Coming Attraction: Bank Nationalization?

Bank nationalization may not be the policy preference of Democrats and Republicans alike, but it may well be the last resort of both parties, as more and more analysts say nationalization is no longer a matter of "if" but "when."

With the banking sector in a quagmire of bad assets, poor demand and shrinking profits, and government policy initiatives to date showing meagerly results, the concept of nationalization—long considered anathema—is now a real policy option in a growing number of quarters.

“I think nationalization makes an awful lot of sense,” says Walker Todd, a former Federal Reserve official now with American Institute for Economic Research. “Not only is it a viable alternative to keep going with TARP or bad bank solutions, eventually you reach the point where the money needed surpasses the capacity of the taxpayer.”

Nationalization has always had its share of high-profile supporters, such as Nobel Prize-winning economist Joseph Stiglitz, but when free-market champions such as former Fed boss Allen Greenspan mention the possibility, the concept has clearly moved to another level of policy debate.

Sen. Lindsey Graham (R-SC) is among those who admit nationalization may soon be on the table.

“The tolerance for throwing good money after bad has ended,” says Kevin Bishop, a spokesman for Graham. “We're talking about certain banks … temporary surgical stabilization.”

Nationalization Meaning What?

Phrases like that illustrate how the current debate over nationalization may be as much about semantics as it is about political ideology.

Nationalization means different things to different people. By one definition the U.S. government has been doing it for decades, and mostly quite successfully.

• Slideshow: Bank Failures Of 2008

Typically, the FDIC shuts down what it’s determined to be an insolvent bank and briefly assumes control while finding a buyer. The government supplies the necessary capital to satisfy the needs of the buyer as well as regulatory requirements. Insured deposits are protected and the bank reopens under new management.

“We did 1,000 savings and loans and 1,000 commercial banks, 20-years ago,” says Lawrence White, a savings and loan regulator at the time, who’s also served as a White House economist. “If you want (you can) call it nationalization. That's not how I thought of it.”

And that’s exactly what a growing number of people would have the government do with a limited number of banks—big ones—if the current rescue measures fail to pay off.

“Short term, given the alternatives, it’s not such a dreadful thing,” says White, adding the government needs to “make it clear it would be sold back into the market.”

White and others make it clear they are not talking about the primary alternative—outright industry nationalization, best illustrated by the socialist French government of Francois Mitterand in the early 1980s. That was direct government control of the banks' operations. Later, the banks were privatized.

The growing talk of nationalization also reflects a standard progression of crisis management, say experts.

“It’s common that when countries go into a financial crisis, they follow a piece meal approach, partly because of constraints in the political arena," says Luc Laeven, a senior economist at the International Monetary Fund, who co-authored a 2008 study of systemic banking crises and government policy responses in the past four decades.

“Considering nationalization as an option is the right thing to do. It is better to save a bank after you write down the shareholders and take control and have direct control over how the money spent.”

The Bush administration struggled over those issues from the moment the financial crisis began causing direct and collateral damage on a major level—the Bear Stearns collapse-shotgun marriage to JPMorgan Chase in early March—while they also appear to have influenced the Obama administration's significant revisions to the original TARP program

Thus far the effort has centered on injecting capital for government equity and protecting shareholder value, while also protecting taxpayer exposure. Neither, however, has succeeded.

The market capitalizations of Citigroup and Bank of America ,two of the big financial firms struggling the most under the weight of bad assets, are now well below the amount of government assistance.

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Citigroup Center

“Pay out the shareholders and move on,” says Gerald O’Driscoll, a former official at the Dallas Federal Reserve Bank and former vice president at Citigroup. “You could do it that way—the Bear Stearns model. Give them something nominal, so they don't resist.”

O’Driscoll, who's now with the Cato Institute, is among those who predict that nationalization will take place on a case-by-case basis as part of the solution. “I think they're going to end up with a certain number of cases, even though they procrastinated, hoping the situation would work itself out.”

Past Cases

Proponents of nationalization cite the Sweden government’s use of the concept in the 1990s, which is widely regarded as successful crisis management. Though the crisis was much smaller in size and involved traditional real estate assets and also didn’t happen to coincide with a global calamity, the Swedish government injected capital into some institutions, separated bad assets from good ones, replaced management, ran them as long as necessary and sold them back into the market.

“A number of aspects worked well, others did not,” says Laeven. “The management of assets was done well. They recovered a lot of value and were able to sell back into the market as the economy grew back. The ultimate cost to the taxpayers was low.”

The US accomplished much of the same in resolving the savings and loan crisis of the late 1980s and early 1990s.

Previous to that, the federal government took control of Continental Illinois (1984), then one of the nation’s largest bank, and Penn Central (1976), a major railroad company, and ran them for a considerable amount of time before selling them back to the private sector.

More recently, the FDIC took over the failed thrift IndyMac in July and is now waiting to close on a sale to private investors. In the fall of 2008. Washington wound up with a near 80-percent stake in AIG in exchange for massive federal assistance.

Some say AIG is worse off because of the government's involvement and are adamantly opposed to nationalization.

"I don’t believe it is the answer to today’s problems because I believe if we attempted to do it with one or more major banks today we would essentially destroy the franchise. These are much larger and complex institutions" says William Isaac, who was chairman of the FDIC from 1978-1985, and now is chairman of chairman of the Secura Group.

"I think the talk of nationalization is very, very harmful," adds Isaac. "Look what it's doing to [bank] stock prices. I think the government needs to make it clear that is not on the table."

Fed boss Ben Bernanke tried to do much the same in a major speech earlier this weeky, but a slip of the tongue only added to the uncertainty, some say (Watch the video).

The Obama administration's recent announcement that it would start using a "stress test" for banks with assets over $100 billion as part of the financial aid process is seen as a prelude to some nationalization process. Such thinking has dragged on financial stocks in recent days, but that is not thought to be the Treasury Department’s purpose.

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Treasury Building

“If you run it properly you find out how big the hole is,” says Todd, who's also an economic historian.

He points to the Great Depression, when the government's Reconstruction Finance Corporation used something resembling a stress test and a national bank holiday to sort out the weak and strong banks.

Some 12,000 of the 17,000 banks reopened. About half of them received federal loans to boost their capital, based on a government formula, and had ten years to get their capital back up to par.

“We have to start naming names,” says independent bank analyst Bert Ely. “We have a bunch of smaller banks that the FDIC can take over. When you get past Bank of America and Citigroup who are we talking about? People need to start talking specific cases and approaches tailored to those situations.”

That may well be necessary, given the different balance sheets and problems of Citigroup and Bank of America, the latter of which acquired troubled companies such as Countrywide and Merrill Lynch, with the government’s blessings and financial inducements.

In the meantime, the nationalization clock is ticking. A change in government is often a condition for dramatic action.

As one industry insider puts it: “We are in the land of last resort."