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The Fine Print of Nationalization

By Larry Doyle on February 23, 2009 at 3:10 PM in Bank Nationalization, Banking Institutions, Current Affairs, Economy

fine-printMany leading economists and market mavens are calling for the formal nationalization of certain banking institutions in our country. There are numerous arguments for and against nationalization. While many of these arguments are philosophical in nature, perhaps it is the fine print in CDS (credit derivatives) contracts that are the major hurdle.

In a communication with a European derivatives expert this morning, I received some truly enlightening color on this fine print. From what is being shared with me, the contractual agreement embodied in standard CDS transactions addresses the nationalization topic. What occurs?

Nationalization of an institution serves as a “trigger” event for detonating the CDS counterparty market. Cross default provisions in the holding company indentures would likely bring about the bankruptcy of hundreds of billions of dollars of holding company debt which in and of itself would probably have a a systemic impact on the global finance market. (Cross default provisions mean that a holding company of a bank is responsible for the obligations of its’ subsidiaries.)

What does that mean? Effectively, the formal full blown nationalization of a banking institution would serve as a trigger to cause a domino effect throughout the global markets. As one bank holding company defaults on its debt obligations it will cause its’ counterparties to default as well and right on down the line. I am not a derivatives expert, but if in fact this is the case then we will likely see prolonged government intervention into distressed banks in the form of public-private partnerships.

I do not think that is a healthy arrangement nor one that promotes long term growth. That said, the global markets may not have any other alternatives.

I will be watching and writing.

LD

  • ownaa

    correct me if I am wrong, but is it not nationalization of a bank or a company means that the gov. ie the public OWNs it? so what is this talk about share holders and stocks paying their debts and all that stuff. The way I keep hearing about it in the news looks to me like bail out not nationlization.

    • Larry Doyle

      If the government takes ownership the information I was provided indicates to me that that event would serve to trigger a default on its debt obligations which would create a domino effect across a number of other banking institutions.

      In short, this piece is indicating that the banks are effectively all intertwined in this mess. If one gets taken over it serves to have others go down.

      As a result, the govt will likely take large stakes but not majority stakes in banks.

      As a result, economic growth slows because credit continues to be constrained.

      Hope this helps.

  • TeakWoodKite

    On the radio I heard a discussion of the government considering swapping preferred stock to common stock (CITI and BofA). The point being it would allow banks to have more on the balance sheet and consequently have more more money to loan. The jockey was saying their stocks where up on this speculation by 10 to 15%.

    Would this not greatly increase the goverment risk exposure (read taxpayer) to insolvent banks?

    Is this domino effect what Soros and Volker where talking about, according to recently published comments?

    This whole situation is getting more complicated than a game of Jenga

    The global economy has some serious CHALLENGES.

    • Larry Doyle

      Teak….In order for a bank to be considered a worthy counterparty it needs to maintain a sufficient degree of capital. The capital ratios are determined by the amount of common shareholder equity. If a bank does not have a ratio that is deemed acceptable then other entities will cease to trade with it.

      The motivation behind the government’s intervention is to improve the capital ratios.

      The problem with this appraoch however is that the government MAY have to continue to inject more and more capital into the system in order to maintain the ratios. In a manner of speaking this is exactly what is occurring with AIG. I just heard that they are coming back to the govt once again for more capital. AIG is or was the largest player in the CDS market. Effectively many other institutions hedged their books by buying insurance (CDS) from AIG. If AIG goes away thoae insurance contracts are useless and the rest is history.

      This is in fact the scenario that Soros and Volcker are referring.

      If the govt were to officially take over a bank,say Citi, from what I understand by material provided to me today that would serve to trigger a provision in CDS contracts that would result in a cascade of bankruptcies. I am assuming that this is why the adminsitration is saying that nationalization is off the table.

      End result, the govt will probably take a 40+% per cent stake in Citi and be forced to continue to pump more capital.

      End result. This may very well be the Japan in the 90s.

      • TeakWoodKite

        Thanks for your clarity. I guess I should invest in monetary bulldoser. A wheel barrel might not do.

