Why Bank Nationalization Is So Scary

A federal takeover would be a deeply desperate move

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Scan the headlines, and you’d think it’s a no-brainer: The government takes over the most troubled banks, whips them back into shape, then returns them to the private sector in a few years. Problem solved.

Former Federal Reserve Chairman Alan Greenspan has advocated nationalizing select banks. Famed prognosticator Nouriel Roubini says it’s the only way to go, since the whole sector is effectively insolvent. Sen. Chris Dodd, chairman of the Senate Banking Committee, roiled the markets recently by saying nationalization may be necessary for awhile.

A federal takeover of Citigroup, Bank of America, and other tottering giants might end up being the only logical thing to do. But nationalizing such banks would be a desperate move, with no guarantee that it would accomplish anything the banks can’t do for themselves.

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Worst of all, a dramatic federal takeover might create expectations that the government can solve a deeply vexing problem overnight – then leave the nation feeling more distressed than ever when the move fails to stem vast losses, revive the credit markets or fix the foreclosure epidemic. Here’s why nationalizing the banks would be so draconian:

It wouldn’t solve the underlying problem. The main problem at struggling banks like Citigroup is a mountain of losses – which the banks may not have enough cash to cover. Those losses are already a done deal: They stem from mounting defaults on loans given to homeowners over the last several years, and also to car buyers, students paying for college, and consumers who ran up credit-card balances they can’t pay off. The banks have written off some of those losses. But many still lurk, since the deepening recession means more people will lose their jobs and the ability to pay their bills.

The government can pump taxpayer dollars into banks to help cover losses, which it’s already doing. But even if it owns the banks, “the government can’t make embedded losses go away,” says economist James Barth of the nonprofit Milken Institute. “The question is how to prevent additional losses.” If troubled banks were making wild decisions that were exacerbating their problems, then a government takeover might be one way to install more prudent management. But by most accounts, government regulators are now watching troubled banks so carefully that they’re effectively clamping down on any risky moves anyway. So it’s not clear what additional protection nationalization would add.

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A government takeover would vaporize a lot of wealth. This is why the markets freak out every time there’s a rumor, or a rumor of a rumor, about nationalization. If the government took over a bank, public shares would suddenly be worthless and shareholders would lose everything. With Citi and Bank of America shares down more than 90 percent over the last 12 months, many shareholders have already lost a fortune. But there’s still a chance they’ll get some of it back if the bank recovers. That potential upside would disappear if the feds stepped in.

Even worse, the banks’ bondholders and other creditors could lose a bundle too. Same with depositors and institutional customers whose account balances exceed the amount guaranteed by the FDIC. To prevent a panic, the government would probably cover those stakeholders up to a certain level – with taxpayers footing the bill once again.

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There are thorny geopolitical questions. One of Citigroup’s biggest shareholders, for instance, is Saudi Prince Alwaleed bin Talal. You might not shed tears if a Saudi billionaire lost a bunch of money when his Citi shares got wiped out. But last year, Alwaleed was lauded as a white knight when he increased his stake in Citi, while other financiers were sitting on their money and staying out of sight. Plenty of other foreign investors – including sovereign wealth funds run by national governments - hold big stakes in U.S. banks. Like it or not, banks today require investors from all over the world. Wiping out foreign investments could easily scare away money that banks need to survive.

Nationalization could easily incite a panic. If the government takes over one or two banks, the obvious question is how many more are in equally desperate shape. Shares in the entire banking sector would plummet even more than they have already. Short sellers, capitalizing on the panic, would drive shares even lower. The government could make a definitive statement limiting its acquisitions to a fixed number of banks, and no more. But to do that, it would have to know for sure that losses at other banks wouldn’t become equally insurmountable. And that’s the very thing nobody knows, since it depends on the depth of the recession and other factors that are far beyond anybody’s control at this point. If the feds nationalized a few banks, said they were done, and then found it necessary to nationalize a few more, that would look absolutely desperate and send the markets into a paroxysm.

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Somebody would still have to run the banks. A key reason for the government to take over a bank would be to boot the existing management. That might sound satisfying, but it raises all sorts of troubling questions. “Who’s going to replace current management?” asks Barth. “Some assistant secretary of the Treasury? Does President Obama become chairman of the board? Would they run it like the U.S. Postal System? Would that instill more confidence in the banking sector, or less?”

Besides, many of the CEOs who caused the worst problems at firms like Citi, Merrill Lynch, Wachovia, Washington Mutual and Countrywide Financial are long gone. Most of the people now running those banks, or the remnants of them, are cleaning up problems left by others.

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Nationalization could threaten healthy banks. If Citigroup were run by the government, it would suddenly be the safest bank in the country. If you had a big account at a private bank that seemed a little less safe, what would you do? Leave your money there? Or transfer it over to the government bank? If healthy banks started losing customers, that would make existing problems even worse.

The banks might recover on their own. There’s no doubt it’s going to be a tense year for banks, and there will be more failures. But the banks will recover when the economy does. Propping them up until then will require profound patience and probably a lot more money. But that may be a lot better than the alternative.

Bank of America
  • Rick Newman

    Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success and the co-author of two other books. Follow him on Twitter or e-mail him at rnewman@usnews.com.

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