The Pain Of Bank Nationalization

I have been posting on the possibility of the banking system being nationalized to save it from itself.  The following is from an article written by Peter Coy.

The key to understanding the nationalization debate is to focus on who will bear the pain of bank restructuring: Will it be mostly taxpayers and common shareholders, as it has been so far? Or will the pain be shared by preferred shareholders and even some classes of creditors, ranging from foreign bondholders to other banks to the counterparties of exotic derivative contracts?

Other nationalization issues generate heat but are distractions. You can safely ignore the controversy over whether the government will spend a lot of money to support nationalized banks; taxpayers are already spending billions, with or without nationalization. Likewise, while the risk that the government could interfere in lending decisions is valid, it’s avoidable, especially if the bank is quickly reprivatized. Besides, regulators and Congress are already micromanaging their wards. Just ask Citigroup CEO Vikram S. Pandit or Bank of America CEO Kenneth D. Lewis.

So how should the burdens be shifted in the U.S., if at all? Well, creditors of weak banks have been largely spared to date. The political question—and let’s face it, nationalization is a political issue as much as an economic one—is whether that favored treatment can or should continue. Big bondholders are getting nervous that the tide of opinion is turning against them. Kathleen C. Gaffney, who is co-manager of the Loomis Sayles Bond Fund (LSBDX), says it’s fair enough for stockholders to lose in a bank rescue because “stockholders know the risk.” In contrast, she argues, “bondholders expect to at least get a return of their principal.” Likewise, Joshua S. Siegel, managing principal of New York-based StoneCastle Partners, a private equity firm that invests in banks, says forcing bank creditors to take a haircut “would be rewriting the laws of commerce. The capital markets would collapse, because who would ever again buy debt in any company that’s regulated?”

What nationalization-hating bondholders hope for is the same thing that Bernanke and Treasury Secretary Timothy Geithner are counting on: That the big banks can be cured with a smallish, temporary injection of public capital, coupled with the new Treasury initiative to get weak assets off their balance sheets. In the ideal scenario, the taxpayers come out ahead in the long run when banks’ net worth recovers and the government’s stake becomes highly valuable. (On Feb. 25, Treasury said that by the end of April it will finish stress tests to determine whether the 19 biggest banks need more capital.)

Yet there are equally strong voices arguing that taxpayers are being played for suckers and that creditors should absorb some of the bailout cost, now. The airwaves are alive with taxpayers complaining about having to bail out unnamed “fat cat” investors. Some finance experts share their view. “The bond and equity holders should lose first before the taxpayers do. They made the choice to invest without adequate due diligence,” says Donn Vickrey, co-founder of Gradient Analytics, a research firm in Scottsdale, Ariz.

Of course, even if the government wants to make creditors pay a price, it’s not clear how it could do so. It’s easy enough when the Federal Deposit Insurance Corp. takes over a deposit-taking bank: If the assets are worth less than the liabilities, the FDIC is authorized to force unsecured creditors to share the loss. But the FDIC has no such authority over bank holding companies—the umbrella organizations that control sister subsidiaries such as Bank of America’s Merrill Lynch. Technically, the only way to impose a loss on creditors would be to push the bank holding company into bankruptcy court. But no one wants to go through another bankruptcy like that of Lehman Brothers last fall, which helped cause the global financial system to seize up.

Nevertheless, many analysts say that if push comes to shove, the government will somehow find a way to make creditors absorb some pain. R. Christopher Whalen of Institutional Risk Analytics says he thinks Citigroup is the only banking company so weak it will have to be nationalized. If it is, he predicts, bondholders will take at least a 70% loss, if they are not wiped out entirely. They won’t suffer it lightly, either, Whalen predicts: “Bondholders are probably the best-organized investor class that there is. You’re talking about little old ladies, pension funds, and foreign governments.”