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Busch: Extending the Banking Crisis

From US banking to US fiscal spending, the political theme for the week is responsibility. In response to last week's dive in bank stocks due to uncertainty over nationalization, the U.S. Department of the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board today issued the following joint statement attempting to reassure the markets.

"A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery. The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments."

Here's the full statement

This sounds great except that they are going to stress test the capital needs of the major U.S. banking institutions to determine who needs the assistance. If a bank is deemed to need a cash infusion, then they'll first be allowed to raise it from a private source before being required to accept the capital from the government. "Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory." They did say that they are starting the process on February 25th, but didn't give us a date when they will make their findings known.

If the government tells the bank that they need more capital, it's highly unlikely any "private" source would step up due to the stigma. This means that the government's designation could signal a further death spiral for the bank's common stock shareholders. Today's discussion about the US government converting their preferred Citigroup shares into common stock. According to the WSJ, "While the discussions could fall apart, the government could wind up holding as much as 40% of Citigroup's common stock. Bank executives hope the stake will be closer to 25%, these people said."

As an example of what can happen when the government owns a bank, take a look at the United Kingdom. Today, UK Chancellor of the Exchequer Alistair Darling ordered Northern Rock to expand lending by 14 billion pounds. "This is against a background where a lot of foreign-based banks have withdrawn. What I want to do here is use Northern Rock to help fill the gap." Hmm, think they'll be making sound, prudent lending decisions? (Well, they probably can't do any worse...)

The Citibank action would mean current common stock shareholders would be diluted and it signals the intense problems the company is facing. Anticipation of the US government becoming a large common stock shareholder and/or running the bank is why the stock fell to $2.0. It is the pall that is cast upon all of the financial sector until the government finishes their testing and announces the list of those needing capital.

Let's hope that George Soros is wrong when he said that the current economic upheaval signals the end of a free-market model that has since dominated capitalist countries since the 1980s.

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Andrew Busch
Andrew Busch

Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him here. </</p>