- The Washington Times - Tuesday, February 24, 2009

The federal government is negotiating a deal with Citigroup that may expand its ownership share to the point that it effectively nationalizes the nation’s third-largest bank.

The Treasury and bank regulators sought to reassure investors Monday by pledging to stand behind Citi and other major banks, outlining a new strategy of allowing banks to convert Treasury’s preferred stock in the banks to common shares. The move boosts bank capital without having to invest more taxpayer money, but also gives the government substantial ownership of the firms - raising the specter of nationalization.

The Treasury statement temporarily spurred sagging bank shares Monday morning - particularly those of Citi and Bank of America. The stock downdraft accelerated midday after the Standard & Poor’s 500 Index broke through an 11-year low set on Nov. 20 and fell to its lowest level since April 1997. The Dow Jones Industrial Average ended down nearly 251 points at 7,114, its lowest close since May 1997.

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“Nationalization is already beginning,” despite the Obama administration’s strenuous attempts to prevent the slide toward government takeover of major banks, said Joseph Brusuelas, an analyst at Moody’s Economy.com. He said none of the big money-center banks like Citi and Bank of America seems likely to pass a rigorous “stress test” that Treasury plans to impose. The negotiations with Citigroup show that the New York bank may have already accepted the likely outcome.

Negotiations with Citigroup center on whether the government will take as much as 40 percent ownership of the bank or as little as 25 percent through conversion of preferred shares into common shares. A 40 percent stake would make the government by far the bank’s largest shareholder, and most analysts consider that to be effective nationalization. Some say the government crosses that threshold at 25 percent.

For weeks, the administration and Congress have been exercising effective ownership of banks by dictating what executive compensation will be allowed and even instructing Citi not to take delivery of a corporate jet it ordered during its salad days.

“The question of whether to nationalize banks has come and gone. De facto nationalization of a portion of the banking industry is already under way,” Mr. Brusuelas said. No one but the government is willing to step forward and give the banks the money they need to survive an onslaught of rising loan problems, he said.

Britain and several other European countries already have nationalized some of their biggest banks, and the United States in September took control over three of its largest financial institutions - Fannie Mae, Freddie Mac and American International Group, once the largest insurer. But it would be unprecedented for the federal government to take over a private bank, something that did not occur even in the depths of the Great Depression when thousands of banks were failing.

If the Treasury takes effective control over a bank through conversion of its preferred stock to common stock, it would have a mixed effect on the bank’s shareholders. The value of their holdings would be diluted, but the move also would align the government’s interest closely with those of private shareholders, giving it an important stake in the survival and success of the firms.

Brian Gardner, a Washington analyst at Keefe, Bruyette & Woods, said he defines nationalization as 40 percent government ownership, but he thinks the Treasury is weeks or months away from taking over any major banks.

“Despite nationalization being all the rage on Wall Street and in the press, we think it’s significantly more difficult to implement than many appreciate and the unintended consequences are, in our opinion, daunting,” he said. “We think that nationalization is an option that the administration prefers to avoid.”

The Treasury’s joint statement with other federal bank regulators Monday said it hopes to avoid nationalization. “Because our economy functions better when financial institutions are well managed in the private sector, the strong presumption of the Capital Assistance Program is that banks should remain in private hands.”

Mr. Gardner said Treasury’s takeover of a bank would give that bank an advantage over other banks because of its access to Treasury’s deep pockets. But he said the Treasury or Federal Deposit Insurance Corp. would not be able to rebuff political pressures from Congress in running the firm.

The prospect of extensive political interference that comes with nationalization would be particularly troubling for foreign governments and investors, and might cause a backlash against the U.S. banks, he said.

Because of the large market forces that nationalization could unleash, Mr. Gardner said, he does not think the administration will make any rash moves to take over any bank. “On this matter, there are no do-overs,” he said.

Robert Eisenbeis, an economist at Cumberland Advisors, said the administration “has gotten itself trapped” in a debate on nationalization as it increases control of the sector.

“Once you have government ownership, it is hard to say that doesn’t constitute a form of nationalization,” he said. “Once the government money is in there, government can start to call the tune on policies, salaries. I think a lot of this debate is semantics.”

Mr. Eisenbeis and Princeton economist Paul Krugman, a Nobel laureate, argue that the government should shut down insolvent banking giants just as it closes smaller banks.

“The only reason [some banks] haven’t already failed is that the government is acting as a backstop, implicitly guaranteeing their obligations,” said Mr. Krugman. “But they’re zombie banks, unable to supply the credit the economy needs.”

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