The N-Word

In the past year, the government has stepped up its involvement in the financial system to unprecedented levels: U.S. taxpayers now formally own Fannie Mae and Freddie Mac, two of the nation's largest financial institutions; the vast majority of AIG, formerly the largest American insurance company; as well as chunks of pretty much every major bank.

Concern is growing in some circles that the federal government will soon nationalize big banks, notably the nation's largest bank, Citi. Federal Reserve Chairman Ben Bernanke has repeatedly pooh-poohed the notion. Nationalization "is when the government seizes the bank and zeros out its shareholders ... we don't plan anything like that." The Obama administration has repeatedly said it opposes the concept. U.S. News' Rick Newman laid out the many reasons nationalization is scary, one of which is that "a government takeover would vaporize a lot of wealth."

On the other hand, Citi's management has done a pretty good job vaporizing wealth on its own, as this five-year chart shows. Last November, the government agreed to inject $40 billion into Citi by purchasing preferred stock and guaranteeing a $306 billion portfolio of "securities, loans, and commitments backed by residential and commercial real estate and other assets." (Once that portfolio loses $29 billion, the government will absorb 90 percent of any losses.) Citi has also been given easy access to several Federal Reserve funding facilities.

Given that 1) Citi is heavily reliant on extraordinary direct and indirect government support, and 2) the value of the company's publicly traded stock is significantly less than the amount of money the government has bought in preferred shares, and 3) government officials are exercising what seems to be unprecedented oversight over the company's management, one could make the case that it already has been nationalized.

If that were the case, would it be so bad? On the one hand, nationalization does sound rather un-American. But the debate might shift if we were to use slightly different language. To many, nationalization sounds like what the Socialist government of France did in the 1980s, telling healthy banks that the state wants to own and operate them. In the United States, by contrast, the nationalization of financial institutions and assets, when it occurs, tends to be a last resort made necessary by a colossal private-sector failure. And it tends to be temporary.

For small institutions, a form of nationalization is routine. On many Fridays, the Federal Deposit Insurance Corporation, a federal agency, takes over the operations of a bank whose management has failed. It seizes control of the bank's assets and offices, makes sure the doors open the next Monday, and guarantees that insured depositors are paid in full. But these nationalizations—the FDIC calls them "resolutions"—don't last long. As soon as practicable, often the same day as the seizure, the FDIC finds a buyer or manager for the deposits and branches of the failed bank. Last Friday, for example, the FDIC took over Silver Falls Bank and found a new corporate owner for its deposits and branches.

The bigger they come, the longer it takes for the FDIC to extricate itself from ownership. Last July, the FDIC took over IndyMac Bank. Six months later, on Jan. 2, 2009, having absorbed between $8.5 billion and $9.4 billion in losses, the FDIC denationalized IndyMac, selling it to a group of private investors for $13.9 billion.

When the failures are systemic in nature, and the volume of assets needed to be sold is vast, the government ownership period can extend to several years. The Resolution Trust Corp., set up in the late 1980s, took over—i.e., nationalized—the assets of failed savings and loans: golf courses, buildings, developments, etc., that had to be liberated from failed financial institutions. Over a six-year period, the RTC returned the nationalized assets to the private sector. In 1984, Continental Illinois, the sixth-largest bank, was the first bank that was too big to fail. To prevent systemic fallout, the FDIC went above and beyond its usual protocol. It purchased bad loans from the bank, infused new capital, fully covered all deposits (above and beyond the deposit insurance limits), fired the management and board of directors who ran the bank into the ground, and took an 80 percent stake. Then it took its time, as this study notes. "The FDIC was interested in selling its ownership position, but not at just any price or necessarily immediately." Between 1986 and 1991, the FDIC slowly sold off its shares in Continental Illinois, returning it to full private ownership in June 1991. Holding on, allowing the markets to recover, and collecting dividends helped minimize the government loss on the failure of Continental to $1.1 billion.

Here's the challenge for Citi, and for regulators. Many of its far-flung units are vibrant, viable businesses (retail banking, money management, the Mexican giant Banamex). But they're tethered to an investment bank and commercial bank that have racked up billions of dollars in losses and that may suffer many more billions in losses. And now the ability of these viable units to operate is being complicated by partial government ownership. Taxpayers look askance at big retention bonuses for brokers, and foreign governments are wary of banks with significant U.S.-government ownership operating on their turf. So what's the shortest route to freedom for the good parts of the bank? Given the macroeconomic climate, management may have a difficult time generating sufficient earnings or raising funds through asset sales to stay current on its debt and get the government off its back. That process could take several years. No private institution is willing to take over the whole bank, absorb the losses, and run the businesses free of government interference. And if Citi tries to sell the healthy parts into this market, it won't get a very good price. Call it a good bank/bad bank deal, call it receivership, call it a resolution, but a temporary passage into government ownership (in exchange for a full and final agreement by the Feds to absorb Citi's manifold losses) may be the surest path to liberty for the bank's still-healthy units yearning to breathe free. Just don't call it nationalization.