Doubts rising over plan to fix banks

Mr. Bernanke last week rejected the word “zombie” to describe some of the largest banks. He described Citigroup, whose stock price fell to $1 per share last Friday, as “under stress,” but said it could restructure without requiring a government takeover.

Geithner, too, has emphasized that he hopes to avoid temporary nationalization of large institutions, for restructuring.

By contrast, that’s exactly what Mr. Hoenig urged in his speech. It’s a sharp debate.

Drawbacks of nationalization

In the views of Bernanke and Geithner, the nationalization of a large firm would be a slow and costly process – and one that would probably shake markets with uncertainty, as occurred when the investment bank Lehman Brothers entered bankruptcy last September.

Critics of this view say the market panics have been caused by inconsistent US policies and the resulting uncertainty.

In fact, Hoenig cited the standard used during the Great Depression as a successful model. Regulators took over insolvent institutions, restructured them, and reprivatized the operations.

Key to resolving the credit crisis is getting an accurate sense of the weakness of banks. Many economists are skeptical that the assessments now in progress, which Geithner hopes to finish by April, will settle that question. They worry that the test will not be stringent enough, that the needed capital infusions may be delayed as the Obama administration tries to hold to a minimum politically unpopular requests for rescue money.

If that’s what happens, the result could be a more protracted crisis, as investors remain uncertain about the health of big banks.

The crisis can best be resolved by making sure that banks become convincingly well capitalized as soon as possible, says Pete Kyle, a finance professor at the University of Maryland. The Geithner plan, he notes, provides for a six-month window in which banks can try to raise needed capital – too long in Mr. Kyle’s estimation.

Some capital may not need to come from taxpayers at all. By forcing holders of debt in weak banks to convert their investment into common equity – considered the strongest form of capital – capital positions could be strengthened.

How to divvy up banks’ losses?

No move comes without costs, since it’s all about different ways to divvy up big financial losses. Any shift in policy could rattle financial markets.

But already, creditors have taken a hit at some banks, and the price of large-bank debt appears to reflect the expectation that this could happen more frequently, even though this is not part of Geithner’s official plan.

At this point, even the nationalization of a large bank might not faze investors, if it were perceived as part of a clear and consistent policy.

“We think investors would ultimately respond more favorably if the US government seized [troubled] assets rather than purchased them,” Richard Bernstein, chief investment strategist at Merrill Lynch, wrote in a recent note to clients.

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