Banking clarity

The federal government has taken over 17 failing banks and thrifts this year, seizing them at a rate three times faster than last year. At that pace, it will "nationalize" 85 banks by year's end, compared with three -- yes, three three -- in 2007. Yet many analysts and investors wonder whether the government should be taking over more financial institutions, particularly a number of "too big to fail" firms that may not have the money to cover their expanding losses. The push for nationalizing big, troubled firms is coming from liberals and conservatives alike, as is the resistance. President Obama, Federal Reserve Chairman Ben S. Bernanke and other top administration officials have spoken out against nationalization, yet their comments haven't provided much reassurance to investors fearful of being wiped out by a federal takeover. That uncertainty is hampering the financial industry's recovery, potentially dragging the government -- and taxpayers -- more deeply into the mess.

The term "nationalization" calls up images of centrally planned economies and intrusive governments, but for banks and thrifts it's simply a streamlined process for resolving a bankruptcy. In 16 of the 17 seizures this year, the feds quickly sold the firm to a larger, healthier institution; the 17th was closed and its depositors reimbursed. Failed banks' shareholders lose their stakes in a takeover, and the banks' bondholders and other debt investors take at least a partial loss. The larger the bank, however, the more difficult it can be for the government to unload it; for example, the Federal Deposit Insurance Corp. had to manage the failed IndyMac Bancorp for eight months before finally selling it to a private equity group.

Another problem posed when giant banks veer toward insolvency is "systemic risk." The banks' depositors are insured up to the limits set by the FDIC, but there are no such guarantees for the investors who bought the banks' bonds or traded in their derivatives. Those investors often include other banks, insurance companies and financial firms around the globe. Forcing them to absorb billions in losses could set off a cascade of write-downs and asset sales that exacerbate the credit crunch. A case in point is the shock wave that hit the financial industry when Lehman Bros. failed, paralyzing the credit markets and sending American International Group into a costly federal receivership.

That's the main rationale that has guided the Obama and Bush administrations, which have tried to keep the largest financial institutions liquid and solvent by making multibillion-dollar investments in them (typically by buying nonvoting shares of stock). This approach has its share of problems too. First, there's something fundamentally unfair about seizing small banks but not large ones. Second, using taxpayer money to keep a bank afloat protects the investors who hold its debt, much of it in the form of speculative and opaque derivatives that have contributed to the financial industry's woes. And it's not as if those investors were naifs -- they had professional advisors. If the bank were seized, they wouldn't be so insulated from the pain. Third, the Obama and Bush administrations have required numerous banks to take the government funding so as not to stigmatize the ones that truly needed the money. As a consequence, investors have lost confidence in all of them.

Nevertheless, we don't think nationalizing the banks that have benefited most heavily from the Treasury, such as Citigroup and Bank of America, makes sense unless and until they clearly become insolvent. That's not an easy line to draw, admittedly. Some analysts argue that Citi, whose shares have lost more than 95% of their value:symbol=c;range=2y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined in the last two years, has already crossed the line and become a "zombie bank," using taxpayer dollars to stay afloat instead of lending more money to businesses and consumers. But Citi's ability to cover its bad bets is closely tied to the overall economy. How soon and how strongly the economy recovers will help determine the extent of the defaults faced not just by Citi but by every other big financial institution.

In the meantime, the Obama administration should be doing whatever it can to provide the kind of transparency and clarity that investors demand. The big firms' balance sheets are fogged by billions of dollars worth of illiquid assets, such as mortgage-backed securities and credit derivatives. Those assets make it hard for the investors who've fled financial industry stocks to know whether it's safe to return. The administration has outlined a plan for a public-private venture to buy those assets, which would clarify their value and start to remove them from the banks' books. But investors are still waiting for the details of the program, which has been delayed as the Treasury Department finished prepping a long-stalled effort to revive the credit markets for consumers and small businesses.

The funding supplied by the Treasury Department isn't just a poor substitute for private investment. The feds' involvement makes it harder for banks to sell shares. Analysts at Keefe, Bruyette & Woods, a New York investment bank, recently advised clients that the department's latest aid program would be helpful overall to banks but could sharply limit dividends paid to private shareholders and, eventually, dilute the value of their holdings. That's because the preferred shares owned by the government would automatically convert to voting shares after seven years. And simply accepting an investment from the government forces on a bank a new set of rules that reflects Congress' social goals, which don't necessarily align with the bank's profit motives.

Administration officials and lawmakers have complained loudly about federally assisted banks not making enough loans. It's just a matter of time before they start trying to influence the kinds of loans those banks make. For example, will lawmakers try to stop loans for mergers and acquisitions that wipe out thousands of jobs? That's a good example of how taxpayers' interests and an individual bank's can conflict, a problem that arises well before a bank is nationalized. Again, the solution is to bring private capital back into the banks, not public funds, and all the administration's rescue efforts should be trained on that target.