I am coming out in favor of nationalization in the United States. The efforts to fix the banking system to date have failed. As a result, America is still threatened by the menace of systemic risk. In my view, this risk can only be diminished significantly by ‘pre-privatizing’ large, bankrupt institutions. I am talking about temporary nationalization of a few institutions rather than a wholesale longer-term government ownership of the banking sector. I will often use the word ‘pre-privatization’ because the word nationalization conjures up a Hugo Chavez-style asset confiscation which I believe is not accurate and clouds the picture.

Through the pre-privatization of large institutions which are effectively insolvent, trust will be restored, asset prices will find a natural equilibrium level and prudent lending can commence once again. By resisting pre-privatization in any and all forms, the Obama Administration is setting itself up for failure. In that scenario, President Obama might end up looking a lot more like Herbert Hoover than Franklin Roosevelt in American history books.

A few days ago, I issued a poll here on this site asking readers what they felt about nationalization. A plurality came out for my favored choice that nationalization is definitely a good option because “some banks are effectively insolvent.”

Illiquidity of insolvency?

As we debate this issue, it is critical that we ask a few questions first because the answers will be determinative of the right approach to take. The first such question is the question of illiquidity and insolvency. This is a topic I first broached last September, in a post called “Solvency” immediately before the Lehman bankruptcy. And how you answer it changes your view on everything else regarding the pre-privatization issue.

If one believes that financial services firms merely need to work through a period of abnormally low market liquidity, then nationalization is akin to asset confiscation. However, if one believes, as I do, that we are seeing a return to normal market pricing which reveals the insolvency of many institutions, then one should believe nationalization is critical to addressing the problem.

My basic point was that ‘solvency’ is almost never an issue for a firm going into administration. It is almost always liquidity drying up that forces an organization into Chapter 11. Lenders pull credit lines, investors stop buying the organization’s bonds, counterparties call in loans.

In the case of financial institutions then, there will always be a question as to whether the institution is truly ‘insolvent’ or merely ‘illiquid.’ This is more so the case in a credit crisis because asset prices are falling, thus reducing capital and triggering a pullback in liquidity. If the liquidity were there, would the institution eventually fail because of asset writedowns? Or would it be a survivor? This was the central question with Northern Rock, the first bank to be nationalized in this crisis in 2007. Northern Rock is a very good example of the basic question here: would their imprudent lending have bankrupted them due to loan charge-offs and asset writedowns or were they a victim of illiquidity.

I believe Northern Rock was an insolvent company as was Wachovia, Washington Mutual and other institutions that have since disappeared. My view is that asset price declines have reflected a reversion to the mean and a return to realistic valuation levels. (I also anticipate that the decline in asset prices will eventually overshoot to the downside.) Thus, these institutions were carrying assets on their books at inflated values, that –when marked down to values that reflected median levels of house prices-to-rent, house prices-to-income, rolling 10-yr. house price appreciation, real price-per-sq. ft., Debt-to-EBITDA or whatever realistic metric you use — would later reveal a catastrophic shortfall in capital — otherwise known as insolvency.

How does one deal with illiquidity?

But, for the sake of arguments, assume we are talking about illiquidity. How do you deal with this? U.S. government officials have decided that one way is for the government to step in as lender of last resort. This is one reason you have seen the Federal Reserve becoming active in many asset markets. The problem here has been that asset prices have continued to fall and markets have remained illiquid, requiring more government interference. At this point, one must wonder whether illiquidity is the problem. The markets are sending a signal that it is not. On the other hand, capital injections are not a good way to solve questions of illiquidity. The need to top up an institution’s capital base is an a priori sign that the institution is insolvent.

How does one deal with insolvency?

To my mind, there are three ways to deal with an insolvent financial institution:

Bankruptcy . Allow the institution to collapse (like Lehman Brothers)

. Allow the institution to collapse (like Lehman Brothers) Nationalization . Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae)

. Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae) Bailout. Inject capital into the institution in order to allow it breathing room until it can meet capital adequacy levels.

As you can see, governments have tried all three solutions. However, there are vast differences between the three.

The bailout solution is the most ‘anti-free market’ choice and seems to be the favored solution of governments everywhere. It props up organizations, giving them an unfair advantage at the expense of other more prudent institutions. It also acts as a subsidy, which favors domestic institutions over foreign rivals. Bailouts increase moral hazard by rewarding risky and reckless lending practices. And they are often the result of crony capitalism due to the power of the financial services lobby. There are many other problems with bailouts. All around, bailouts are a poor solution.

Then comes bankruptcy. I like this solution in general. This is the most hands-off approach and the ultimate free-market approach. However, it is one tried with Lehman Brothers to disastrous consequences. Unfortunately, bankruptcy of large organizations increases systemic risk. And, as we saw when Lehman Brothers failed, systemic risk is quite acute at present. Bank of America and Citigroup should not be allowed to fail.

If we had the time, one might be tempted to break larger financial institutions up into smaller organizations and allow these smaller units to fail. But, this is not a realistic proposal given the speed with which this crisis is moving. Therefore, we are left with one alternative: Pre-Privatization.

Pre-Privatization

Rather than debate the merits of nationalization, I am going to dismiss that term out of hand. No one is talking about a longer-term government ownership of all or part of the financial sector. What is needed is temporary recovery assistance on the way to banking health.

Think of the banks as potential cancer patients and the government as the hospital. Some patients have no tumors or at least benign tumors. These patients can be quickly evaluated for health and sent on their merry way. Others have potentially malignant tumors. These patients must undergo more significant evaluation and continued monitoring. To the degree that the cancer is malignant, it must be excised.

Now, sometimes the cancer will have metastasized from subprime cancer to CDO to high yield bond to leveraged loan and all manner of cancerous, toxic stuff. In this case, excising the cancer will not be enough, the patient needs more serious attention that can only be given through pre-privatization. Mind you, this is intended as a temporary stay. But, we have to assume some patients will not make it.

Perhaps, this is the mysterious process by which Geithner is going to proceed. I doubt it. Moreover, the ad hoc way decisions are being made regarding bankruptcy, bailout or pre-privatization is not going to attract much private capital to Geithner’s plan because, quite frankly, one cannot be sure if the government is going to later seize a bank outright — confiscating any capital provided — or ‘top up’ capital again — diluting all private capital investment.

In the end, bailouts must cease. They add uncertainty and a nefarious moral hazard into the picture that only reduces liquidity and increases systemic risk. Bank failures, on the other hand, should be the preferred mechanism for dealing with non-systemic risk. Small institutions are being seized by the FDIC every week. Not only should this continue, but the FDIC should be given greater capital and more resources with which to continue doing so.

Ultimately, this crisis is about the large institutions like Citigroup, JPMorgan Chase or PNC Bank. The systemic risk, the illiquidity and the fear have everything to do with these giant organizations. Some of these larger institutions are effectively insolvent. The government should pre-privatize those which are insolvent, thereby reducing systemic risk and uncertainty in the banking system and paving the way to a healthy banking sector and renewed lending in the future.