Street Capitalist: Event Driven Value Investments

Check out Tunku Varadarajan’s interview with Nouriel Roubini in the WSJ. A few couple quotes:

Mr. Roubini tells me that bank nationalization “is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] — i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector — it’s clear that it’s temporary. No one’s in favor of a permanent government takeover of the financial system.”

There’s another reason why the concept should appeal to (fiscal) conservatives, he explains. “The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic. Paradoxically, the proposal is more market-friendly than the alternative of zombie banks.”

One of the things I encounter with conservatives is the utter disgust for anything that sounds like nationalization. But I think that until the bad assets are flushed out, we’re going to keep seeing financial bloodbaths like what happened on friday. Nationalization may be the only way to bring about the kind of confidence that you need for banks to regain their strength.

I know that some investors have crept into financial institutions over the last quarter, by building stakes in companies like GE and Wells Fargo (both of which hit multi-year lows on friday), but I hesitate. For me, I’ve always preferred non-financial businesses in the sense that if they end up failing, they can liquidate and you’ll extract some kind of value. With financials, it’s much trickier. If this panic keeps up, you might see runs on banks and when deposits flee any of these behemoths can be quickly cut down.

Nationalization at the very least could take the banks away from Mr. Market’s glaring eyes and give management there some time to really make proactive changes without having to worry about their daily stock price. These decisions would be made for creating and preserving value, rather than defending the company from whatever psychological assaults that the market throws at them.

In reading about the Swedish model, the one thing I’ve noticed is that the government there still has somewhat of a controlling stake in their formerly nationalized banks. But over all, the effect of such action was quite positive. Here though I think we’d see a lot of investors who would love to jump into any of these financial institutions after they’ve been stripped of the bad assets so the government stake would likely be sold off after a short period of time.

Roubini brings up another worry though:

…Yet another reason why bank nationalization is a good idea, Mr. Roubini continues, is that “we started with banks that were too big to fail, but what has happened, in the process, is that these banks have become even-bigger-to-fail. J.P. Morgan took over Bear Stearns and WaMu. BofA took over Countrywide and then Merrill. Wells Fargo took over Wachovia. It doesn’t work! You can’t take two zombie banks, put them together, and make a strong bank. It’s like having two drunks trying to keep each other standing.

“So if you took over a big bank, and you split the assets in three or four pieces, maybe you create three or four regional or national banks, and they’re stronger! Nationalization — or ‘temporary receivership,’ if you like, if the N-word is a political liability — is an occasion to undo the sort of consolidation that has created an even bigger systemic problem. And the only way to do it is by essentially taking them over and breaking them up.”

If you think about it, he’s correct. Our policy at the start of the crisis was one where the government essentially financed or at least backstopped consolidation transactions. Rather than fix the dreaded “too big to fail banks” we had banks that were even larger come in and swallow them up. This does little else than create a problem for the future. Until these are broken apart, any issue with these banks would impose a huge systemic risk.

One of my biggest questions right now is what kinds of effects government intervention will have on equity holders. The fact is, it’s a little ridiculous for these guys to get a free ride while taxpayer money is guaranteeing their businesses. There needs to be a re-alignment of risks and rewards here, in order to prevent moral hazard from ensuing. The way I could envision it is sort of an application of the stress-testing that everyone seems to be talking about right now. The banks with a greater degree of bad assets will see higher rates of common equity holders wiped out, while the banks with less will see less of a reduction.

My guess is that such a policy will be difficult to implement, but something like it should happen. Until it does, you should expect the roller coaster equity markets to continue.