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Financial Crisis Watch February 25, 2009, 6:15PM EST

Bank Nationalization: Who Would Bear the Pain?

Bank bondholders have gotten off easy so far. Government takeovers of companies like Citigroup and Bank of America might change that

By Peter Coy

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The question of whether big, weak banks such as Citigroup (C) and Bank of America (BAC) should be nationalized is dividing the nation right up to the highest realms of finance. On Feb. 18 the Financial Times quoted former Federal Reserve Chairman Alan Greenspan as saying that temporary nationalization of some banks "may be necessary." Six days later his successor, Ben Bernanke, told Congress that nationalization "just isn't necessary." At that bank stocks zoomed 13%.

The truth is, nationalization is not a painless cure for unhealthy banks. It could get both expensive and messy. But it may nevertheless be the right solution for one or more of the biggest, most vulnerable institutions. The reason is simple: The U.S. economy continues to spiral downward despite nearly two years' worth of half-measures aimed at propping up the status quo. Extreme actions are needed to fix the financial system. It could turn out that such steps can be taken only via nationalization. That would give the federal government power to negotiate—and, if necessary, force—a workable solution for all of the important players.

The Real Debate

The key to understanding the nationalization debate is to focus on who will bear the pain of bank restructuring: Will it be mostly taxpayers and common shareholders, as it has been so far? Or will the pain be shared by preferred shareholders and even some classes of creditors, ranging from foreign bondholders to other banks to the counterparties of exotic derivative contracts?

Other nationalization issues generate heat but are distractions. You can safely ignore the controversy over whether the government will spend a lot of money to support nationalized banks; taxpayers are already spending billions, with or without nationalization. Likewise, while the risk that the government could interfere in lending decisions is valid, it's avoidable, especially if the bank is quickly reprivatized. Besides, regulators and Congress are already micromanaging their wards. Just ask Citigroup CEO Vikram S. Pandit or Bank of America CEO Kenneth D. Lewis.

Japan's experience during its low-growth "lost decade" of the 1990s, when it propped up zombie banks rather than decisively fixing them, is a cautionary tale for the U.S. A big reason Tokyo resisted drastic, costly measures was an ongoing backlash from resentful Japanese taxpayers. The twin lessons from Japan, then, are to act swiftly and to earn the public's support by convincing taxpayers that they're not being forced to shoulder an unfair share of the burden.

So how should the burdens be shifted in the U.S., if at all? Well, creditors of weak banks have been largely spared to date. The political question—and let's face it, nationalization is a political issue as much as an economic one—is whether that favored treatment can or should continue. Big bondholders are getting nervous that the tide of opinion is turning against them. Kathleen C. Gaffney, who is co-manager of the Loomis Sayles Bond Fund (LSBDX), says it's fair enough for stockholders to lose in a bank rescue because "stockholders know the risk." In contrast, she argues, "bondholders expect to at least get a return of their principal." Likewise, Joshua S. Siegel, managing principal of New York-based StoneCastle Partners, a private equity firm that invests in banks, says forcing bank creditors to take a haircut "would be rewriting the laws of commerce. The capital markets would collapse, because who would ever again buy debt in any company that's regulated?"

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