There is a fear in America today, and it is a real one.  It is part of the reason you keep seeing destruction of value in the stock market every day.  That growing fear is the new “N” word.  That word is nationalization.  If you bank with any of the large money center banks, there is a chance that your bank will essentially be none other Uncle Sam.  But let’s forget about the scary predictions for a moment.  There is one very annoying and very pressing issue at hand.  No one seems to know what nationalization really is, at least not in practice.  We have been in discussions with more contacts than we’d like to count over this notion.  Our conclusion is rather simple: nationalization means something very different from person to person.  And nationalization may be very different from institution to institution, case by case.

We hope that nationalization does not come to pass.  After all, we are Americans who live here and rely on the same system as everyone else.  But there is a growing chance that nationalization could occur at one or more of the large money center or super-regional banks.  What is most important is what nationalization will really mean to banks…. AND TO YOU.  Here is what we think this means for the major money center banks of Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), Wells Fargo & Co. (NYSE: WFC), and J.P. Morgan Chase & Co. (NYSE: JPM).  And you better not forget about some other nationalization candidates like American International Group (NYSE: AIG), Fannie Mae (NYSE: FNM), and Freddie Mac (NYSE: FRE).

A basic dictionary definition is “to bring under the ownership or control of a nation, as industries and land.”  Wikipedia notes that nationalization “is the act of taking an industry or assets into the public ownership of a national government or state.”   Fortunately or unfortunately, if nationalization occurs, you might as well throw the most classical definitions right out the window.

Again, this fear of nationalization is a fear of nationalizing the big banks.  We put the chances of forced FDIC takeovers of many troubled small banks on the semi-regional or local level at just about 100%.  There are many smaller banks who are stretched so far that even a grand inquisitor might cringe.  We do not have the “new” Geithner, Obama, and Congressional plan yet.  But nationalization provisions seem to be there, or at least some allowances are definitely there.  After all, the FDIC can seize control of banks who are failing or are about to fail.  Is that or is that not nationalization?    Think back to a year ago.  We noted how financial mergers may come via a government mandate rather than via choice or opportunity.  Some of the “havens” turned out to be disasters, but we feel that the troubled entities were no short of mandated mergers.

And the White House and Senator Dodd have conflicting messages, both of which allow for nationalization.  As we noted earlier, the White House yesterday noted, “This administration continues to strongly believe that a privately held banking system is the correct way to go, ensuring they are regulated sufficiently by this government.”  This is not a promise of “no nationalization.”  It will offer many hope that nationalization won’t occur, but in no way is that removed as a possibility.  Senator Dodd this last week also threw in his comments that some banks might have to be nationalized for a short time.  He noted that he doesn’t welcome it at all, but notes the possibility.

A parent probably does not want to punish their kids either.  But when kids get caught in their mom’s purse or in dad’s wallet, they get grounded, spanked, or other forms of punishment are used.  Saying “I don’t want to do this” does not at all imply that it won’t happen.  There are many comments on the web that support or criticize Dodd over this.  That is to be expected.  But to tip a hand of cards like this is in complete disregard for the goodwill of the financial system.

So, you have heard of TARP, TALF, a good bank bad bank scenario, pay limits, and more.  And now you have heard the nationalization word thrown about left and right over the last week to two weeks.  But what the media is not telling you is how this will pan out nor what it would look like.  From our best measure, they are still trying to figure it out.  We have some thoughts here, but we want to stress that all of our scenarios revolve around at least some form of continuity.  If the FDIC or the Treasury just takes the seizure of banks and closing the doors with the promise of getting everyone their insured limits back, then this thought won’t even matter.  You could argue that the world would be using bullets and food rations for currency.  That is obviously more than an extreme outcome of course.  But forced seizure and subsequent closures with public auctions for everything in short order would be nothing short of pulling the pin on a grenade, not throwing it away, and just hoping for the best.

We have argued against the notion of capping pay at these institutions.  But regardless of our opinion, one thing seems almost certain: if a company is nationalized, then it is likely that even the producer-level employees will be capped in pay.  They will in turn flee to other companies willing to pay for their books of business and production.  And then the nationalized asset is going to be far less than what it would have been worth had it remained independent.

We want to address how this may pan out at various instutions and what the fallout could be.  Again, Geithner’s first round of plans is supposed to be out this week. Let’s all hope his plan has more concrete data and actual plans rather than a broad outline with no meat.  That mistake was made once already, and critics will be out for blood if that mistake is made again.  Keep in mind that right after he was confirmed and took the Treasury Secretary seat that he did stop short of saying nationalization was an impossibility.  He said everything but that, but left an out if needed.

