Put away the hammer: Nationalizing banks won't solve the financial crisis

The new in thing among the cool kids in the world of finance is to do what they did in Sweden. Let's nationalize the banks! Backing this idea are current and former Fed Chairs, Ben Bernanke and Alan Greenspan, the doomster Nouriel Roubini, and Simon Johnson, a former IMF economist who teaches at MIT.

They could be wrong in recommending that we nationalize the banks, and fear that it might happen is driving down banks stocks -- Citigroup (C) fell 20% and Bank of America (BAC) has fallen 14%. But their comments raise some basic questions: What does 'nationalizing the banks' mean? Will it happen in the U.S.? And who would be the winners and losers?

Nationalization of banks means that the government takes them over from private investors. This wipes out common shareholders and replaces the CEOs and management teams with government employees. Sweden nationalized its banks and some cite its success as a reason to do the same in the U.S.

In the early 1990s, Sweden's banks were bankrupt. So Sweden took 100% control of them and put the ones with troubled assets into a "bad bank," where they were held and then sold over time when market and economic conditions improved. In the meantime, it used taxpayer money to provide enough capital to allow banks to resume normal lending.

I don't think the U.S. will nationalize the banks. First of all, the politics of the situation will prevent it from happening. The people who got us into this mess -- Greenspan and Bernanke -- are supporting it, which contributes to the idea's political radioactivity.

But the more important reason not to do it is that our sickest banks are already nationalized in every way that matters. The U.S. is their largest shareholder and is likely controlling key decisions -- and it's not working. By working, I mean that lending is not happening and that's because these zombie banks have too much toxic waste.

If the banks were nationalized, the losers would be just about everyone except for the people who have supported the idea. Taxpayers would lose because they would see their prior investment in the banks wiped out. So would common shareholders who have already lost 95% of their investment.

More importantly, borrowers would suffer because of lost opportunity. The U.S. could create far more credit with a more efficient solution. Moreover, although some of the executives running the banks now should be replaced, I am not convinced that a government employee would necessarily make better decisions than an experienced financial executive.

What should we do instead? Remember the twin goals I described: getting credit flowing and cleaning up the problem assets. To solve the first one, it would be much more effective to create new banks. As I posted, if the U.S. used the second $350 billion of TARP to capitalize new banks, at a 9:1 assets/equity ratio, it would create $3.5 trillion in lending capacity to meet demand (more would be available if private investors chipped in).

This is important because the collapse of the securitization market has wiped out $1.9 trillion -- about half of lending capacity -- the money borrowed by businesses and consumers before credit markets collapsed in 2007.

This leads to the second goal -- how to clean up the troubled assets that are freezing up the market for securitized loans? Securitization is taking, say, 4,000 assets (such as mortgages) putting them in a trust and then selling securities based on the cash flows from those 4,000 mortgages. These securities have a very low value because people are scared to buy them since they don't know which of those 4,000 mortgage holders are likely to keep paying and which aren't.

But we could cut out that cancer and solve the problem. As I posted, there is a solution: let the FDIC buy the, say, 15% of those mortgages that aren't paying. This would free up the mortgage-backed securities to trade freely since the remaining 3,400 mortgages in that security I mentioned above would consist of paying mortgages that would have a real value. Banks could then sell those securities or keep them on their books at a high value. And they'd be able to lend out their capital instead of hoarding it. Meanwhile, the FDIC could work with mortgage holders to restructure the loans and keep their houses off the market.

Sweden's banking system in the 1990s was different than ours is now. So applying the same solution that worked there to a different problem won't have the same positive effect.

Unfortunately, many of the proponents of nationalization only have a hammer on their tool belt, so they think that every problem is a nail. What we face here is a new problem and nationalizing the banks won't solve it.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares and has no financial interest in Bank of America securities.

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