[Pen-l] Three Reasons Why Investors Should Worry About Bank Nationalization

[Charles Brown <cdb1003@xxxxxxxxxxx>]

Three Reasons Why Investors Should Worry About Bank Nationalization 4Âcomments
by: Martin Hutchinson March 01, 2009 |ÂÂÂÂÂÂ

http://seekingalpha.com/article/123394-three-reasons-why-investors-should-worry-about-bank-nationalization?source=article_lb_articles
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Itâs a tough time to be a bank shareholder. Youâre not just worrying about whether the ongoing recession or a further lurch downwards in housing prices is going to 
decimate the value of your bankâs loan portfolio. Youâre also worrying about whether some government âstress testâ or â worse still â nationalization is going to 
destroy most or all of your investmentâs remaining value.
And finally, if youâre smart, youâre worrying about whether some cockamamie government loan scheme is going to artificially force down the nice juicy interest
Âmargins your bank is earning on the new loans it makes.
Clearly, when it comes to bank nationalization, thereâs more to be worried about than most investors realize.

Reason No. 1: Nationalization Distorts the Marketplace
Letâs start by just talking about nationalization in general.
ÂIf youâre a shareholder in one of the banks I christened âzombiesâ last week, then youâve probably already lost 90% of your investment. Youâre also not getting 
any significant dividends, nor are you likely to get any for at least a couple of years. In a truly free market situation you would already have been wiped out â your bank
Âis only still in existence thanks to the money it raised from last Octoberâs âTroubled Assets Relief Programâ (TARP) preferred-stock sale.
Full nationalization â giving the government 100% of the bank â 
would wipe you out altogether; by giving the bank the chance to turn itself around, you may be able to keep some small portion of your shareholding.
Thus, bank nationalization is not just a threat to shareholders 
of the âzombieâ banks that are likely to be the ones nationalized. It is also a threat to the shareholders of healthier banks that will not be nationalized.
To understand just why this is true, we first must understand some banking business basics.

Reason No. 2: Nationalization Creates Artificial Support
The banking business grew to absorb too much of the nationâs 
output, and now needs to shrink back to its traditional role. The economically healthiest way for that to happen would be for several banks â the zombies â to go out of
Âbusiness. That would give new market space for all the other banks, allowing them to get new business from ex-zombie bank clients and to take advantage of reduced competition by fattening lending margins.
However, banks whose lives are artificially prolonged will get in 
the way of that healthy development; they soak up good business to pay back the government, or absorb yet more of their losses, and they prevent loan margins from rising to their new competitive level, making it more difficult for healthy banks to pay for the losses on their
Âown past mistakes.
In other words, if youâre a shareholder in a healthy bank you should 
object to bank nationalization. Your ideal would be for the sick behemoths to get out of the way and give you more customers and better margins. Nationalization is a particular danger, because the nationalized banks will be forced to increase lending volumes artificially, making 
their competitorsâ lives even more difficult.
Even more threatening to a healthy bank shareholder, however, 
would be a new government lending institution, as proposed in U.S. President Barack Obamaâs speech Tuesday night. While that institution might be very slow in getting organized and not a particularly intelligent competitor once it did, it would be able to use the resources 
of the Federal government to make credit-card loans, automobile loans and mortgage loans at subsidized rates.
Bank shareholders can hope that it would have a heavy social objective component, concentrating on those borrowers who are âleft outâ by the banking system. In 
that case, it would merely take away customers the banks didnât really want, scooping up all the high-risk business for itself.
However, if this new government-backed lender concentrated on
Âmaking regular loans, competing with the banks on the theory that lending had âseized up,â it would decimate industry lending margins.
Economically, that would prolong the recession as convalescent
Âbanks found it more difficult to absorb past losses and become fully healthy again. As a bank shareholder, it would use your own taxpayer money to depress artificially your returns as bank shareholder. A truly lousy idea, in other words!


Reason No. 3: Stressed Testing Could Overstress Weak Players
Finally, thereâs âstress testing.â The Top 19 U.S. banks, presumably 
including Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), will be stress-tested over the next couple of months, to see how much money they might lose in
Âa âworst-caseâ recession, in which house prices drop another 25% and growth is minus 3% in 2009 and plus 0.5% in 2010.
This is a generally sensible proposal: If executed correctly, this stress-testing will enable the government to identify the clear âzombiesâ that require immediate recapitalization,
Âand to also hopefully determine which banks among the so-called âwalking woundedâ must have government capital, and which ones can survive on their own.
The problem is that the âstress testâ may be too severe, particularly
Âif it requires banks to be fully capitalized even after stress has been applied. A further 25% drop in house prices is a very severe assumption; house prices are already
Âclose to their long-term equilibrium in terms of their ratio to earnings, so a 25% further drop would imply a âbear marketâ similar to that in stocks. That seems unlikely; the traditional level of U.S. house prices was a rather smaller multiple of earnings than in most other 
industrial economies, so a sustained drop below that level should meet with an upsurge of new demand from renters who could now afford homes.
Conversely, we have really no idea what effect a further 25% drop in house prices â almost 50% from the peak â would have on mortgage delinquencies. The only previous
Âsuch event was during the Great Depression, when the mortgage market was far less developed. Stress testers, being cautious, will make assumptions about this that will probably be much too pessimistic.
A stress test that is too severe will force even healthy banks into 
further government shareholdings. Those shareholdings will initially be non-voting preference shares, but will be convertible into common shares at a 10% discount to the stock prices of Feb. 9 â i.e. at an already depressed level that will dilute common shareholders. 
They will also be accompanied by restrictions on bonuses, which will disrupt even regional banksâ activities in areas such as foreign exchange and bond trading, and by restrictions on dividends, which will slash shareholdersâ income and probably make share prices vulnerable.
Shareholders in healthy banks should thus hope that the governmentâs
Âattention is turned away from the banking sector as soon as possible. As a result of the current flurry of policies, investors can see one clear disaster (the government lending 
program), one significant problem (nationalization of the zombies), and one huge uncertainty (stress testing).
If the recession isnât already keeping investors awake at night, the government actions certainly will â
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