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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  1. Mark Jones | February 27, 2009

    The additional issue here is the long term overhang on the stock price and mkt as a whole as these large cos have significant gvt holdings

  2. Ciceroji | February 27, 2009

    Martin I think you are definitely a banker. Your entire argument is from the banking point of view. And I think you are entirely right nationalization is not good for healthy banks. However, who cares. Yes banks are the lifeblood of the economy. As long as they are lending to good clients even if they are barely making any money (think utilities here) I have no problem with that. Yes, their stocks will go in the toilet, but once again as long as there is money flowing to good projects in the economy not a problem. The only potential hazard I can see is if the nationalized banks start throwing good money at bad investments (That would be a disaster). All the rest is only a problem if you are a banker, however the rest of the economy will be fine.

    I am not sure the nationalized banks will necessarily be more competetive. It depends on how tough uncle sam is. If uncle sam requires a 6-10% yield on their investment, these bank will be struggling to repay uncles sam. If they get free money well thats a different story.

    If they get free money and really drive down interests (which is by the way what uncle sam wants) then a problem might arise if that makes some other previously healthy banks unhealthy.

  3. Monte | February 27, 2009

    My Dear Martin,

    I can't help but wonder if this problem would exist if an "eccentric" like Dr. Paul had become president. We are now in an extra-constitutional period that promises not yet realized horrors for us all. Perhaps " The Great Pretender" can request the help of the brilliant minds that rule his native Kenya.

    Adios mates, been good to know ya!

    Monte

  4. Bill | February 27, 2009

    Another consideration regarding bank nationalization would be that the government will decide what loans are made. The same government who controls and manages the postal service, social security, Fannie Mae, Freddie Mac, Medicare, and Medicaid – all stellar successes – will determine who will get the loans to make cloths, shoes, cars, houses, software, food, and virtually everything we buy. Your choices will diminish, and your opinion will have less value. Free open market competition will end. You will be told what you like and want, not by advertising, but rather by availability as chosen by your government. In the future, to get a loan, you could have to donate to a federal representative's election campaign. And you thought things were changing.

  5. John H. Adams | February 28, 2009

    This article makes several incorrect assumptions.

    One of the fundamentally incorrect assumptions it makes is that market forces can produce a healthy market. The so-called "credit crisis" clearly shows that this is not true. All that market forces produced was a den of thieves. The great economic thinker, Karl Polanyi, has observed over 50 years ago that SOCIETY MUST CONTROL MARKETS and MARKETS MUST NOT BE ALLOWED TO CONTROL SOCIETIES. The government is the representative of society and it must act to control markets effectively.

    When banks have been found to be nothing but a den of thieves, then it is necessary for governments to step in and take control in order to clean them up. One approach to clean them up and put them on a good footing may be nationalization. Another approach will be to introduce more effective regulations. Regardless of the approach, the government needs to intervene in order to protect members of society.

    If the government takes the nationalization approach, it may gradually withdraw from direct involvement and allow private organizations to take control. Once it has done this, it still has to enforce all the regulations diligently as the representative of society.

    Finally, it must be remembered that members of society have to eternally vigilant to ensure that corrupt or incompetent government officials do not create or allow to be created yet another den of thieves. It is ultimately the responsibility of members of society to ensure that their government does its job properly.. This cannot happen if members of society think that once they have elected a government their job is done and they can go back to watching their favourite game on TV along with mindless consumption of beer and potato chips.

    It has been said that the price of liberty is eternal vigilance. In the same vein, the price of financial security is also eternal vigilance and activism.

    Merely criticising nationalization does not serve any useful purpose. It merely helps to further selfish and vested interests that, as has been shown clearly by the recent "credit crisis", only result in causing great suffering to many.

    Sincerely,

    John H. Adams

  6. martin s | February 28, 2009

    use the capitolization system instead of socialization .allow the banks to sell more stock and bonds with no taxation of the interest and dividends for 5 years. This would enclurage investors to put up their money instead of the govt.
    allow a larger write off from taxes each year instead of the measly 3,000 carry over . This would allow investors to swallow their losses instead of selling the stocks they have gains in to offset theirl losses .Selling the winners at this time will only drive the market lower.

  7. shaiby | February 28, 2009

    i want something on the economic situation of pakistan…. i believe that banks in banking sector in pakistan is not as affected as the banking sector in countries like US or European….

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