Recently we have been hearing talk of ‘nationalizing the banks’ and there has been considerable panic over the prospect. I am no financial expert but I do know a few things and have researched the topic a bit to find out exactly what is going on. To the degree I don’t get all the terms right I would welcome input from those more expert than I am but it sounds like the Obama administration is planning some good changes.

The first issue they are dealing with has to do with just what kind of ownership stake the government has in the banks who are getting TARP and/or bailout funds. To understand this requires a short tutorial in what makes up ownership of a corporation.

Basically, you normally have three kinds of investors in a business: 1) Bondholders, 2) Preferred stockholders and 3) Common stockholders.

Common stockholders are what most of us are, assuming we own stock either directly or through some sort of retirement plan/mutual fund/etc. Common stockholders are powerful in the sense that they control the company, they elect the boards of directors, etc.

But they are weak in the sense that when profits are being handed out, they are normally last in line to get any sort of a dividend. Similarly when a company dissolves, they are the last to be paid, which often means that they don’t get anything.

At the other end of the scale are bondholders. Bondholders are people who have loaned money to the company so they have no real impact on the day to day operation of the business. But they get paid first when it comes to handing out the money. They are guaranteed payment of their interest every year and if the company goes out of business, they get paid off first.

Sort of in the middle are preferred stockholders. They are owners of the company but in most cases they have little or no vote in how the company is run. They get paid after bondholders but they usually get a much bigger dividend than common stockholders. When the company goes out of business then they get paid after bondholders, but before ordinary stockholders so they normally get a little something.

So what does this have to do with the proposed changes ? Well read below the fold to find out.

When the government first bought in to these banks they purchased preferred stock. The idea was that they would thus be protected in terms of investment and they wouldn’t be getting in to taking over control of the companies. The infusion of cash would help the banks stay in operation and get past the short term crisis.

This was basically what happened but what nobody really considered was the fact that these huge infusions of cash would not help the banks open up the credit markets (IE begin loaning money to people to buy houses, run small businesses, etc). The reason for this has to do, oddly enough given all the issues of deregulation connected with the current problems, with a regulation still on the books.

I’m not enough of a financial expert to spell it out in detail, and indeed I doubt you really want me to try and do that. Simply put the rule says that a bank can only loan out so much money as a ratio to the total value of it’s assets. And preferred stock and bondholder investments do not count towards this asset value calculation.

So even if Bank Of America has $ 25 billion in their accounts from TARP funds, they cannot loan out the money because it would put them over the lending limits. The only way to fix this is for the government to convert from preferred stock ownership to common stock ownership. Then the money in that stock would count as assets and could allow them to loan out more money.

It is true that the conversion would give the government a large stake in these companies but it would also mean the banks could start to make loans, make money and help to get the economy going again. I might agree that on a purely theoretical level we’d prefer not to see our government owning 30% of a corporation but it is not a choice between 30% ownership and no ownership anymore. It is now a choice between 30% ownership of a viable bank or 0% ownership of a failed bank.

Further, in time the government can divest itself of this stock ownership and sell the shares to the public, thus getting back the money they put out into the bank through TARP. So it is less a case of nationalization of the bank than it is of making sure the bank is able to do the things it needs to do without lifting the regulations that we all (or mostly all) agree are important to not only keep in place but perhaps expand.

On another note, the government seems to also be looking at changing some out of date accounting rules that have also been hurting the banks. One of the things banks have on their books are all of these bad investments in home loans and mortgages.

Right now these assets are not worth very much but the fact remains that they do have tangible assets behind them (IE the homes themselves). Once the housing market recovers these assets will be worth much more and their current value isn’t particularly relevant to the operation of a bank since they are not going to be selling them now.

But under a rule called ‘mark to market’ the banks are required to continually lower the value of these assets (and thus the total value of the bank itself) to a theoretical current market value. This was not always the case.

Up until 2007 a bank could base the number on what would be a reasonable value in a normal market. This allowed them to weather short term drops in the value of the asset (and also prevented them from taking advantage of a short term boost).

Returning to the old system would allow the banks to boost their net asset value and as discussed above would allow them to make more use of the TARP funds to open up the credit markets.

Both of these reforms seem to me to be a good step to fixing the current problem. I obviously yield to the experts on exactly how to make the changes, but they need to be made, and fast.