      • Baba Rum Raisin

        A 40% stake is like screwing your sister-in-law.

        The only operational reason I can see to underwrite BofA and Citi is because of their Clearing operations.

        If the shareholders’ rquity of all these institutions was diluted to (near) zero, there would be NEW risk-takers starting new institutions.

        Probably have JD’s with “Bank Charter in a Box” standing by.

        If not for the CDS entanglement, much of this could be corrected in the fashion of Resolution Trust Corporation, and life could go on.

  • Peggy Sue

    Is this what happened in Japan, Larry, during the 90s? They propped up the bad banks, the so-called “zombie banks” but growth came to a standstill.

    I’ve heard it referred to as the “lost decade.”

    None of this sounds good. When I was listening to Roubini on Charlie Rose he said temporary nationalization was the cleanest, most effective way to attack the banking problem. He didn’t say anything about a cascading effect. At least, none that I heard.

    Sounds pretty ugly all around.

    • Larry Doyle

      Peggy Sue…pls see my response above to Teakwoodkite.

      • Peggy Sue

        Thanks, Larry. I was afraid that was going to be the answer.

  • Touchet

    If the government takes hold of this, how would you have any legal recourse if the contract is not upheld. Meaning that if the government decides to screw you, whom would you sue?

    • Baba Rum Raisin

      >>> Meaning that if the government decides to screw you, whom would you sue?

      Perhaps the government of the US will become a Brass Plate entity on Bermuda or Panama.

      I KNOW the gov’t will screw me whenever they can. Been doing it since before Khe Sanh. But I’d like to get Kissed Good-Night occasionally.

    • Larry Doyle

      Touchet…for that very reason the govt will likely take a large but minority stake currently.

      However, if the contract stipulates that in case of nationalization the contract is no longer valid. I do not know that a suit would have merit.

      What a mess.

      Please see my response to Teakwoodkite above for more color.

  • Idiocracy08

    You mean WHEN the govt decides to screw you AGAIN.

  • HARP

    Your money is also going to:

    http://www.stimuluswatch.org/

  • kgirl 1028

    Putin in Russia warned us against this road. Not pay close attention to what i’m saying, Putin, ex KGB head, warned us against this method of solving our problem.

    Let’s be honest, the government created this mess, regardless of party, why the hell would anyone want them controling the banking system, these people can’t run their own cafeteria.

    I mean do people not realize Hitler was a real person? Do they not realize the more control you let thegovernment have the less you have. And that should the wrong person take office, we could end up with our very own Sadaam or Stalin? The people in this country have lost their minds.

    • Baba Rum Raisin

      Almost makes it worth moving to Canada, eh?

      But there’s that SNow Thing, and, of course, waiting 354 years to get your ingrown toenail removed…right?

    • fiscalliberal

      Kgirl – would it be better to say that the government let this mess happen and it was the financial indurstry that created the mess.

      Small distinction? I agree, but the real problem is the moral hazard if we bail these failed institutions out. If a management team got their company in this mess, and they are bailed out, they or some one else will do it again and we taxpayers get to pay for their high living

      • Baba Rum Raisin

        >>> but the real problem is the moral hazard if we bail these failed institutions out

        Have you not been paying attention to the news since September of 2008?

        “Moral Hazard,” like Taxes, is for the Little People. Large Business in the US does not have Moral Hazard. Large Business experiences, “Unforseen Conditions,” “Exigient Circumstances,” “Unfair Foreign Competition,” “Regulatory Impediments to Innovation,” “Greedy Trial Attorneys,” etc.

        If you or I get behind the 8-ball on our home mortgage, we are, of course, “Behaving Badly/Irresponsibly.”

        Should a gang of Yalies running a mutual fund screw the pooch because they took a position In Castro Convertibles thinking it was a line of Cuban sports cars, they, of course, require and demand Bail Out Bucks from us Little People, lest they start wearing Florsheims versus French Shriners and have to start looking for summer places in Fort Lee instead of the Hamptons.

        • TeakwoodKite

          Exigient Circumstances… very funny.
          Sounds like a Sneek and peek NSL.
          I agree Baba Rum Raisin.

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