Bank Nationalization Fever Wanes

Remarks by Federal Reserve Board Chairman Ben Bernanke allayed fears of the federal government nationalizing major banks. Appearing before the House Financial Services Committee he said the major banks were not in jeopardy of failing and nationalization was not necessary.

Bernanke stated that nationalization is when the government seizes the bank, zeros out the shareholders, and manages the bank; and, they don't have anything like that planned. His remarks caused a significant rally in beaten down bank stocks.

The positive comments by the Fed Chairman came the day after President Obama’s optimistic State of the Union address. Their remarks were the first meaningful statements to effectively offset the cries for nationalization that had been increasingly dominating the print and cable media.

The loud voices favoring bank nationalization have suffered their first major setback. Those opposed to nationalization hope this is the first of many defeats that the talking heads will receive going forward. Baseless rhetoric by inexperienced pundits has simply become too much for the nation to bear.

A Name Can Hurt

On December 11, 1930 the Bank of United States failed setting off runs on numerous other banks that had refused to come to its aid. It was only one of the 352 banks that failed that month but its failure had worldwide repercussions, because many thought it was owned by the federal government. It was actually a relatively small state-chartered bank with slightly over $200 million in deposits located in New York City. But - it had an imposing name!

In the aftermath of that confidence shattering failure it was determined that no newly chartered bank would be allowed to use “United States” in its name. Of course that did not affect the Bank of America, which was already operating under that name.

Those now shouting fire in the bank theater would do well to read about the failure of the Bank of the United States. That bank was not nearly as large or as important as its name implied, but its failure helped usher in the last depression as it helped erode confidence at home and abroad.

By contrast, the Bank of America is a truly dominant bank that holds more than 10% of the total deposits of the entire banking industry. It claims that 50% of the people in the Unites States are customers of the Bank of America.

Those talking heads who daily spread the view that the Bank of America needs to be nationalized so that this economy can turn around are, at best, illinformed. They have no background in banking and they fail to appreciate the shock such an announcement would have domestically and internationally.

Bank Nationalization Opponents Need To Thank Greenspan

Alan Greenspan, the former Chairman of the Federal Reserve, who many view as the primary culprit for today’s economic problems, has come out of hiding to express his views on the subject of bank nationalization. Greenspan told The Financial Times “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.”

Opponents of bank nationalization should thank Greenspan. After all, who in their right mind would rely on the views of a person weighed down with an admittedly broken economic model. He greased the skids for this slide into the abyss; he does not hold the solution.

Bank Nationalization is Wrong

The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets thereby wiping out, as needed, the equity of common shareholders followed by the interests of preferred stockholders and then the bond owners.

The bad assets would then become assets of the FDIC or a special entity established by the federal government. The new owners could then keep them or sell them to private investors, who are reportedly waiting anxiously to acquire these bad assets.

Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy and it provides just punishment for making stupid decisions.

Nationalization is neither a necessary nor a sufficient condition to solving today’s problems. The treatment of Continental Illinois in the 1980s and the purported success of the RTC are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the U S currency and our U S government debt.

The truth is that de-leveraging by financial institutions, corporations, and individuals takes time. The bad assets on the books of the banks will disappear as they either heal, are liquidated, or are charged off through earnings. The debt of corporations will be reduced as corporations either take bankruptcy or use their cash flow to reduce debt. Individuals will similarly de-lever by either erasing debt through bankruptcy or curtailing consumption. During this period the level of economic activity will be negatively impacted unless the government expands its expenditures and levers its balance sheet. Nationalization of banks will not prevent this process from occurring.

The fact that “vulture investors” are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closures of financial institutions in the 1980s and 1990s. They can’t wait to once again be the beneficiaries of a large transfer of wealth courtesy of the federal government.

While fans of the RTC cover it in accolades, the beneficiaries of its largess chuckle. Here is what one person had to say about the RTC, “When working on a mortgage-backed trading desk back in the '80s, the RTC went to the street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff so they can once again buy distressed assets at fire sale prices. It is the way of the street.”

Bank nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going concern basis has no place in their playbook. Calling these investors “vulture investors” gives vultures a bad name!

Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.

There are two issues that merit careful consideration before being swept up in this drive for nationalization. First, who determines what “bad assets” need to be excised from a bank being nationalized? Second. who determines the price of a bad asset at the time of its removal?

In the case where a loan is determined to be a bad asset and is transferred to another entity that borrower loses their right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than they would otherwise be, since the new holder of the loan would either be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.

Recent events with securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of a bank that made it is greater than the intrinsic value of that loan when it is housed and administered elsewhere. Furthermore, an original lender is far more likely to advance additional funds to borrowers, thus extending the economic life of a borrower.

Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are greater than the comparable values if they are held by most private investors. This is so because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available thanks to expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve. The intrinsic values of assets on the balance sheet of a bank today are understandably greater than what non-bank investors’ claim.

