In September 2008, Hank Paulson, Ben Bernanke and Tim Geithner made a colossal, almost fatal mistake when they let Lehman Brothers fail; apparently Paulson & Co. didn’t want to be viewed as “bailing out shareholders.” The result of their folly was that the world financial system ceased operating. In November, Paulson refused to make the same mistake twice when the Treasury took action in the Citibank matter. Subsequently, he said that no systemically important financial institution would henceforth be allowed to fail. That was smart and appropriate. The market recovered a bit from the lows just before Citibank’s November rescue, but now we’re back to those levels. The reason, in our opinion, is largely political.

We thought that the government had learned from its mistakes. Articles like this make we fear that we were wrong (and the folly extends to Republicans as well as Democrats). FT:

Nationalisation, long regarded in Washington as a folly of Europeans, is gaining rapid ground among US opinion-formers…Lindsey Graham, a Republican senator for South Carolina, said that many of his colleagues, including John McCain, the defeated presidential candidate, agreed with his view that nationalisation of some banks should be “on the table”…

Barack Obama, the president, who has tried to avoid panicking lawmakers and markets by entertaining the idea, has recently moved more towards what he calls the “Swedish model” -– an approach backed strongly by Mr Graham…

Mr Obama made it clear last week that he favoured this model over the piecemeal approach taken in Japan, which many would argue is the direction US public policy appears to be heading. “They [the Japanese] sort of papered things over,” Mr Obama said. “They never really bit the bullet . . . and so you never got credit flowing the way it should have, and the bad assets in their system just corroded the economy for a long period of time.”

Senior administration officials acknowledge that the financial rescue plan unveiled by Tim Geithner, Treasury secretary, last week could result in the temporary nationalisation of some weak banks.

Here’s what we fear: that the awful performance of Tim Geithner before Congress last week was due to unresolved policy differences within the administration, perhaps most importantly the nationalization issue. In our scenario, that’s why Geithner had nothing new or substantive to say in his testimony. In our nightmare, those in positions of political influence within the Obama administration, who approve of bailing out governments and the imprudent amongst us, are dead-set against anything that might “bail out” stockholders. Here’s what will likely transpire if they win the argument: Armageddon.

In theory, we suppose there’s nothing wrong with the notion of wiping out shareholders in banks that, by a mark-to-market accounting, are technically insolvent today. The problem is that we live in a world other than the world of theory.

In our view, what can potentially happen in the real world following the nationalization of, say, a Citibank, is the wholesale destruction of entire segments of the world’s equity markets. We have previously described how this destructive circle works. The hedge funds or others (who can short stocks, buy puts, and manipulate CDS prices) create a vicious, self-reinforcing cycle with the media and the ratings agencies that can drive a common stock to zero. They can do this to company after company; it is particularly easy with institutions that are leveraged. (The vicious cycle has already gone pretty far with Citibank, with its CDS’s reaching record highs, the stock reaching record lows, and the media hype substantial.)

The destruction would start with banks (as it has with Citibank now below its November bailout lows), move on to insurance companies (as it is now doing), and continue to industrial companies with large finance subsidiaries (GE traded below $10 today). In our view it would be preferable for the Fed or Treasury to buy as much zero dividend preferred stock as is necessary in financial companies to avoid the self-inflicted catastrophe that would come with nationalization. Nationalization could be, in our opinion, the folly that could trigger a wholly unnecessary new Great Depression.

This is possibly the gloomiest piece ever posted on this site. We hope we’re wrong. Even more than that, we hope this nationalization talk is taken off the table so we don’t ever find out.

This entry was posted on Friday, February 20th, 2009 at 1:50 am and is filed under business, Democrats, General, Republicans. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.