Citigroup Inc. (NYSE: C) is the one that keeps coming up as the most likely candidate for some form of nationalization.  Its stock was down 22% Friday to $1.95.  It had been down as low as $1.61 and it traded more than 600 million shares.  Vikram Pandit probably wishes that he never took this CEO role.  It was an impossible situation.  To win, he would have had to fire over 100,000 workers.  Who wants that over their head?  But now he has started with the waves of layoffs.  He has also started carving it up into units.  And then there is the broker carve-out with Morgan Stanley.  Citi would by far be the easiest bank to nationalize.  The government could more rapidly carve up the pieces since the process has already started.  It can also jettison each unit internationally.  Those might fetch little or they could fetch a pretty penny if you started carving that out country by country.  Citi has around 12,000 offices globally.  If done properly, there is a chance that the millions of Americans and millions of foreign accounts would see little to no interruption.  Citi is not located on every street corner in America.  Many Americans have never even seen a Citi office.  There is a chance, repeat chance, that a Citi nationalization would not create a major blow to an already dented morale of America.  The chances that Uncle Sam would take this over and just shutter everything are near zero.  The tentacles go too far.  A likely outcome is that you might end up with dozens of Citi-babies as new financial entities.   Influential banking analyst Meredith Whitney just said it was “still a sell” on Thursday.  Our outlook for who gets nailed in the line of security holders would not just be at the common stock level.  A wipe out here would likely extend up into the preferred stock and would likely carry over into the the face value of some of the debt.  It would also come with a long drawn out process as many of the units will just take forever to carve out.

Bank of America Corp. (NYSE: BAC) fell 3.6% to $3.79 Friday.  But this is only a fraction of the picture.  The stock traded as low as $2.53.  There was a real fear that nationalization would come here as well.  But Ken Lewis issued a statement calling nationalization fears just not factual and not at all in understanding of the business.  He has also said recently that he has never had any nationalization talks.  B of A has been hurt by the takeover of Countrywide.  But the takeover of Merrill Lynch did the most damage here.  It absorbed many more bad assets, and it took on a personnel challenge from hell here.  Countrywide did not create the infighting employee relations, but many of the B of A brokers feel betrayed by what Merrill Lynch workers got.  Many Merrill team members on the producing level got retention packages and payouts, while the B of A producer-level members got deferred pay compensation packages and all of their stock is so far out of the money that they could wallpaper their houses with them.  But an outright nationalization at Bank of America is a scary notion with or without all of the internal issues.  It has something to tune of 11% of the deposits under FDIC control.  Other acquisitions have been FleetBoston, MBNA, USTrust, and the ABN AMRO LaSalle assets in the U.S.  Before the Merrill Lynch deal, it had almost 60 million consumer and business relationships.  It also had more than 6,100 retail banking offices and more than 18,500 ATMs.  Uncle Sam would be crazy to just walk in one day and swipe this bank with the hopes of sorting everything out.  The fallout would be a catastrophe and a psychological damage to a huge portion of America.  With all the branches it has, imagine the panic that would be created if everyone going by a B of A branch saw lines and lines of customers trying to get their money out.  If Uncle Sam wants to nationalize any part of B of A here, it better be using kid gloves and it better be handled with tender loving care and only in certain units.  A forced seizure here after it has been given the backing and endorsement by Treasury mixed with how large it is would be a crushing blow.  Yesterday Dick Bove on CNBC said that nationalization here was just not possible if you consider the size of the liabilities already on the government balance sheet.  While he endorsed it, Jim Cramer said it was reckless to call a buy in the stock but said if you really want to own it you should do so via the preferred shares.  We feel that a nationalization even in the slightest form would wipe out the common stock holders.  The good news is that the preferred stocks should at least be mostly made whole, and the debt holders would be made whole.  If any of these banks are TBTF (too big to fail), we think Uncle Sam better think more than twice or thrice about this one.

Wells Fargo & Co. (NYSE: WFC) is the wild card here in the group and perhaps the one we have the least amount of conviction on either way.  We think that because the FDIC was taking down Wachovia and that Wells Fargo prevailed over a Citigroup takeover that Uncle Sam has some duty here.  If you speak with any  pundits, you can find an equal number of lovers and haters among the lot.  Its stock fell  9.2% to $10.91 Friday, but it got as low as $8.81 during the day.  It has many of the same fears as B of A, but so far its stock has been punished far less.  It has a huge footprint now with over 11,000 retail locations and over 12,000 ATM’s.  One asset that it did get was the old A.G.Edwards unit which Wachovia bought before its mudslide started.  Warren Buffett may endorse B of A with a small stake, but heowns a slug of Wells Fargo at the Berkshire Hathaway Inc. (NYSE: BRK-A) level and even in his personal account. What does 290 million shares tell you for a Buffett endorsement? We think that Buffett could come to the rescue here if it really comes close to that point.  He could then carve out what he wanted and either sell the unwanted parts or spin them off. The credit ratings agencies would take yet another significant blow if a nationalization took place here, although by now you are probably as used to bashing them as we are.  Wachovia was supposed to be the bank riddled with those pay option ARMs in its mortgage portfolio, but the odds of Uncle Sam swiping this one just seem out of touch with philosophy.

