Nationalize Ailing Banks? Pressure Grows on the US

The longer the credit crisis sends a chill through the global economy, the more pressure the US Treasury will be under to do what it has long resisted: injecting capital directly into the beleaguered banking system.

Proponents insist government purchases of stock in troubled banks more directly addresses the central challenge of encouraging new bank lending and thawing out credit markets.

Critics say such a move would effectively nationalize troubled banks. But advocates say that the government could take relatively small stakes—and buy non-voting shares—so there would be minimal federal interference.

Proponents also argue that it's a quick way to broaden the reach of the government rescue efforts while the Treasury sets up the $700 billion bailout fund to help big banks unload toxic mortgage debt. That fund, which was approved by Congress last week, could take several weeks to implement.

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“We are in the midst of an raging international credit meltdown and we do not have the luxury of waiting for (the bailout fund) to be implemented,” argues Robert Johnson, a former managing  director of Bankers Trust and Soros Fund Management executive. “Treasury needs to inject $500 billion of capital as soon as possible into at least the large 19 primary dealer banks and probably some large regional banks as well.” 

The direct recapitalization of ailing banks is “high-impact” money versus the “low-impact” approach that Treasury is pursuing through the bailout fund.

Equity infusions would introduce 10 to 12 times the amount of the initial government investment into our credit markets, argues Johnson who also served as chief economist of the Senate Banking Committee in the late 1980s.

This means that capital infusions of $700 billion would free up $8.4 trillion in overall credit, while purchasing $700 billion worth of assets wouldn't unleash any additional credit.

Direct recapitalization is “something we need right now—to change the mood of the markets,” said Martin Bailey, former chairman of the Council of Economic Advisors, currently a scholar at the Brookings Institution.

Europe is already moving in this direction, although its efforts more closely resemble outright nationalizations, in which the government simply takes control of the bank.

“In the US, for pretty good reasons, we are much more reluctant to nationalize things—although we have done it with Fannie (Mae) and Freddie (Mac)," Baily says, referring to the two US mortgage giants that had to be taken over recently. "But I think [direct capital injection] would have the same effect without having the problem of actually nationalizing the institutions.”

The Federal Reserve effectively did the same in its rescue of insurance giant American International Group (AIG), in which it took a 79.9 percent stake in exchange for a life-sustaining loan of $85 billion.

On Wednesday the Federal Reserve said AIG would get up to $37.8 billion of fresh liquidity under a plan that authorizes the Fed to borrow securities in exchange for cash collateral.

Still, big banks are likely to oppose capital injections, preferring the government just help buy troubled assets and not buy stock directly, which would dilute the holdings of existing shareholders.

“The banking industry will not be in favor [of direct equity purchases] because nobody likes to pay for their own mistakes—It is much better to have the taxpayers pay for their mistakes,” argues Luigi Zingales, a leading financial scholar, who teaches at the University of Chicago. “And to the extent that the Treasury Department is captured by the banking industry they will oppose this.”

“Banks prefer the Paulson approach [of asset purchase] because their hope is that they can sell this stuff for more to the Treasury than they can to anybody else,” said John Makin, a former consultant to Treasury and the IMF, now at the American Enterprise Institute.

In a press conference late Wednesday Treasury Secretary Henry Paulson said it has all the tools needed to deal with the credit crisis, and included apparently new emphasis on the option of injecting capital. But he clearly suggested other options would be tried first.

Paulson said global financial markets turmoil wil not end quickly, adding also “we expect it will be several seeks before our first purchases" of troubled assets.

© 2009 CNBC.com