Commentary

Feds Scheme to Nationalize Citigroup

It’s round three in the federal government’s fight to save Citigroup. Last weekend, officials from the Obama administration and Citigroup discussed the possibility of expanding the government’s ownership stake in the troubled banking giant by converting existing preferred shares into common stock. This development makes the question of nationalizing large, troubled commercial banks a matter of semantics – it’s inevitable. In this piece I will offer my view with regard to the government’s motives. I will also discuss what I consider to be the core issues: the protection of taxpayer investments, the potential for undermining competition in the financial services industry, and the risk of political meddling in the allocation of loans.

The federal government is already exerting its will over the Citigroup’s affairs, ordering the disposal of subsidiaries, restructuring its board, reinstalling proper risk controls and capping executive pay and perks. As I mentioned in my opening statement, the increase in ownership as defined by the percentage of common shares held is just a talking point – the government already calls the shots at Citigroup.

In my view, the apparent goal behind the government’s conversion of preferred shares to common equity is to allow Citigroup to pass a newly minted “stress test” for the 20 largest U.S. commercial banks. The ones that come up short will be forced to raise capital from private investors, and if that fails – which it undoubtedly will – they will have to accept government funds. If Citigroup swaps the government’s preferred shares to common stock, its capital base – and perceived financial health – will increase significantly. The bank will be deemed healthy due to a substantial infusion of equity capital, and both creditors and depositors will be relieved. And, shareholders will sense calm in knowing that although their ownership stake will decrease, Citigroup will not be allowed to fail.

Should Citigroup’s recent request for increasing government ownership become a model for saving the financial services industry, other troubled banks will rush to convert government preferred shares into common stock as well – which will be recorded as equity and not debt on their balance sheets. The increase in common equity – from the feds – is designed to put banks on firmer financial ground, increasing their capital cushions and calming nervous depositors, creditors and investors around the globe.

If these preliminary discussions turn into concrete action, the government could increase its stake in Citigroup to 40 percent. This would expose the taxpayer to greater risk because owners of common shares will be wiped out in the event of bankruptcy, and the preferred stock dividend would no longer be paid to the U.S. Treasury. (Under the original arrangement, the government was set to receive $2.25 billion a year in dividend payments through the purchase of preferred shares, which are higher on the pecking order than common stock, and thus less risky.)

The problems with even the “stealth” nationalization proceeding from the ranks of the U.S. Treasury lie in the unfair competitive advantages that come with federal ownership and financial guarantees, and the political meddling that will surely follow – just as night follows day, and prolonged economic busts dawn after extended credit booms.

Banks that have Uncle Sam listed as majority owner and guarantor will drive private deposits and investment away from weaker rivals that do not share this privileged position. Larger, state-supported competitors will devour the struggling banks, or they will eventually fold under the weight of bad loans. The result will be less competition and therefore fewer, but more expensive financial service options for the public in the years ahead.

Political interference is also a major concern if increased government ownership of distressed commercial banks is indeed the road chosen to arrive at a healthy financial system. Political pressure helped expand the loan books of Fannie Mae and Freddie Mac, the two GSEs (Government Sponsored Entities) that imploded last year – and are now majority-owned by the taxpayer. Both companies continue to lose mountains of cash on souring mortgages, and will take years and many more billions to recover from decades of lax oversight and political interference.

The government should take the steps necessary to restore major banks to financial health. If this means shoring up capital bases through majority equity stakes, so be it. They should also lay out a clear plan that will lead to a transparent and efficient mechanism that will dispose of toxic assets (no more opaque mumblings from camera shy Treasury secretaries on such a crucial subject.)

As I mentioned in my piece last week, in the aftermath of the abrupt end to the largest credit boom in history, banks need not only time and money to heel, they need to engage in sound business practices that will restore them to health. The government must move away from economic stimulus toward measures that promote long-term financial stability. The U.S. Treasury and the Federal Reserve should help banks dispose of toxic assets and restructure existing loans in a way that will benefit their customers, creditors and shareholders. This means attracting deposits from customers, not cramming unnecessary credit offers in millions of mailboxes. And, the potential demise of competition in the financial services industry and the risk of political interference should not be ignored during this period of economic distress. Nationalization of the banking system is already occurring, it’s now time to manage the consequences and stop bickering over semantics.

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