We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs; their cost of funding is plummeting; they have very favorable interest spreads; and, their earning assets exceed their paying liabilities.

The truth is that almost all of the banks and savings and loans that were closed during the past 30 years would have survived if they had today’s deposit guarantees, deposit rates, and were given some time. The exceptions are those institutions that were caught by persistent negative interest rate spreads when interest rates soared and those banks closed because of fraud and malfeasance.

The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.

Bank of America’s Stock Action For Week Ending February 6th

Volatility in the price of bank stocks returned last week with renewed vigor as bears and bulls clashed over the Obama administration’s failure to release its bank rescue plan. Rumors regarding imminent nationalization focused especially on Citigroup ( C ) and Bank of America ( BAC ) and caused those stocks to plummet on Thursday morning. Citigroup traded as low as $3.20, which was still above its $2.80 low of January 20th.

BAC, however, was really taken to the woodshed and collapsed to $3.77, which was a 27 year low. The last time Bank of America stock was this low was 1982. At that time it was known as North Carolina National Bank and at the end of 1982 it only owned three small banks (all in Florida) outside its home state. Those current and past executives who have followed a buy and hold strategy have watched their net worth disappear along with the price of BAC stock.

Members of the Obama administration much have been watching the deterioration, because news began to leak regarding the forthcoming bank plan. The leaks were all attributed to unidentified sources close to the discussions and revealed that this administration was not hell-bent on destroying the last remnants of common equity in the large banks.

As that news spread, the shorts ran for cover, the longs said “gotcha,” and the market in bank stocks improved dramatically along with the rest of the market. At the close on Friday, BAC was trading at $6.13. In after hours trading it continued to trade higher and finished trading at about $6.36.

The rising price of BAC stock coincided with a TV interview of CEO Kenneth Lewis in which he did a masterful job of fielding tough questions and giving short, positive answers. For example, when he was asked about the prospects of nationalization he said he has never heard a regulator, member of Congress, and an administration official ever mention the word. He said talk of nationalization is absurd.

Lewis went on to say that Bank of America has plenty of capital and does not intend to ask for any more funds from the U.S. Government. Furthermore, he said he hopes that Bank of America will be able to return all of the government’s money within three years. Lewis also suggested that January was a pretty good month.

Lewis could not have done a better job of saying the right thing at the right time. If he does lose his job as CEO, he could get top dollar coaching other CEO’s on how to answer tough questions in a public forum.

Get The Wagon

The origins of the Bank of America trace back to the legendary banker Amadeo Pietro Giannini who opened the Bank of Italy in a former San Francisco Saloon on October 17, 1904. Total deposits at the end of that first day amounted to $8,780.

The first crisis to face the bank was the great San Francisco Earthquake of 1906. A.P. Giannini reportedly managed to get the money out of the vault of his ravaged bank and transport it in a horsedrawn wagon. The money was hidden under produce and taken to his home in San Mateo.

The Bank of Italy was one of the few banks that had money and was able to provide loans in the immediate aftermath of the quake. Giannini himself loaned money on the basis of handshakes while standing behind a plank supported by two barrels. In later years he relished telling this story and the fact that every loan was repaid. He died in 1949.

The Bank of America has been hit by economic forces that are at least as powerful as those that rocked its headquarters in 1906. This time, however, it will not be as simple as finding a horsedrawn wagon to save the bank assets.

Senator Schumer Favors Guarantees

Bloomberg and the Financial Times report that Senator Charles Schumer in a CNBC interview today said he favored the guarantee of troubled bank assets rather than the establishment of a so-called “bad bank.” His views carry weight because he is a leading Senate Democrat and member of the influential Senate Finance Committee.

The guarantee of $301 billion of Citigroup (Citi) assets in November 2008 might very well serve as a template for any such guarantees. In that deal the U.S. Government agreed to "ring-fence" $306 billion (later modified to $301 billion) of loans, investments, and commitments. These assets remain on the books of Citi; however, it is responsible for only the first $39.5 billion loss plus 10% of any losses greater than that. Citi's total exposure on these toxic assets is therefore $65.65 billion.

In return for this guarantee, Citi issued $4.034 billion in 8% Cumulative Perpetual Preferred Stock to the U.S. Treasury and $3.025 billion in the same 8% preferred to the FDIC as a "fee". Citigroup also issued to the U.S. Treasury a warrant for an additional 66,531,728 shares of common stock at the $10.61 strike price, which was the average of the closing prices of Citigroup common stock for the preceding 20 trading days.

Interestingly, the arrangement is really like Citigroup buying an insurance policy with an initial non-cash premium of $7.059 billion, which is the sum of the awarded preferred stock, and a quarterly cash premium of $141.2 million. As the insurer the U.S. Treasury is also given an equity kicker via the warrant.