The Beleaguered Banks Get Ready for Their Big Test

Bank nationalization is the phrase on everyone's lips at the moment — with Alan Greenspan, Chris Dodd and Paul Krugman among the leading lights of the unlikely coalition in favor of it, and members of the Obama Administration repeatedly denying that it's in their plans. It's a misleading debate, though, given that the U.S. banking system was effectively nationalized on Oct. 13, when then Treasury Secretary Henry Paulson called the heads of the country's nine biggest banks into his office and told them they couldn't leave the room before agreeing to sell shares to the government.

What's happening now is really better described as a sorting out. The big banks in the most trouble are going to have to accept ever greater government ownership and control of their affairs. The ones in the least trouble are going to try to run away from the feds as fast as they can. (See 25 people to blame for the financial crisis.)

At the head of the former line is beleaguered giant Citigroup, which is currently negotiating with the Treasury Department to swap common stock in the company for some of the $45 billion in preferred stock that the government has purchased so far to shore up the bank's finances. The advantages for Citi are that it wouldn't have to pay dividends on the common stock, and certain capital ratios would improve. In return, the government would get more of an upside if Citi were to return to health, plus effective control of the company. Whether the government's stake would rise to the 100% that many economists recommend — completely wiping out existing shareholders — is questionable. But Citi does seem inexorably headed for the same ward-of-the-state status currently occupied by insurer AIG and mortgage giants Fannie Mae and Freddie Mac.

At the opposite end of the spectrum is the still reasonably healthy JPMorgan Chase, which announced Monday that it is slashing its dividend 87% — in part, said CEO Jamie Dimon, to enable it to buy back as quickly as possible the $25 billion in preferred shares the government purchased from the company in October. That would free JPMorgan from government-imposed pay limits and other pressure from Washington and allow its shareholders to profit more fully from a financial rebound. (Read "How to Know When the Economy Is Turning Up.")

The big questions involve what happens to everybody in between. The various federal banking agencies on Monday announced the procedures by which they will convert preferred shares to common stock at troubled banks, and later this week they will begin the promised "stress tests" of the assets of the country's 20 biggest banks. But nobody knows yet how tough those tests will be — and to be honest, nobody knows how tough they should be.

If banks were to be simply judged for their liquidation value — what they could get for selling off their assets on the open market today — most major financial institutions in the U.S. would be determined insolvent and due for government takeover. But that isn't the standard by which banks are judged. If it were, most of the country's big banks would have been nationalized in the early 1990s.

In a financial panic, markets for certain assets simply stop functioning, and relying on market prices to determine the health of banks would simply mean succumbing to the panic. Then again, relying on bank executives to accurately price their own assets is no good either. Treasury Secretary Tim Geithner hopes to get around this by jump-starting a market for troubled mortgage securities, but he hasn't decided yet how exactly to do that. For the moment, determining the health of banks remains a government judgment call.

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Read "Why Your Bank Is Broke."