Paulson's answer was preferred stock, a weird hybrid entity that counts as equity but is really just a thinly disguised loan. There's nothing inherently wrong with that, except that Paulson bought the shares on giveaway terms. Take Goldman Sachs, for example, which received $5 billion in new capital from Warren Buffett last September. In return Buffett received a dividend yield of 10 percent per year and, according to an analysis by Bloomberg, warrants worth $3.6 billion.
And Paulson? He gave Goldman $10 billion a month later, and in return received a dividend of 5 percent for the first five years and warrants worth less than $1 billion. Eight other big banks got similar terms at the same time. It was a sweetheart deal deliberately designed to not put additional stress on the banks, but the flip side is that taxpayers got robbed. Simon Johnson, a former research director for the International Monetary Fund, said at the time that the transactions were "just egregious." Paulson seemed to be spending more time figuring out how to spend taxpayer dollars in ways that wouldn't offend the delicate sensibilities of the folks getting the checks than he was in getting a good deal for the taxpayers.
But the reason for those easy terms isn't hard to figure out. Basically, if Paulson had paid any more, he would have owned several of the banks he gave money to. Take Citigroup. So far they've received two capital injections from the government worth a total of $45 billion. But that's more than the entire bank is worth. As I write this, Citigroup stock is trading for less than $2; you could buy up the entire bank for less than $10 billion. But Paulson didn't want to own Citi, and the only way to make sure he didn't was to give it money on such absurdly favorable terms that $45 billion only bought a small share of the company. That's good news for Citi and the other banks that got easy money from the government, but both politicians and the public have gotten tired of such handouts.
So, finally, this brings us to option No: 4: temporary nationalization. Here, the big problem is, since the banks haven't exactly been honest about their books, how do you decide which ones are insolvent and which can keep going on their own? Assessing the capital position of a big bank with a complex balance sheet is a notoriously tricky task, as much art as science, and shareholders and creditors have a legitimate beef if the government takes over a bank and wipes out their investment when the bank might still be solvent and able to grow out of its problems on its own. John Hempton, a former bank executive and Australian treasury official, suggests a solution he calls "nationalization after due process": A third party is hired to comb the bank's books, and if they're found to be undercapitalized they're given a chance to raise the needed capital privately from investors. If investors aren't willing to pony up even knowing the bank's position, then it's nationalized, and shareholders can't complain that they weren't given a fair chance to save their investment.
This specific idea might or might not work, but certainly some kind of consistent, transparent system is needed to make the process fair and acceptable. Sweden, for example, which went through a housing bubble followed by a banking crisis in the early '90s, created a Bank Support Authority that forced banks to fairly account for their losses without the smoke and mirrors common to internal accounting. Two were eventually taken over.
President Obama clearly has considered the Swedish experience: "They took over the banks," he said on Nightline last month, "nationalized them, got rid of the bad assets, resold the banks, and a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model." Yet, he went on, the United States has a "different set of cultures" than Sweden, and Americans would find nationalization a hard pill to swallow.
Unsaid but implicit in Obama's statement, though, is that Americans could likely be persuaded to accept nationalization if they understand that all the alternatives are worse. In fact, this may have been exactly the point of the bank rescue plan Obama's treasury secretary, Timothy Geithner, announced shortly after that interview. A key element of the plan involves a mandatory "stress test" for the country's biggest banks, which sounds remarkably similar to Hempton's third-party auditor and Sweden's Bank Support Authority. It could turn out to have been a smart PR move as much as anything: Get everyone talking about the stress tests, worrying about the stress tests, gossiping about the stress tests—and by the time the results become public, it's hard to imagine any recourse other than nationalization for the banks that don't pass.
The stress test is also a way to address both of the two big problems with nationalization. Not only can it fairly decide which banks are solvent and which ones aren't, but it also addresses the dreaded "contagion" problem: Since investors are wiped out when a bank is nationalized, the mere fear of nationalization can scare private investors away from every bank, even the good ones. But if stress tests are done on every bank and the bad ones are all nationalized at once, the good banks are freed from fears that they might be next on the government chopping block.
And in truth, nationalization is more than the least worst option: It actually has a lot of benefits. It allows rapid reorganization and write-down of debts without the associated chaos of a bank failure. It wipes out shareholders and forces creditors to take a haircut, just as in a normal bankruptcy. And unlike endless capital injections in return for small stakes, it's a fair option for American taxpayers, who deserve to own more than just a minority share if they're investing more than the bank is worth in the first place.
Nationalization also solves the problem of valuing toxic assets: The government can simply sit on the stuff until the market turns up and then sell it off for the best price it can get. There's no need to immediately value it at all. Most important, with the full faith and credit of the United States government behind them, nationalized banks can be recapitalized and made into functional credit providers again. And as soon as they're back on their feet, they can be sold back to the private sector, as happened in Sweden. Taxpayers will still lose a lot of money on the deal—there's really no way of avoiding that at this point—but nationalization keeps those losses lower than any of the alternatives.
And there's one more thing about nationalization to keep in mind: We already do it all the time. The FDIC now takes over small banks every week, and among bigger institutions the government has already effectively nationalized Fannie Mae, Freddie Mac, and insurance giant AIG. And for the most part, life goes on as usual. If Citigroup or Bank of America were taken over, the board of directors would be dissolved, some of the senior staff would be replaced, shareholders and bondholders would take a hit, and the bank would continue running as normal except with a stronger capital base and government guarantees behind it. Then, in a few years, it would be refloated and put back in private hands. It's not as scary as it sounds.
As finance blogger Steve Waldman has put it, "real capitalists nationalize." The fundamental principle of a free market system is that ownership and control of failed enterprises should reside in the hands of whoever buys up the corpse. If that's the government, then that means nationalization. This may be why temporary nationalization has won the support not just of mainstream economists like Nouriel Roubini and Paul Krugman, but of no less a free market acolyte than former Fed chairman Alan Greenspan. "It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring," he told the Financial Times in February. "I understand that once in a hundred years this is what you do."
A version of this piece will appear in Mother Jones' May/June issue.