Bank Nationalization: The Moment of Truth Approaches

Posted by: Michael Mandel on February 27

This morning’s Citi announcement puts us one step closer to the moment of truth for the U.S. financial system. The key is not whether to nationalize or not—the government has made it clear that it will do whatever it takes to keep Citi and the other large banks afloat.

The real question: Who will have to take the hit? I can’t do any better than Peter Coy’s story here).

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?

I think this morning’s announcement effectively puts the arm on the preferred stock holders (such as the Government of Singapore Investment Corporation, and as the Citi press release puts it, “HRH Prince Alwaleed Bin Talal Bin Abdulaziz Alsaud” ) by forcing them to exchange their preferred stock for common, which now no longer pays a dividend. They have now absorbed some of the hit.

But Citi is still on the hook for $359 billion in long-term bonds (as of the end of the fourth quarter). In addition, Citi has the obligation to pay derivative counterparties an unknown and potentially huge amount, depending on how bad the economy gets.

So the government is now faced with two choices—to commit the taxpayer to make good on all of Citi’s risky bets, or to force some of these folks, the bondholders and the counterparties, to accept a big haircut.

There are no other alternatives. The bankruptcy option is out, because no one wants another Lehman. So it’s either door number 1 or door number 2.

Because many of these bondholders and derivative counterparties are outside the U.S., it’s also going to be a phenomenonal foreign policy mess. How does the U.S.—the richest country in the world and now the effective owner of Citi—say that it can’t pay back its debts?

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Reader Comments

Viking

February 27, 2009 03:34 PM

So,Mike do you now see the pandoras box we created when we started bailing out the banks?When these foreign investors and others,made their investments,no government guarantee was implied at that time.These investors understood their place in the capital structure of the company and would have gotten their deminished share of the pie in a bankrupcy proceeding along with everyone else.The problem occurs when the government gets involved and start picking winners and losers.So as your last sentence implies,if the government had stayed on the sideline and protected depositors only,the question of whether we as a country will pay our debt,would not have come up in this case.

Rycoka

February 27, 2009 06:20 PM

I think there is another option. Lehman Bros bankruptcy was rendered a disaster by the derivates exposures. Could not governments intervene in the derivatives market (freezing derivatives trades and exposures) rather than intervene at a corporate level. This would have the benefit of allowing those corporations that have made poor judgements to go bankrupt while preventing the systemic collapse promised by derivatives.

Viking

February 27, 2009 09:09 PM

Rycoka,you are correct that we could have done a number of things,such as you suggest,to prevent systemic failure,but that would have allowed Lehman Bros to go bankrupt.Some say that the FDIC is not large enough to handle a takeover of a CITI,but if you would pump even 30% of all the bailout money into the FDIC that we have spend so far,it would probable be able to handle it and allow an orderly liquidation or restructuring,while protecting depositors.We are on a slippery slope now,where we are in the process of bailing out people and corporations,who took excessive risk,while we are punishing the prudent people,who lived within their means,because the government is taking their taxes to bail out the risk takers.This will have profound implications for our future and not for the better!!

Joe Cushing

February 28, 2009 08:54 AM

Maybe we should jsut hand it over to the bond holders.

Joe Cushing

February 28, 2009 08:54 AM

Maybe we should just hand Citi over to the bond holders.

Steve Hemingway

March 13, 2009 06:43 PM

HRH Prince Alwaleed Bin Talal Bin Abdulaziz Alsaud is the ideal person to own and run Citi. He could hardly do a worse job at it than Prince or Pandit. He has enough money to pay for some competent managers. This would solve the problem of the embarrassment of the US govt. having to welsh on its obligations to foreigners.

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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