Let’s call a spade a spade

While investors continue to speculate as to if, when and how the banking system will be nationalized, it strikes us that the process has already begun. Paul Miller of FBR Capital Markets says, “We define nationalization as significant government assistance. We argue that government guarantees on bank debt, TARP funding, and credit wraps are “soft” forms of nationalization, so we believe the government has already taken the first steps.” We tend to agree.

The news du jour is that the government may be looking to convert some or all of its $52 billion in Citigroup preferred stock to common equity in an effort to help the bank address mounting losses. Citigroup’s current market capitalization is less than $12 billion. Therefore, if the preferred stock were to convert to common at today’s price, the government would end up owning over 80% of Citigroup. (I would note that Citigroup is attempting to cap the government’s ownership in the company to 25-40% through a combination of partial preferred stock conversions and a higher conversion price). According to a Bloomberg article released yesterday, Citigroup is “among more than 20 lenders that could wind up majority-owned by the government if such conversions took place.” The article goes on to say “Bank of America, which has received $45 billion in TARP funds in exchange for preferred shares and warrants, would be 66% owned by the government if its entire stake were converted to common equity, according to data compiled by KBW, Inc., a New York-based investment bank. The figure would be 69% at Regions Financial Corp. in Birmingham, Alabama, which has received $3.5 billion from the U.S. It would be 83% at Fifth Third Bancorp, the largest Ohio-based lender, which got $3.4 billion.”

So the question becomes, does a bank have to be 100% owned by the government for a “nationalization” to have occurred? How about 51%? I would argue that at a minimum, “nationalization” occurs when the government gains control of the bank, and that happens at 51%. And given that provisions in the TARP agreement allow the government to “unilaterally amend” the original terms associated with past TARP preferred stock purchases, we would suggest that the federal government already controls the destiny of many of these undercapitalized banks.

Meanwhile, the Federal government continues to say it supports “a privately held banking system.” Is the government suggesting that it is against all individual bank nationalizations, or just that it wants to avoid the nationalization of the entire system? Can the government effectively nationalize some of the weaker banks while not adversely affecting the businesses of those that remain private? It seems to me that these are the precise questions that are being asked inside the government right now, and we don’t believe anyone has the answers.

Our best guess is that the government’s proposed “stress test” will indeed reveal individual banks with severe capital deficiencies, and that ultimately the government will end up owning majority stakes in several of these banks (including some large banks). Whether or not this is deemed “nationalization” is subject to interpretation. In our opinion, the government is already in control of the destiny of our banks. So we would just as soon call a spade a spade.

Semantics aside, we tend to believe that many of the government actions taken so far to stem the financial crisis may have been necessary. The government did not suddenly and arbitrarily decide that it needed to be involved in the financial services industry. Its intention was to keep the financial system functioning in the face of the unacceptable risk of complete collapse. I would add that there is precedent for nationalization of not only banks, but also other industries. In nearly all cases, the respective industries ultimately emerged as private industries again. We are optimistic that this process will end the same way.