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De Facto Bank Nationalization?   April 20th, 2009
Possible administration plan for capitalization could amount to nationalization       

 
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The latest news reports suggest that the administration's possible solution to problems in the financial sector amount to de facto nationalization.

The Obama administration has a plan to continue bailing out America's banks without asking Congress for more money -- by converting its loans to common stock, and in turn taking a large ownership stake in the companies.

Though such a move could stir fears of de facto nationalization, The New York Times reported Monday that President Obama's advisers are floating the idea as way to extend the remainder of the $700 billion bank bailout fund.


The situation is that the administration feels--according to the stress tests--that some banks are still undercapitalized. The solution to that undercapitalization would be for the banks to either raise more money from the private sector or, more probably, accept more money from the government.

However, the Obama Administration knows there isn't much appetite in Congress to give more money to the banks which means the administration probably wouldn't be able to get more money to give to the banks. Their solution, then, is to convert the money the government has already loaned to the banks into common stock. Whereas previously the banks would have to eventually pay the government back (which made them uncomfortable loaning the money out), if the loans are converted into common stock then that means the banks don't have to pay the money back. That would mean the money would belong to the banks, free and clear, and the money could presumably be used to make loans.

There are two problems:
  1. The government has no guarantee it will ever get repaid. The government will own stock and will only be able to get its money back if the stock prices rise.
  2. This would amount to de facto nationalization. The government would likely get a huge amount of common stock which means it would likely have significant--or absolute--control over the bank. At the same time the control and value of existing holders of common stock would be reduced.
As I mentioned before, the scary thing is that the government can decide a bank must take money from the government if the government unilaterally determines that the bank is undercapitalized. And since the administration is now floating the idea that banks might be capitalized by converting the previously-provided money into common stock, that means the government can arbitrarily take control of any bank that it decides has failed its stress test.

In fact, this is almost exactly what I wrote about two weeks ago. I wrote: "This is speculation, but it doesn't seem that far-fetched anymore. It could be about control. Government control... I hope I'm wrong about the potential impact of these stress tests and the potential for the government to effectively take control of an even larger portion of the banking industry."

If the idea currently being floated turns out to be implemented, it looks like I was right to be worried. It seems it only took two weeks to go from "Hey, maybe it's irrational fear" to "No, it looks like it was completely rational fear."

It seems like every time we express fear about the government doing something unthinkable, the administration announces (or floats) that exact thing as their next plan. It's getting surreal.

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