Shades of Nationalization: Citi vs. AIG and Fannie Mae

As part of the ongoing bailout of Citigroup, it was recently announced that the government’s investment of about $25 billion in preferred stock would be converted to common shares, increasing the government’s ownership from 8 percent to about 36 percent. This move was designed to remove a large amount of expensive preferred stock from Citigroup’s balance sheet, shoring up the firm’s tangible common equity and hopefully calming down the continually deteriorating financial markets. As a result, the government became by far the largest shareholder of Citigroup stock, while stopping short of a full-blown “nationalization,” according to a popular view. Are we on a path to a nationalized the banking sector?

It is not a semantic technicality to say that the answer depends on the definition of “nationalization.”  The term typically stands for an action by the government where assets, companies, or entire industries are taken into public ownership. In the process, stakeholders are typically wiped out, and the government assumes all of the attendant risks and debts.

Nationalization has historically been a feature of socialist countries where the government wanted to control economies, reallocate resources, redistribute wealth or income, or to pursue certain public policies. An important feature of the nationalization is that the government intends to run companies for long periods of time, if not indefinitely. In this sense, it can be argued that happened to Fannie Mae and Freddie Mack was true nationalization. In this regard, the resignation of Freddie Mac’s CEO, David Moffett, after just six months on the job is noteworthy. “The resignation resulted partly from Mr. Moffett’s frustration over the need to consult with regulators on all major decisions and follow public-policy mandates that he didn’t necessarily see as food for the company,” according to the WSJ.

U.S. Stance So Far

In the case of U.S. banks, according to Government and Fed officials say, it is not their intention to take over these institutions and run them indefinitely, under the belief that the government can do a better job than the private sector or that such actions are needed for public policy purposes.  On the contrary, they have repeatedly affirmed their belief that properly incentivized and accountable bankers are better able to manage banks than government officials.  Therefore, too-bid-to-fail banks are likely to be taken over by the government only to prevent a Lehman Brothers’-style spillover into capital markets and real economies. Such nationalization, therefore, would be more akin to a government-led orderly liquidation. The only caveat here is a scenario where the government fails to find buyers for various parts of an institution, as it appears to be the case with AIG. In this case, the government may end up owning and running a company for a long time – a strange hybrid of nationalization and orderly liquidation, as “buy-and-hold strategy” of sorts, as aptly summarized by a WSJ headline.

The Goal: Preserve Economic Dynamism

There are benefits, uncertainties, and dilemmas related to such interventions as we have recently observed. Among the reasonable and perhaps desirable aspects is the government’s say in dividend policy, executive compensation, and accountability – the government is an important stakeholder (think of a board member) after all. The danger arises when the government gets involved in strategic decisions of financial institutions, for instance, by dictating that economic rationale should be sacrificed for the sake of public policy objectives.

The discussion on bank nationalization is part of a wide-ranging debate on the future of capitalism. Arguably, improperly incentivized and inadequately regulated animal spirits of “unfettered capitalism” must be addressed while maintaining vigilance against protectionism and overregulation. Even though, as observed by Nobel Laureate Edmund Phelps in his Foreword to Financial Darwinism, “capitalism has been disgraced in the area of its greatest competence – the knack for profitable innovation,” it remains the premier economic system whose advantages need to be continually preserved and enhanced. True nationalization impairs economic dynamism – the ability of a capitalism system to discover, finance, and bring to market viable commercial innovations. From this viewpoint, nationalization of financial institutions should be resisted at all costs.