Proceeding with Nationalization: Where to Begin

Includes: AIG, BAC, C, GM, GS, JPM, MS, WFC
by: Balaji Viswanathan

Until this point government stuck to preferred stocks instead of common stocks traded in the market. Preferred stocks are not exactly ownership, as there are no voting rights, and this arrangement between government and the banks is deliberate.

Preferreds are closer to debt than to equity. With yesterday’s announcement, that might change with the government trying to convert its preferred holdings into common stocks. When it holds a majority of common stocks, it would then be defacto nationalization.

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. Previous capital injections under the Troubled Asset Relief Program will also be eligible to be exchanged for the mandatory convertible preferred shares.

How much can the government take?

The Treasury’s current preferred investments in Citi (NYSE:C) for example is 5x times its market cap and theoretically government could take Citi 5 times over. In Bank of America (NYSE:BAC), it is 2X, in AIG and GM it is probably 100X J, 33% in JP Morgan (NYSE:JPM), etc. So, if the government wants to nationalize it can do so with its current holdings without spending anything extra. As I have mentioned earlier, we are very close to seeing some blockbuster nationalization (most likely Citi).


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How to proceed with the Citi nationalization?

The scale of announcements the last few days means that it is a matter of just a few hours / days before the receivership, and what will be most interesting is how government is going to run it. Unlike AIG, Freddie Mac (FRE) and Fannie Mae (FNM), Citi is far more complex and far more global. Insurance was pretty highly regulated and hence they could take receivership and slice off the portions, whereas investment banks are not.

The biggest concern why the President is postponing the day of reckoning is the global mess and confusion this will generate. What will happen to the 100+ global divisions of Citi – will they all be taken over by the US of A, or will it be left for the local authorities to manage? This must be negotiated with all the major stakeholders and it is a real problem.

So, in short the devil is in the details. Citi cannot survive under the current form, but government ownership can cause serious issues to the long-term survival of the industry. In Sweden the government kept banks at arm's-length to prevent political interference. You cannot rely on the U.S. government to do that.

My plan would be to split Citi into potentially good divisions (Smith Barney-Global Wealth Management, Citicards, Banamex) and sell them in the market now. The rest of the assets should be put in a separate account managed by the government and got rid of, slowly. The most important point is to remove the cancer cells from the healthy ones, and also keep the government out of running the well-run divisions.

The government has no experience in running Smith Barney and the rest of Citi’s private banking division and should not mess with it. The government should sell all of them (there can be good buyers given that those divisions make money) and retain only the toxic assets for a while, and dispose of them slowly.