Over the past week, many of the U.S. banks have been hit hard due to fears that nationalization of our banking system could happen soon. How likely is this option though? The U.S. has prided itself on being one of the strongest free market economies. If banks were to be nationalized, how would that affect the rest of the economy and the morale of investors?
In July 2008, I wrote an article about the future of investment banks and the extreme likelihood that there wouldn’t be a pure play investment bank by the end of the year. I underestimated the speed in which this transformation would occur, especially with the unexpected bankruptcy of Lehman. Now, after looking at the U.S. banking system, it is apparent that without a sharp turnaround in the financial markets, action is necessary to prevent a total collapse on the U.S.’s financial system. The one thing the Fed cannot allow to happen is the freezing of payments and lending not only between banks, but also to consumers and businesses. Without an easy flow of money, the economy will come to a screeching halt.
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Loans Outstanding
Over the past year, the U.S. government has already handed out nearly $180 billion in preferred equity to the largest U.S. financial institutions, including:
- Citigroup (C) C: 2.14, 0.00 (0.00%)
- Bank of America (BAC) BAC: 3.91, 0.00 (0.00%)
- J.P. Morgan Chase (JPM) JPM: 19.51, 0.00 (0.00%)
- Wells Fargo (WFC) WFC: 11.03, 0.00 (0.00%)
- Goldman Sachs (GS) GS: 80.07, 0.00 (0.00%)
- Morgan Stanley (MS) MS: 18.82, 0.00 (0.00%)
- PNC Financial Services (PNC) PNC: 24.61, 0.00 (0.00%)
- U.S. Bancorp (USB) USB: 11.33, 0.00 (0.00%)
This amount doesn’t include the backstop funding provided to Citigroup, Bank of America, and American International Group [(AIG) AIG: 0.53, 0.00 (0.00%)]. The approximate market cap of all of these institutions combined is approximately $266 billion. This poses an interesting situation for the U.S. government. If the financial sector continues to plummet due to the further de-valuation of assets on these banks’ balance sheets, an overhaul on the system may be necessary. Although this outcome is extremely unlikely, it is still an option that the Treasury may elect to take to restore confidence in the system.
Selective Nationalization
The solution to the problem may be selective and temporary nationalization to fix the banks with the most risk. The government has been against this idea in the past, as President Obama and Treasury Secretary Geithner have spoken out against this plan. Recently Senator Lindsay Graham, spoke about how nationalization may just be the answer in our current situation. When the thought of nationalization is talked about in the media, many Americans often misinterpret it. The government wouldn’t look to take control of the banking system and make decisions for large banks, but rather allow them to restructure their businesses to allow them to operate effectively again.
Under the FDIC, they already have the authority to take over banks that are in distress. One way the FDIC can accomplish this is to put the banks into a receivership. This is exactly what the government did to Fannie Mae [(FNM) FNM: 0.50, 0.00 (0.00%)] and Freddie Mac [(FRE) FRE: 0.50, 0.00 (0.00%)]. This is also what the FDIC did to Washington Mutual after the bank looked to be insolvent. In the case of WaMu, the FDIC stepped in to secure the good assets and deposits, puts these assets into a new company and then sells off those assets to a stronger financial institution. Wamu’s good assets and deposits were sold to Jamie Dimon of J.P. Morgan. What happens to the equity holders of these banks? They usually end up in bankruptcy court to get anything they can from what is left from the remaining company.
Another way in which the FDIC could help in a “nationalization” way is to provide open bank assistance. This doesn’t force the company into bankruptcy or a merger, but allows them to continue to operate at the government’s expense. This outcome is extremely likely for banks like Bank of America and Citigroup. They have already sought the government’s help to backstop the losses on their bad assets. A bad bank structure is a very likely outcome of this situation. The government has already hinted at this possibility over the past months. Last quarter, Citigroup announced that they would be splitting up their business to Citigroup Holdings Corp. and Citicorp. Both of these companies still operate under the Citi name for the time being, but it allows them to be spun off or sold off easier in the future. Citigroup Holdings Corp. would be the entity that would be spun off into the “bad bank” structure if the government chose that route.
Many analysts believe that Bank of America is also at a huge risk to join this structure. Analysts believe that BofA is also behind Citi in the markdowns that they need to take on their bad assets. By the end of 2009, it is likely that both Citi and BofA will need more assistance from the government. This assistance is likely to come in the form of a “bad bank”, government bailout structure.
Citigroup and Bank of America have received $50 and $45 billion, respectively. Considering that the market caps for Citigroup and Bank of America are $15 and $21 billion, respectively, it makes a little bit of sense for the government to invest $40-50 billion more to take control of the outstanding common equity. With the purchase of their common equity, it would allow them to restructure their businesses privately and allow them to strengthen their balance sheets.
Wrap-Up
As I mentioned above, the whole U.S. banking system relies on confidence and liquidity. Right now, we are at a unique time in history in which both are under attack. It is absolutely necessary for the banks to restructure their businesses and balance sheets to restore confidence in the system. The U.S. financial system is teetering on the edge of complete failure if another catastrophe occurs (such as the failure of Lehman Brothers). Although another failure is a possibility, it is very unlikely as the government learned its lesson back in October. The most likely outcome is a bailout through some type of a receivership of the banks that desperately need it.
Disclosure: The mutual fund the author is associated with is long GS and JPM.
