The Problems of Nationalizing the Banks Remain

05/13/2009 05:12 am ET | Updated May 25, 2011

On January 23 of this year I wrote an article titled The Problems of Nationalization In it I outlined three inherent problems with nationalization. Who do you nationalize, how do you actually accomplish the process of nationalization with minimal market disruption and how do you prevent the politicalization of the nationalization process. In the third point I outlined specific points, one of which was, "A person in government (elected or not) leans on a bank to make a sweetheart loan to someone/an entity/a group not qualified to take out the loan." Unfortunately, there is a movement within Democratic circles already proposing to do just that. This regrettably corrupts the idea of nationalization.

The problem centers around JP Morgan's loans to Chrysler. As the Wall Street Journal reported:

Banks that loaned Chrysler LLC $6.8 billion are resisting government pressure to swap more than $5 billion of that for stock to slash the car maker's debt, according to people familiar with the matter, hindering Chrysler's effort to restructure outside of bankruptcy court.

The issue is also slowing the company's drive to cement an alliance with Fiat SpA by May 1, and stalling Chrysler's attempt to renegotiate a health-care agreement with the United Auto Workers union, according to these people.

While significant work needs to be completed with the UAW and Fiat, people involved in the talks say the banks are striking a much tougher stance than the union or Fiat.

The lenders, which include J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Citigroup Inc. and Morgan Stanley, hold great influence in moving the process along. As holders of secured debt, they have the right to take control of Chrysler plants, brands and other assets, which were pledged as collateral for the loans, if the company files for bankruptcy protection.

The listed banks have secured loans, which are:

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral -- in the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to satisfy the debt by regaining the amount originally lent to the borrower. From the creditor's perspective this is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. The opposite of secured debt/loan is unsecured debt, which is not connected to any specific piece of property and instead the creditor may satisfy the debt against the borrower rather than just the borrower's collateral.

In other words, JP Morgan did the smart thing: although they lent money to a questionable borrower, they secured their loan to actual physical assets of the borrower. In the event the borrower defaults, the bank has several options, depending on the structure of the agreement. They could simply file a lien against the assets so that when they are sold the proceeds will first go to pay off the outstanding debt. Or the bank can seize the assets outright and sell them on the open market. The actual terms of the agreement will dictate the bank's course of action, but the preceding two examples are the most common forms of dealing with a default on secured debt. In addition:

Chrysler's bank lenders say they would be in a stronger position than other stakeholders, including taxpayers, in bankruptcy court. Unlike with GM, where many of its bondholders hold debt that isn't secured by assets, almost all of Chrysler's debt is backed by its plants, equipment, patents and other holdings. That gives its senior-most lenders -- which have what is known as first-lien debt -- a strong legal position in bankruptcy.

If Chrysler were to liquidate, billions of dollars in assets would be broken up and sold, with the first-lien lenders getting first dibs. J.P Morgan and other lenders are convinced they would have higher recoveries in a liquidation, compared to what the administration is asking them to accept now , said several people familiar with their thinking.

In the event of a bankruptcy, JP Morgan would be first in line for payment from specific assets.

The bottom line is JP Morgan did what any bank would do in the above situation. When extending credit to a shaky borrower, get a security interest against collateral. This is the standard, smart move. A bank that didn't do that would be considered incredibly foolish and stupid.

The argument being used against JP Morgan is that because they took TARP money and have received other forms of government assistance, they should give up their secured status and instead become equity owners of Chrysler. This would remove them from secured status and make them a general creditor of the corporation thereby removing their preferred status in case of bankruptcy.

There are two problems with this argument. First, it is asking the banks to make a decision that stands a far higher possibility of losing them money. Should JP Morgan accept equity for their debt, the possibility of them not getting paid in the event of bankruptcy is far higher. In other words, forcing them to accept equity for debt is asking them to make an incredibly unwise business decision that will eventually have to be paid for by taxpayers. But the second problem is far more serious. It essentially boils down to this: because you accepted TARP money you are now required to make unwise business decisions. That simply makes no sense. JP Morgan did what any prudent lender would do. Now - because they took TARP money - we are asking them to throw prudence out the window, and accept a loss on a loan which they prudently managed. This is an inherent politicalization of the banking and lending process which does not bode well for the management of institutions in the event of nationalization.

This does not mean I am unsympathetic to the ends we are trying to achieve. As I wrote a few months ago, while I am not for an auto industry bail-out, I am against an auto industry bankruptcy right now. I do not believe the US economy could withstand the shock of Detroit going under right now. Even in a solid economy that is a risky proposition; in the middle of a very difficult recession it is extremely dangerous.

But that does not change the fact that asking a bank which prudently managed its risk to now kick that prudence to the curb because it took TARP money sets a politically dangerous precedent. It indicates that in the event of further nationalization political concerns may trump investment concerns. Should the banks be nationalized it should be done on financially based grounds, not political.