On 2/17/09 I wrote about the so-called "Bond Vigilantes". My belief was that market participants would beat the living daylights out of the banks, especially those considered to be the most troubled until the government does something definitive to address toxic assets (calling some of these assets is being very kind). Market participants and the Obama administration then engaged in a dangerous game of chicken. The administration had better understand that the market will not blink. It will take an institution down if it believes it to be a failed entity. Share prices of certain banks reflect this view.
The administration finally, late this afternoon, said something. Robert Gibbs, a White House spokesman stated that the administration: "continues to strongly believe that a privately held banking system is the correct way to go." Well I'm glad to hear that. Did anyone really believe that nationalization was the best way to go as a rule?
Although its is comforting to hear that the government is not ready to transform the country to a people's republic, the statement did little to satisfy the capital markets. The markets want action. They do not want mark-to-market change. They do not want positive rhetoric. They want to know what assets are on bank balance sheets, what they are expected to be worth on a long-term basis and the want to know what will be done with banks which have an over-abundance of glow in the dark assets. They want action, not talk. The market is saying DO SOMETHING! The problem is, the government does not know what to do. Buying assets at prices which reflect even long-term prospects could sink some banks. If assets could have been purchased, former Treasury Secretary Paulson would have done so last year via TARP.
As if fear of the unknown was not enough to cripple the markets, Senator Chris Dodd (Remember him? He is the guy who accepted sweetheart mortgage deals from Countrywide and, along with Congressman Barney Frank, made the suspension of FNM and FRE preferred dividends a contingent of a Treasury rescue of the GSEs) told Bloomberg News that some banks may have to be temporarily nationalized. I don't know who is dumber, Mr. Dodd or those who elected him?
I don't think Mr. Dodd is dumb because of what he said. There could be a bank which needs nationalization (government administration is more likely), but why say so during a trading day when it is the administration which makes that decision, not Mr. Dodd. Sometimes it is better that people think you a fool than to open your mouth and prove it. An unnamed source at Treasury told Bloomberg News that Secretary Geithner will announce a plan sometime next week. He next announcement had best be better than his last or he will be dealing with a financial system collapse.
The word nationalization is now in vogue. However, most people do not understand what a true nationalization entails. In true nationalization, the government seizes a an institution, manages it and guarantees its debt and counterparty obligations. This is not likely to occur. For one, it is expensive. Secondly, it creates a dangerous unintended consequence. A nationalized bank would be backed explicitly by the government. The result would be deposits guaranteed regardless of amount because the bank itself would be explicitly guaranteed. Depositors would be incentivized to withdraw their money from smaller, non-guaranteed banks (which may not be too important to fail) and move to the new nationalized bank. The possible result are bank runs and failures around the country.
More likely is some version of AIG and or the GSEs. In the case of a troubled bank, the government could converts their preferreds to common equity to increase that bank's tangible common equity (TCE) thereby diluting common shares, making them essentially worthless. The next step could be a suspension of preferred equity dividends (so much for investing along side the government). However, debt securities, including trust preferreds, could be battered, but survive. It is probably a good idea, for those who still wish to invest in troubled banks, to move up the capital structure from common or preferred equity to at least the trust preferred level. At that level, one would still participate in any business recovery, but could be more protected in a less than optimal scenario.
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