The Problems of Nationalization

There has been an increased call for a nationalization of some or perhaps all US banks. I am against this for several reasons. First, given the size of the US financial industry, nationalization is simply impractical. Secondly, the act of transferring ownership from private to public hands will further destabilize the market. Third, nationalization will expose the financial sector to political manipulation. I will argue all of the preceding points by walking through a hypothetical nationalization of the US banking system.

Which banks get nationalized? According to the FDIC there are 8,384 federally insured institutions. Given that total what is/are the criteria for nationalization? There are many ways to judge bank performance -- net earnings, Tier I capital ratio, return on equity, assets or investment. Which one is appropriate? How many times do you nationalize? A bank that doesn't qualify today may qualify in a quarter or two. When they need help does the government turn its back or does it then nationalize them as well? In other words, is this a one shot deal or does it happen over time? But doesn't performing the process piecemeal increase financial instability?

So, before we even start the process of nationalization there are incredibly complicated and difficult questions to answer -- who is nationalized, what are the criteria used, and when/how often does the nationalization happen.

Once the last three questions are answered the next step is the actual nationalization of banks -- that is, making the transition from private to public ownership. Let's start by looking at the money center bank page from Yahoo finance. According to this page the total market capitalization of money center banks is $327 billion. Let's assume nationalization will involved 1/3 of these institutions. This total is pretty easy to get to -- simply nationalize Citigroup, Bank of America and Wells Fargo.

Where does the government's ownership interest come into play in the capital structure? Most people would argue that a nationalized interest would be superior to public shareholders. But that increases the the possibility of common shareholders getting hit hard -- if not wiped out. That means that $107 billion dollars of market wealth (the total market cap in our example) is threatened. Even assuming the best -- that common shareholders continue to hold onto their shares -- nationalization of these banks would stand a good chance of sending these shares into steep discount territory.

According to Yahoo finance, 44% of Bank of America's,64% of Citigroup's shares and 58% of Wells Fargo shares are held by institutions. So nationalization cuts into the net asset values of a number of mutual funds, sending their values lower. Not only are mutual funds taking a hit so are most major averages. Financials compose 13% of the S&P 500 index.

Nationalization is a public admission that a sector is bankrupt. This is the primary reason I am arguing nationalization will send the averages lower. However, let's assume this does not happen -- that the market reacts well to the US government buying a swath of US financial institutions. Now the government has to run these banks. So -- who runs them? Does the management that caused the problems get fired? If so, who replaces them? How does the government handle the interim issues?

In addition, we now have the same problem involved with all processes involving politicians -- undue influence. Within five years I am betting all of the following will happen:

1.) A person in government (elected or not) leans on a bank to make a sweetheart loan to someone/an entity/a group not qualified to take out the loan

2.) A major campaign contributor gets a sweetheart "consulting" contract to service a financial institution.

3.) A major campaign contributor gets a special loan package

4.) The issue of patronage enters the picture: campaign workers/politically connected people who are unqualified to work in the financial field or are minimally qualified get jobs in the financial field

5.) A bank that shouldn't have qualified for government assistance gets government assistance. Actually - that's already happened:

Troubled OneUnited Bank in Boston didn't look much like a candidate for aid from the Treasury Department's bank bailout fund last fall.

The Treasury had said it would give money only to healthy banks, to jump-start lending. But OneUnited had seen most of its capital evaporate.

Moreover, it was under attack from its regulators for allegations of poor lending practices and executive-pay abuses, including owning a Porsche for its executives' use.

Nonetheless, in December OneUnited got a $12 million injection from the Treasury's Troubled Asset Relief Program, or TARP. One apparent factor: the intercession of Rep. Barney Frank, the powerful head of the House Financial Services Committee.

Mr. Frank, by his own account, wrote into the TARP bill a provision specifically aimed at helping this particular home-state bank. And later, he acknowledges, he spoke to regulators urging thatOneUnited be considered for a cash injection.

.....

On Dec. 3, Rep. Spencer Bachus (R., Ala.) forwarded a Dec. 2 letter from Alabama bank regulators complaining about the complexities of applying for federal funds. Alabama banks later received billions in funds.

6.) Less than 50% of the banks return to profitability.

7.) Of the remaining 50%, none of them achieve better than 80% of the previous institutional high of ROE. In other words -- the previous management made more money for shareholders

8.) Lending does not increase to pre-meltdown levels -- or to acceptable levels.

The bottom line is this: there are no easy answers right now -- no magic wand that we can wave to make the problem go away without causing any pain. The problems associated with nationalization in a country as large as the US are huge. There are difficult issues involved with identifying which institutions to nationalize, how to perform the actual nationalization without sending the markets lower and then actually running the banks is such a way that political influence remains out of the process. Simply put, I don't think it's possible for Congress or the government to perform this task effectively.