What really happens when banks are nationalized

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What really happens when banks are nationalized

Kathleen Pender

Saturday, February 28, 2009

Nationalization. Nobody is sure exactly what the word means, but its

mere mention sends shivers up the spine.

On Monday, the Dow fell 250 points after some top legislators said

the government might have to nationalize banks, at least temporarily.

On Tuesday and Wednesday, Fed Chairman Ben Bernanke and Treasury

Secretary Geithner tried hard to reassure investors they had

no plans to nationalize the banks, but on Friday, the U.S. government

moved closer to taking a major stake in Citigroup. After gaining some

ground, the Dow still ended the week down 251 points.

" Nationalization is a loaded term for a lot of people. It's seen as

the kind of thing that European or more socialist governments do, "

says Elliott, a fellow at the Brookings Institution.

But what, exactly, does nationalization mean and what are its pros

and cons? Here's are some answers.

Q: What is nationalization?

A: There is no single definition. In its purest sense, the government

would take complete ownership of a bank, including all of its assets

and liabilities, and run it day-to-day, the way it operates the U.S.

Postal Service. If the company operated at a loss, taxpayers would

foot the difference. If the company was liquidated and its assets

exceeded its debts, taxpayers would be on the hook.

A government could partially nationalize a bank without taking

complete control.

Many people would consider a bank nationalized if the government

owned at least 51 percent of its common stock.

The government could also take effective control of a company without

buying any stock, as it has done with Fannie Mae and Freddie Mac,

says banking analyst Bert Ely.

The U.S. government has bought preferred stock in the eight largest

banks and hundreds of smaller ones under the Troubled Asset Relief

Plan. This is generally not considered nationalization because the

preferred stock doesn't have voting rights.

On Wednesday, however, the Treasury unveiled a new Capital Assistance

Program. Under the plan, large banks that can't pass a " stress test "

will have six months to raise additional capital from private

investors. If they can't, they must sell the government preferred

stock that is convertible into common stock after seven years. The

bank could convert the stock or buy it back before seven years. Some

people see this as creeping nationalization.

On Friday, Citigroup said it will offer to convert almost $27.5

billion in preferred stock held by investors and up to $25 billion

held by the government into common stock. If all shares are

exchanged, the government would own 36 percent of the company. The

government is already demanding that Citigroup overhaul its board.

It's hard not to see this as partial nationalization.

Q: Has the United States ever nationalized a bank?

A: Yes. In 1983, it took over Continental Illinois, at that time the

sixth-largest bank. The Federal Deposit Insurance Corp. has also

taken over failed banks when it couldn't find a buyer, as it did with

IndyMac last year, Elliott says.

Although the FDIC sold IndyMac within a few months, it took the

government seven years to wind down its stake in Continental Illinois.

Today's banks in danger of nationalization are many times bigger and

more complex

Q: Didn't the government nationalize thrifts in the early 1990s?

A: Yes, but the situation was different from today.

The Resolution Trust Corp. took over failed savings & loan

associations with the sole purpose of liquidating them.

" The government was the undertaker. We were burying the dead, " says

Ely. " Today, we are dealing with institutions that have issues but

many pieces are very viable. " The government would be more like a

vet, " nursing the sick whales back to health. "

Q: Why do investors worry about nationalization?

A: If the government took over a bank, its common stockholders would

get little or nothing. Although depositors would not lose money,

other creditors, such as bondholders, could get hurt if their debt

were restructured, as it would be in a bankruptcy.

Even in a partial nationalization, common shareholders would get hurt

if the bank issued new shares to the government because their

ownership stake would be proportionately less.

Q: What are the other dangers?

A: Taxpayers would probably lose money. There would also be political

pressure to pursue social goals such as lending to low-income people.

Money will go " to sectors of the economy that are in trouble or those

with the lowest rates of return. The government will direct funds to

aid the poor, not to rebuild the nation, " writes Bove, a

banking analyst with Rochedale Research.

While some see this as a positive, it would probably hurt taxpayers.

Government ownership would also create " a competitive imbalance

between banks that are nationalized and those that are not, " says

Ely. " It becomes a rerun of the Fannie-Freddie problem. "

Although Fannie and Freddie were shareholder-owned companies with no

explicit government backing, most investors assumed that the

government - which set them up - would come to their rescue if times

got tough. As a result, they could borrow more money, at lower rates,

than other companies.

" They used the implicit guarantee of the government to take much

riskier positions than they would have if they were (purely) private

enterprises, " Elliott says.

It also forced them to serve two masters - politicians who wanted

them to increase homeownership and shareholders who wanted them to

increase profit.

" This was a big part of Fannie and Freddie's undoing, " Elliott says.

Q: Why consider nationalization?

A: To prevent a run on a large bank and the chain reaction that would

set off.

" Whether we like the banks or not ... they are central to our whole

economy, " Elliott says. " They are the main way we get money from

savers to businesses, homeowners. If we let the existing banking

system fall apart, it will cause immense destruction. "