Nationalization Pride

Tuesday's enthusiasm for the new administration was not reflected in stock prices. Most markets dropped and continue to be on a downslide. Why are investors so pessimistic? Mostly it has less to do with the Obama administration than concerns about major banks such as Bank of America and CitiGroup. Share prices for banking stocks have taken a beating the last year, but in the last few days prices have dropped closer to dangerous sub $5 zones ($3 for Citi and $5 for BofA). WellsFargo and JP Morgan Chase are not far behind. Even with equity from the TARP 'bailout' investors fear these firms lack enough liquidity to absorb more loan losses.

Some estimates suggest US banks have written off $1 Trillion so far (yes "T") and have another trillion to go...so they are only halfway there. As share prices drop the bank's equity erodes further. This makes creditors nervous so they demand higher returns. The cycle continues as just as banks need more capital they are forced to pay more for it. All of this hurts their ability to make loans and truly make markets. It hurts the firms and the economy.

So the rumor now is one of more of these firms will be 'nationalized'. This could take many forms. Shareholders might be wiped out. This strikes some policy makers as sweet revenge. These firms were mismanaged and the shareholders rode that wave to extraordinary profits year after year. In other models shareholders might be weakened but still alive--similar to the Fannie Mae and Freddie Mac 'conservatory' models. Prices would plummet, but the potential for a comeback might exist. In either case the federal government would manage the banks until they could be sold off--probably in smaller chunks.

But while nationalization may seem to be a way to just 'get the mess cleaned up and move on', it is not so easy. FDIC take overs generally result in heavy costs to the Treasury. Viable parts of the business are sold to existing firms at a discount and the losers get government bail outs. This would take some time and quite a lot of money. Not to mention someone to manage these firms.

Even if it saved some firms, it might undermine others. The markets will become nervous about every bank not on the nationalization list and dump it for fear it might go on the list. And in doing so, more firms would need help and the list grows.

Does any of this matter for consumers? Yes and no. Banking will continue, but the cost of services/products will increase. Borrowers on the margin of qualifying for a loan will be further excluded. And for many years shareholders will likely punish any bank that lends to consumers viewed as 'risky'--which could be code for not White or living in an inner city or even a small business. So this is important in the long run to keep an eye on.

And there is always the danger consumers over react and we need a FDR style bank holiday to restore order. Unless the FDIC looks insolvent this is unlikely however.

What are the alternatives to nationalization? Creditors could be wiped out or debt could be re-organized under bankruptcy provisions. The Treasury has already guaranteed some bank debt so that would be an added cost. Of course more cash infusions could be arranged. This did not seem to work last time (in Oct-Nov) but arguably there the Treasury's investment were not big enough. Another $400 billion just might do the trick. But no one really knows. This is all a grand experiment.

A final option is do nothing. Banks will need to look for ways to shore up their balance sheets without worrying about common stock. Making policy based on volatile share prices is probably never a good idea. Maybe the best approach is wait and see.

Did Obama tip his hand in his address Tuesday? He stated our financial crisis reminds us that “without a watchful eye, the market can spin out of control.” He also stated "The question we ask today is not whether our government is too big or too small, but whether it works." Perhaps we will see some bold new approaches in the coming days and weeks. Or maybe the wait and see approach will prove to be exactly the bold action required.