-out institutions granted high-level managers bonuses and severance packages in the hundreds of millions of dollars. But, said the bailout’s defenders, the bailout was necessary: it was the only alternative to letting the entire financial system go under.
This simply isn’t true. There was, in fact, a different remedy: banks could have been temporarily nationalized rather than bailed out. This solution was widely favored by economists and economic journalists at the time, garnering support from an ideologically diverse group including Paul Krugman, Greg Mankiw, Joseph Stiglitz, Alan Greenspan, Simon Johnson, Alan Blinder, Nouriel Roubini, Brad DeLong, Martin Wolf, Adam Posen, and Mark Thoma.
Although the country’s largest insolvent banks did not undergo temporary nationalizations during the crisis, the Dodd-Frank Act actually mandated that other insolvent banks will do so in the future. In addition, Title II of Dodd-Frank created the Orderly Liquidation Authority (OLA), funded by large institutions and non-bank SIFIs (systemically important financial institutions). And while the Republicans’ quiet effort to repeal the law isn’t getting significant media attention, the effects of such a repeal would be pernicious. It would effectively allow bankers to enjoy the full gains of reckless lending while sticking taxpayers with the bill whenever a bank goes under.
In a temporary nationalization, the government briefly takes ownership of an insolvent bank. The bank’s shareholders are wiped out, its depositors are completely protected, and its bondholders are typically compensated to the extent they can without being bailed out by the American public.
Banks only find themselves in need of a bailout or a temporary nationalization if their liabilities (what they owe to depositors) exceed their assets (cash, bank reserves, outstanding loans, etcetera) and if they are determined to be “too big to fail”. In a bailout, the full costs of propping up otherwise-insolvent banks are borne by taxpayers, and few strings are attached to the bailout money these institutions receive. During the 2008-2009 financial crisis, many bailed-out financial firms used taxpayer money to pay their executives lavish salaries, purchase condos, throw extravagant weekend parties, and even buy retreats to luxury resorts and spas.
The Dodd-Frank Act made this sort of behavior illegal. Large insolvent financial institutions that have been determined by the Secretary of the Treasury to be too systemically important for normal bankruptcy procedures must now undergo temporary nationalizations rather than bailouts, and they are required to make payouts in the following order (see “Priority of Expenses and Unsecured Claims”):
1. Paying off the administrative costs incurred by the bank’s new owner in its acquisition;
2. Any financial liabilities or obligations owed to the U.S. government;
3. The pay of the company’s normal workers, up to a certain threshold;
4. The earned benefits (retirement plan contributions, health insurance, etc.) of normal workers, again up to a certain threshold;
5. “Any other general or senior liability of the covered financial company”;
6. Money owed to general bondholders;
7. The pay of the company’s senior executives and directors;
8. Money owed to shareholders and other individuals who have invested equity in the company.
This ordering virtually guarantees that shareholders, senior executives, and company directors—not taxpayers—will bear the costs of a temporary nationalization. Shareholders will typically be completely wiped out, since any bank that could afford to keep paying its shareholders wouldn’t require a temporary nationalization in the first place. The status of bondholders is more uncertain and will depend on the degree of the bank’s financial woes. Depositors—not mentioned in the list above—always have their deposits insured through the Federal Deposit Insurance Corporation’s (FDIC’s) Deposit Insurance Fund.
All costs associated with these proceedings are funded by the Orderly Liquidation Fund (OLF) that was created in Title II of the Dodd-Frank Act. While recent legislation (the Financial Choice Act of 2017) has proposed removal of the FDIC’s use of the OLF in order to reduce budget deficits, the CBO has estimated that the FDIC would realize additional net costs of $1 billion through normal bankruptcy proceedings.
After the government has taken over the bank and restored its financial viability, it sells the bank off to a private buyer (the “new owner” mentioned in point #1 above). In this sense, temporary nationalization is far different from the permanent bank nationalizations pursued by the likes of Vladimir Lenin and Hugo Chávez. Permanent nationalizations are based on the false belief that governments should run the banking sector and determine the allocation of loans throughout the economy; historically, this has resulted in economic stagnation and corruption. By contrast, during temporary nationalizations, the government essentially serves as the middleman between two private companies; the point is not for the government to run the banking sector, but rather for it to serve as a backstop in the case of private-market failures.
Such an approach has proven of value in other instances. For example, it has worked for smaller American banks operating under FDIC guidelines. According to public data, the FDIC successfully took over and then sold 539 banks between 2008 and 2017, including 465 between 2008 and 2012. As a second example, temporary bank nationalization led to a quick recovery in Sweden after the early ’90s financial crisis; the temporary nationalization was so successful that it “led to taxpayers making money in the long run”.
Sweden’s experience alludes to one of the main reasons why temporary nationalizations are superior to bailouts: they cost the American taxpayer less. The initial costs of a nationalization are lower than those of a bailout: neither the bank’s shareholders nor its bondholders will ever receive taxpayer money, which is what happens in a bailout. Perhaps more importantly, taxpayers are allowed to see some of the upside of the bank’s recapitalization: the taxpayer benefits from the re-sale of the bank. By contrast, bailouts represent a situation in which taxpayers cover the downside but never see the upside: they pay the bailout costs, while shareholders reap the gains of a healthier, recapitalized institution.
A second reason to favor temporary nationalization is that it doesn’t encourage moral hazard. If bailouts are the norm, bankers know that they won’t lose much money if their bank becomes insolvent. They can keep their previous earnings, and if they receive compensation in the form of stock options, then those options are going to be protected (since shareholders aren’t wiped out). This encourages bankers to take huge risks: if their bets pay off, they will be compensated handsomely, but if their bets go bad, taxpayers will be there to cover the losses. However, when the government temporarily nationalizes banks and invokes “clawback” provisions, the story is quite different: management is kicked out; the elimination of shareholders leaves executives unable to realize stock options; and bankers’ income from previous years can be seized in order to minimize the costs to the taxpayer. If temporary nationalizations rather than bailouts are the norm, risk is more symmetric: Wall Street executives and traders are faced with a properly balanced “heads I win, tails I lose” scenario.
Given that banks must be rescued in times of crisis, the U.S. needs a uniform policy for dealing with insolvent institutions. It’s clear that on every measure, temporary nationalization is better than bailouts: it is less costly for the American taxpayer and mitigates the problem of moral hazard. Fortunately, the 2010 Dodd-Frank Act replaced bailouts with temporary nationalizations. This is an important restriction for keeping bankers from playing fast and loose with depositors’ money—after all, if they make bad bets, it’s now their money that’s on the line. But if the Republicans succeed in repealing the Dodd-Frank Act, taxpayers will again be on the hook for subsidizing bankers’ reckless behavior.