Unless there is something out there that no one publicly knows, J.P. Morgan Chase & Co. (NYSE: JPM) is under almost no nationalization risk.  Jamie Dimon even has said over and over how Uncle Sam essentially forced that TARP money on him.  He has said over and over how he wants to pay that TARP money back.  Barney Frank has even said that he’d try to pursue remedies to allow banks to give this money back if they could.  We would suggest that Dimon starts trying to write the checks to at least start paying this back.  He can hold a press conference about how he is trying to pay it down and they won’t let him.  The public would rally behind him.  Or so we think.  But we think that in any nationalization scenario at any of the big banks, J.P.Morgan will be the biggest winner of the lot.  It has problems, but it still has some of the highest credit core metrics for its banking customers.  Its stock was down 3.4% to $19.90 Friday.  That is still above the $17.70 low of the last year and right around the lows of 2002.  The WaMu (and therefore the Providian unit) brought on added pressure here, but the current belief on Wall Street is that Jamie Dimon’s books were so clean before that merger that there is little risk here.  If a nationalization occurs at any of of the money center banks, we really feel that the good accounts will instantly go open up accounts here.  It becomes the de-facto safe harbor if nationalization occurs at any of the large money center banks.

American International Group, Inc. (NYSE: AIG) is not a bank.  But they are so far in debt to Uncle Sam now that we could argue they are as close to nationalization as one could get.  So many units are for sale and have already been cleaved off that many do not even know what the company’s business model will be ahead.  The government already diluted shareholders by about 80% for what it holds over AIG now.  We think the only reason this has not been just shut down is because the systematic effect of all the insurance policies being suddenly wiped out and the counter-party failures that would result.  States would not be able to cover all the policies and past transactions with just about every major institution would be entirely wiped out rather than just a huge portion of the face value.  And Uncle Sam does not want to have to put the entirety of the liabilities on the public balance sheet.  AIG’s stock at $0.54 represents nothing more than a warrant.  It is not even a call option.  This is a price that represents a way out of the money option with no expiration that has major upside if the financial meltdown suddenly stops melting.  Just like Lester Moore’s tombstone in Tombstone.  “Here Lies Lester Moore. Four Slugs from a 44. NO LES, NO MORE.”  We already see negative value in the equity, so any nationalization here or forced seizures would likely go deep into the ranks up the ladder of creditors.

And what about Fannie Mae (NYSE: FNM) at $0.52 and Freddie Mac (NYSE: FRE) at $0.52?  The Les Moore analogy of the warrants or the embedded way out of the money call option case is in effect here every bit as much.  Alan Greenspan already called for these to be partially nationalized last year.   The play here was to carve these up into five to ten entities and then sell them back to the market.  Frankly, these companies have already or always been thought of as under the wing of Uncle Sam.  After all, the government sponsored entity (GSE) status was supposed to mean something.  We have yet to find a single person out there who currently believes that these are viable entities on their own today without the aid of Uncle Sam.  The current mortgage relief will likely help stave off some fears here, but anyone buying these GSE stocks better be using pure risk-based capital and better understand that these might already be on the list. We already see no equity value, so any formal seizure and nationalization would have to come at the expense of preferred holders and at the expense of debt holders.  As the balance sheets are a mystery, we cannot even give any quantified guess on how deep the pain would go up the credit ladder here.  Just assume it is “very far up the ladder.”

We can easily make an argument on both sides here for and against nationalization.  It can be argued that it will almost instantly save the entire system.  It would be at a massive cost and the pain will be sharp and real.  We could also argue at the same time that this would officially allow our U.N. charter name abbreviation of U.S.A. to the “U.S.S.A.” abbreviation.

Again, we are not trying to scare anyone here nor are we trying to dictate policies.  We obviously hope there is no formal nationalization of the big money center banks.  We DO expect bank seizures to occur at the local and semi-regional level.  Some banks just drank too much punch at the party.  Those will see outright closures in many cases and public auction may be held or could end up being held under whatever the new RTC entity ends up being.  It is shocking to us that the variation of “OK, well what happens if one of the major institutions gets nationalized?” is so wide.  We have yet to see much of this in public presentations.  Perhaps that is why no one really knows what to say or what to think.  Government policy is something that we do not think the government itself has a full grasp of yet.  That is what happens in transition periods.

Here is the best case for equity holders that the government could make.  Geithner could come out and talk about the currently funded banks not at all being in danger of imminent nationalization.  Geithner could even lay out the plan that they could be nationalized in certain cases down the road but not unilaterally and that nothing of the sort is under plan.  Until we have whatever the “stress test” conditions are, then this is just unfinished business.  Geithner could also have some sort of allowance for some relaxation of a mark to market policy as long as cash flows or temporary restrictions are used.  It will also be a tough sell to just go takeover the large banks.  After all of the fighting that took place over the TARP money even going to the banks would all be for waste if Uncle Sam started nationalizing those institutions it tried to save.  And now the cold shower case… the government probably won’t care what the best case is for the stocks.  Nor for the stock market.

Jon C. Ogg
February 21, 2009

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