Whatever you do, do not nationalize the banks*.

I was sitting in Spanish class learning the use of the conditional tense: the tense used to express what you would have done in place of another. The prompt was how we would have fixed the financial markets when a girl chimes in, “If I were the President, I would nationalize the banks.” Normally I am very receptive to the opinions of others, but today was a black swan day. Without hesitation, I replied, “And what would that solve? Have we not learnt enough from historical precedent set in the Soviet Union and other cases of failed and still failing practices of government overtaking and planning of private capital to finally throw this solution by the wayside.” No matter the amount of bs coverage and garbage opinions the press can conjure up, nationalizing the banks can never be the answer.

It is rather difficult, at least to me, not to see the apparent conflict of interest inherent in the nationalization of a banking institution by the federal government. Imagine a situation wherein the nationalized bank is completing an M&A deal but the deal is currently facing FTC antitrust approval, does the FTC consider the trickle down benefits of the completed deal on the national economy or does it stay wholly focused on antitrust regulation? Who is the FTC ultimately responsible to in this scenario, the government, the people, or the economy? Can these goals even be separated in this event? Even another scenario is quite apparent. Imagine that the nationalized bank had been overstaffed, does the bank, which needs to trim headcount, continue with the mass firing? Will there be any chance of retribution when election season rolls around? It’s imperative to ask if the federal government is comfortable with a profit motive or will the motive of maximizing the happiness of their constituents get in the way? Whose constituents would a nationalized bank try to appease anyway?

Even if it is at all possible for the government to navigate these conflicts of interest (and I assign a very minuscule probability to that event), it is still possible that by nationalizing a bank, the federal government will have to do everything to prevent that bank from failing, even when it clearly deserves to fail. With a governmental backstop, private monetary capital would flow from other institutions and markets into this nationalized bank due to the relative safety of the governmental guarantee (it is safe to assume for the time being that the US will not default on its debt obligation). At the same time, it is fair to assume that there will be a flight of human capital away from nationalized bank. Apart from the stringent rules that the federal government imposes on banks receiving capital injections at the current moment (for which I agree with and think it should be more stringent), I can only assume the number of rules and governmental red tape that will exist at these new institutions will grow exponential. This would cause most people to either switch firms, or to create new ones. So as there is an inflow of monetary capital into a nationalized bank, there is also an outflow of human capital. Soon the bank would lack the personnel to function properly but it now cannot fail because of the governmental backstop. The very banks that the government is trying to assist will become weaker compared to their competitors due to internal maladies.

Then again, how does the federal government go about deciding which banks it would nationalize? Some banks are staying afloat, even in this economy (or at least the banks are giving us the impression that they are) and others are not. Does the federal government nationalize the ones with exposure to CDOs or the ones unable to raise capital in the private market? The solution to this question is a bit difficult because once a list is created of which banks the government believes to be insolvent, the bank is instantaneously blacklisted. Basically, designating the banks as insolvents instantly makes so^‡ and wipes out the last remaining equity that is still being traded on the exchange and sends their trading partners (or potential partners) into hiding. For some banks, this probably is not a huge problem as the government already owns the majority of shares (albeit preferred shares), but not every firm that could be insolvent currently has a high federal ownership stake. So the decision basically has to be an all-or-nothing response, but somehow punishing the banks (and their private owners) that have escaped the CDO debacle by nationalizing them does not seem the better option either.

Of course, it’s easy to criticize and complain about bad policy yet not offer any solution to the problem. Rather than shirk that responsibility, I’m going to offer a suggestion. Warren Buffett said it best when he uttered the phrase; “Capitalism without failure is like [Christianity] without hell.” Plainly put, the government needs to stop creating a safety net for these companies that are potentially insolvent. I don’t believe there continues to exist a global risk to the markets from the failure of these institutions. The market will suffer soon after, but the US has been there before and survived. Once the federal backstop is removed, we can finally shed some light onto the balance sheet of all these institutions. The weaker banks, or those with too great an exposure to CDOs will either seek to restructure, fade out of existence or be merged into their stronger and well-to-do competitors. Either way, once we swallow the bitter pill, we can finally get better and move on.

* I should note that in the examples I used, I make no distinction between investment banks and commercial banks. While it does allow me leeway to create scenarios in which nationalization is clearly the wrong choice, it should also be noted that neither the federal government, nor the press itself, take care to make the distinction. After all, they are all as concerned about nationalizing Bank of America and Citigroup as they are about Goldman Sachs and Morgan Stanley.

‡ As soon as the government announces which banks it would nationalize (and eliminate the bank’s private equity), those whose equity remain in the institution would immediate seek to recover the equity before the nationalization. The bank would not have sufficient capital to meet the demand of its equity holder and the increasing flight of equity will return the institution back into a position where it is over-levered (debt significantly higher than equity) and would lack the equity to meet its financial and regulation obligation to balance its debt, hence insolvency.