A Ghoulish Prospect

Nationalisation carries risks, but it may still be the best way to deal with American banking's undead.

In a classic horror film, “Night of the Living Dead,” a terrified group of people barricade themselves in a rural farmhouse to escape hordes of flesh-eating zombies. Today Americans are gripped by a similar fear, but this time the walking corpses in their nightmares are banks, tearing insatiably at the public purse. As the Obama administration struggles to get its poorly received bank-rescue plan up and running, it is being pressed to respond to suspicions that some large banks are on the edge of insolvency, if not already there.

In a matter of weeks nationalisation has gone from taboo to talking point. Economists debate its pros and cons across the blogosphere. Politicians on both left and right accept that America’s sickest banks may need to be taken over and restructured and their good parts returned to private ownership. Even Alan Greenspan has become an advocate.

Although the government continues to resist such calls, its hand may be forced by the results of the “stress tests” that it began to perform on February 25th on the 19 largest banks. Officials’ own stress levels are running in inverse relation to the banks’ share prices. Those of Citigroup and Bank of America plumbed new lows on February 20th (see chart 1). That prompted the Treasury and a group of regulators to declare that they stood “firmly” behind the banking system, but that their “strong presumption” was that banks would remain in private hands. Ben Bernanke, the chairman of the Federal Reserve, went further, saying in congressional testimony this week that nationalisation “is when the government seizes the bank and zeroes out the shareholders … we don’t plan anything like that.”

Economist grave


Even so, the neediest banks are heading that way. As The Economist went to press, the government was in talks with Citigroup over what would in essence be partial nationalisation: the conversion into common equity of a chunk of its preferred stock, obtained in return for pumping capital into Citi last year. This would give it a stake of up to 40 percent – eight times the holding of Prince Alwaleed bin Talal, the most influential existing shareholder – and voting power to match.

Citi approached regulators about the conversion, fearful of being swamped by further losses as the recession and housing crisis deepen. The deal would mark the bank’s surrender in its battle to persuade investors that its reasonably healthy “tier-one” ratio is a convincing measure of capital adequacy. These days markets prefer measures using tangible common equity, which is undiluted by hybrid capital such as preferred stock.

The government may end up repeating this across the industry. The first step in its Capital Assistance Program will be the stress tests, which will take a few weeks. The aim will be to map potential losses in a two-year recession with unemployment rising as high as 10.3 percent and house prices continuing to tumble. If the testing shows that banks need more capital, they can first try to raise it over six months from private sources. If they fail, they will get government help. The state will take preferred stock (paying a 9-percent dividend) that converts into common equity if needed.


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