Government's plan to fix banks doesn't include 'nationalization'

— -- Federal Reserve Chairman Ben Bernanke said Tuesday the government did not plan to nationalize major U.S. banks, describing instead a "public-private partnership" under which the government would recapitalize ailing institutions to bolster the financial sector, a crucial step for the economic recovery.

Bernanke, amplifying comments this month by Treasury Secretary Tim Geithner, says the plan doesn't mean nationalizing the nation's biggest banks. But others aren't so sure that the government hasn't already moved in that direction.

"It's a form of creeping nationalization," says Sen. Bob Corker, R-Tenn.

That might not be such a bad idea, others say.

"You have to go in there, take over giant institutions that are in trouble, and clean them up," says Paul Miller of FBR Capital Markets.

A big part of the discussion depends on what "nationalization" means. In the strictest sense, the government routinely nationalizes banks when they fail, as it did with IndyMac Bank last year, which cost the Federal Deposit Insurance Corp. $8.9 billion. And if the government chooses to take common stock in repayment for its bailout money, it also would get voting rights as a shareholder. In some cases, the government could be the majority shareholder — in effect, controlling the company.

To date, the Treasury has spent $196 billion to buy preferred bank stock in its Troubled Asset Relief Program, while spending billions more for American International Group and auto lenders. The Federal Reserve has vastly increased its lending facilities, including the Term Auction Facility, which offers $150 billion in secured loans to banks per auction.

The stock market — and bank stocks particularly — rallied sharply on Bernanke's description, with the Dow Jones industrial average gaining 236 points Tuesday.

The plan entails close scrutiny of the nation's 19 largest financial institutions, propping them up, and hoping to recoup taxpayer money when they return to health. It's a big, complex undertaking, and the health of the financial system depends on it.

"If we don't stabilize the financial system, we're going to founder for some time," Bernanke said Tuesday.

Completing the rescue will likely take more than the $700 billion that Congress set aside last year, President Obama warned in his speech Tuesday night.

"I can assure you that the cost of inaction will be far greater, for it could result in an economy that sputters along for not months or years, but perhaps a decade. That would be worse for our deficit, worse for business, worse for you, and worse for the next generation. And I refuse to let that happen," Obama said.

The plan

How will the government stabilize the banking system? Normally, when a bank fails, the government has two options.

In most cases, it arranges a merger with a healthy bank, sometimes taking the bank's worst loans and riskiest assets to make the merger more attractive. Sometimes, however, the government liquidates the bank outright, wiping out shareholders and paying off insured depositors. So far this year, 14 banks have failed, but only one has been an outright liquidation.

Many of the banks currently under scrutiny, however, have huge deposit bases, so an outright liquidation would be far too costly for the government. And few institutions are in the market to buy vast, troubled banks. These 19 banks have more than $5 trillion in assets combined, according to Institutional Risk Analytics, and any failures could have serious economic consequences.

The government's plan for the largest, most troubled institutions has three major steps:

•Stress test. Although the Treasury has yet to reveal the details of its stress test, it's clear that the government will take a hard look at the financial health of the 19 largest banks to see if they can survive a severe economic downturn. Bernanke said that when regulators begin conducting stress tests today, the goal won't be to issue a pass-or-fail grade. Instead, regulators will determine how much capital each bank needs from the government, if any, to give them a cushion while they restructure.

•Recapitalization. In many cases, the Treasury will get preferred or convertible preferred stock for the money it gives to banks. These shares typically don't have voting rights, possibly to give more of a hands-off appearance to the government, says Jerry Webman, chief economist for Oppenheimer Funds. In addition, preferred stock is a bit safer than common stock. Typically, common stock gets wiped out before preferred stock does, so this would give the government — and taxpayers — more protection in case of a meltdown.

•Exit. Eventually, when troubled banks are strong enough to operate without help, they can repay the government and raise private capital. "That's the end game," Bernanke said. "When private money will start coming back in. And I'm sure it will happen. The sooner, the better." There's no guarantee, but in a best-case scenario, the government could make money on its investments.

Is this nationalization?

Critics of the government's plan charge that it will, in essence, nationalize the banking system — or at least take a big step toward doing so. Bernanke went to great lengths to assure lawmakers that the Fed wasn't, in fact, planning on doing that.

"It's not nationalization, because the banks would not be wholly owned or probably not even majority owned by the government," he told the Senate Banking Committee. "The government will be a shareholder along with private shareholders."

Furthermore, Bernanke said, the government has plenty of regulatory powers over banks without exercising a vote in corporate meetings.

Skeptics abound.

Sen. Corker, for example, doesn't think that the Fed should say that liquidation is not an option. "There are lots of unintended consequences when you say upfront that the public will provide any and all capital necessary to keep them afloat," he says. "It's difficult to imagine a scenario where private-sector money returns to those institutions."

And Miller thinks that more forceful action might be needed. One proposal is a good bank/bad bank plan, in which the government would take over a bank, retain its toxic assets for later disposal, and sell off the good parts of the bank. Under that scenario, however, taxpayers would get very little return on their money, if any. "The people would end up with the bad bank," he says.

Outright nationalization might not be the worst thing for the most stressed banks, some say. Christian Menegatti, a managing editor at the economics blog RGE Monitor, calls bank takeovers the "most efficient way of cleaning up the mess in the credit markets."

And despite the government's hesitance to nationalize banks, if it ends up holding a majority stake in Citigroup, for example, it will effectively have taken over the bank, Menegatti adds.

Citigroup, the third-largest bank by assets, is in talks with the government about increasing its stake in the bank. The government already holds $45 billion of preferred shares and has agreed to share losses on $301 billion of troubled bank assets.

But one option now being discussed involves converting some of the government's preferred shares in Citigroup to common stock. This action would boost a key measure of Citigroup's financial health and could give the government the largest single stake in the bank.

At least for now, the government's caution seems to be appreciated on Wall Street. Stocks of major banks soared Tuesday. Citigroup was up 21.5%, or 46 cents, to $2.60.

Depositors' confidence is crucial and so far, the government's actions have prevented another run on the bank, as when IndyMac collapsed.

After all, the world doesn't end with Citigroup stock below $5 a share. "The real meltdown is when depositors won't keep money in the bank," Webman says.

Contributing: USA TODAY's Barbara Hagenbaugh in Washington and Kathy Chu in New York.