Three Reasons Bank Nationalization Will Keep Investors Awake at Night

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By Martin Hutchinson
Contributing Editor
Money Morning

It’s a tough time to be a bank shareholder. You’re not just worrying about whether the ongoing recession or a further lurch downwards in housing prices is going to decimate the value of your bank’s loan portfolio. You’re also worrying about whether some government “stress test” or – worse still – nationalization is going to destroy most or all of your investment’s remaining value.

And finally, if you’re smart, you’re worrying about whether some cockamamie government loan scheme is going to artificially force down the nice juicy interest margins your bank is earning on the new loans it makes.

Clearly, when it comes to bank nationalization, there’s more to be worried about than most investors realize.

Reason No. 1: Nationalization Distorts the Marketplace

Let’s start by just talking about nationalization in general. If you’re a shareholder

in one of the banks I christened “zombies” last week, then you’ve probably already lost 90% of your investment. You’re also not getting any significant dividends, nor are you likely to get any for at least a couple of years. In a truly free market situation you would already have been wiped out – your bank is only still in existence thanks to the money it raised from last October’s “Troubled Assets Relief Program” (TARP) preferred-stock sale.

Full nationalization – giving the government 100% of the bank – would wipe you out altogether; by giving the bank the chance to turn itself around, you may be able to keep some small portion of your shareholding.

Thus, bank nationalization is not just a threat to shareholders of the “zombie” banks that are likely to be the ones nationalized. It is also a threat to the shareholders of healthier banks that will not be nationalized.

To understand just why this is true, we first must understand some banking business basics.

Reason No. 2: Nationalization Creates Artificial Support

The banking business grew to absorb too much of the nation’s output, and now needs to shrink back to its traditional role. The economically healthiest way for that to happen would be for several banks – the zombies – to go out of business. That would give new market space for all the other banks, allowing them to get new business from ex-zombie bank clients and to take advantage of reduced competition by fattening lending margins.

However, banks whose lives are artificially prolonged will get in the way of that healthy development; they soak up good business to pay back the government, or absorb yet more of their losses, and they prevent loan margins from rising to their new competitive level, making it more difficult for healthy banks to pay for the losses on their own past mistakes.

In other words, if you’re a shareholder in a healthy bank you should object to bank nationalization. Your ideal would be for the sick behemoths to get out of the way and give you more customers and better margins. Nationalization is a particular danger, because the nationalized banks will be forced to increase lending volumes artificially, making their competitors’ lives even more difficult.

Even more threatening to a healthy bank shareholder, however, would be a new government lending institution, as proposed in U.S. President Barack Obama’s speech Tuesday night. While that institution might be very slow in getting organized and not a particularly intelligent competitor once it did, it would be able to use the resources of the Federal government to make credit-card loans, automobile loans and mortgage loans at subsidized rates.

Bank shareholders can hope that it would have a heavy social objective component, concentrating on those borrowers who are “left out” by the banking system. In that case, it would merely take away customers the banks didn’t really want, scooping up all the high-risk business for itself.

However, if this new government-backed lender concentrated on making regular loans, competing with the banks on the theory that lending had “seized up,” it would decimate industry lending margins.

Economically, that would prolong the recession as convalescent banks found it more difficult to absorb past losses and become fully healthy again. As a bank shareholder, it would use your own taxpayer money to depress artificially your returns as bank shareholder. A truly lousy idea, in other words!

Reason No. 3: Stressed Testing Could Overstress Weak Players

Finally, there’s “stress testing.” The Top 19 U.S. banks, presumably including Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), will be stress-tested over the next couple of months, to see how much money they might lose in a “worst-case” recession, in which house prices drop another 25% and growth is minus 3% in 2009 and plus 0.5% in 2010.

This is a generally sensible proposal: If executed correctly, this stress-testing will enable the government to identify the clear “zombies” that require immediate recapitalization, and to also hopefully determine which banks among the so-called “walking wounded” must have government capital, and which ones can survive on their own.

The problem is that the “stress test” may be too severe, particularly if it requires banks to be fully capitalized even after stress has been applied. A further 25% drop in house prices is a very severe assumption; house prices are already close to their long-term equilibrium in terms of their ratio to earnings, so a 25% further drop would imply a “bear market” similar to that in stocks. That seems unlikely; the traditional level of U.S. house prices was a rather smaller multiple of earnings than in most other industrial economies, so a sustained drop below that level should meet with an upsurge of new demand from renters who could now afford homes.

Conversely, we have really no idea what effect a further 25% drop in house prices – almost 50% from the peak – would have on mortgage delinquencies. The only previous such event was during the Great Depression, when the mortgage market was far less developed. Stress testers, being cautious, will make assumptions about this that will probably be much too pessimistic.

A stress test that is too severe will force even healthy banks into further government shareholdings. Those shareholdings will initially be non-voting preference shares, but will be convertible into common shares at a 10% discount to the stock prices of Feb. 9 – i.e. at an already depressed level that will dilute common shareholders. They will also be accompanied by restrictions on bonuses, which will disrupt even regional banks’ activities in areas such as foreign exchange and bond trading, and by restrictions on dividends, which will slash shareholders’ income and probably make share prices vulnerable.

Shareholders in healthy banks should thus hope that the government’s attention is turned away from the banking sector as soon as possible. As a result of the current flurry of policies, investors can see one clear disaster (the government lending program), one significant problem (nationalization of the zombies), and one huge uncertainty (stress testing).

If the recession isn’t already keeping investors awake at night, the government actions certainly will …

[Editor's Note: When it comes to either banking or the international financial markets, there's no one better to hear it from than Money Morning Contributing Editor Martin Hutchinson, for he brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.

It was Hutchinson who penned most of Money Morning's "Election 2008" presidential election coverage. At the very start of the presidential campaign, Hutchinson personally interviewed the economic advisors for candidates John McCain, Barack Obama and John Edwards, and very early on concluded that out of the entire field of presidential hopefuls, Obama and McCain would offer the best profit opportunities for investors - and correctly predicted they would be the two finalists.

Just last week, Hutchinson published an analysis on the "Top 12 U.S. banks" report. If you missed story, which enjoyed a big response when it was published last Wednesday, please click here to access it and check it out. The report is free of charge. The follow-up story on that story was his analysis of Fifth Third Bancorp (FITB). The report on Fifth Third appeared last Friday. Both reports may be well worth your time to read.]

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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