The Bank Nationalization Question

Yesterday, Ben Bernanke assured the Senate Banking Committee that he saw no reason “to formally nationalize a bank when it just isn’t necessary”. President Obama and Treasury Secretary Timothy Geithner have also taken every opportunity to say that they do not want to nationalize the banks. However, “not wanting to” and “not wanting to but will have to anyways” are two different things and it is still quite possible that one or more of the commercial banks teetering on the edge of bankruptcy could be a target for government takeover.

Even hardcore capitalists are grudgingly saying that it may be necessary for the government to assume direct control over some of the more obvious “zombie” banks out there that are only able to remain solvent with the continued support of the government. Also ripe for takeover perhaps are those banks that do have sufficient capital now thanks to the US taxpayer, but choose to hoard the money (as I wrote in a commentary earlier this week) rather then lend it out to help turn the economy around as regulators intended.

Indeed, some industry experts are pointing to the “Swedish Experiment” as proof of the need to nationalize the US banks. In 1992, the Swedish government assumed control of the banks, cleaned up the balance sheets of those that were capable of continuing, while forcing others into bankruptcy. The newly revamped banks were eventually re-privatized but as much smaller institutions.

Reasons Against Nationalization

When Sweden nationalized its banks, taxpayer money was used to assume the bad debts incurred by the banks, but the government first required the banks to write-down their losses thereby dramatically reducing share values. The government bought the shares at the lower market price and forced the banks to issue warrants to the government so that as assets were sold-off, the government (i.e. the taxpayer) received first claims on any positive cash flows. In other words, there would be no profit-taking or big bonuses awarded until the warrants were repaid. Once stability was achieved and as individual banks returned to profitability, share prices naturally began to rise. The government then sold these shares at a profit which helped finance the original takeover.

It is estimated that costs to the taxpayer to nationalize and then re-privatize the banks were negligible. Costs to the original shareholders, well, that’s another story and underscores the critical consideration facing the government in any nationalization scenario – how to balance the interest of the shareholders with the overall health of the economy, while still taking into account the need for protection of the taxpayer’s investment?

Reasons For Nationalization

It is understandable that the US government feels compelled to prevent more banks from failing; when Lehman Brothers collapsed last September, reaction in the markets was instantaneous. Stock prices – especially in the financial sector – plummeted and credit markets froze solid and have remained so pretty much since. George Bush took a lot of heat for selectively saving some banks while letting others fail or be bought up by competitors and you can bet that President Obama will not put his administration in line for the same sort of criticism.

Despite this, one of the arguments against the US government’s approach to the bank rescue to date is that a great deal of public money has been handed over to privately-held banks with little in the way of taxpayer protection or even rules for how the money is to be used. It is a widely-held belief that both Citigroup and Bank of America need an immediate infusion of cash and the government is their last resort. If Obama and Geithner do not take outright control of these banks, except some form of payback guarantee to be included as part of any support agreement and this could very well set the model for how the government deals with the other banks.

There is also the question of moral hazard to be considered – if privately-held companies come to expect that they can count on the government to bail them out anytime they run into money problems, then the temptation to take irresponsible risks for higher reward may be too compelling to resist. By nationalizing the banks rather than simply bailing them out, shareholders and executives will not be protected when banks take extraordinary chances to chase unnatural profits. To do so only rewards the reckless behavior that got us into this mess in the first place.

Decision Time

Interestingly, the US government does have a precedence for forced nationalization having resorted to this with the Savings and Loans scandal of the late 1980s when the government seized control of several insolvent institutions. Worthless assets held by these firms were transferred to a specially-created holding company in order to cleanse the balance sheets sufficiently to make the firms solvent once again. The recovered institutions were then sold by the government to new owners that took over management of the new entities.

Whether or not the US banks are nationalized, one thing is certain; President Obama and Timothy Geithner will not allow these “too big to fail” institutions go under. Between the Troubled Asset Relief Program (TARP) which has already provided nearly $300 billion in aid so far and Obama’s new bank rescue plan which could cost another $2 trillion, the US government is committed to ensuring the survival of the US banking system. The only question remaining is will the government merely be supporting the banks or will it actually own the banks.

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