Bank nationalizing might be better for taxpayers

(breakingviews.com) -- The U.S. is straining to avoid nationalizing its banks. That's the implication of its latest plans to recapitalize wobbly financial institutions. Following last week's panic over the possibility that both Bank of America and Citigroup might be nationalized, it's not surprising that shareholders are rejoicing. Taxpayers, though, may end up with a raw deal.

The Obama administration doesn't plan to inject common equity into the banks. Instead, it will buy "mandatory convertible preferred" shares in any bank that fails a stress test. These kick off this week. Previous capital injections, which were in the form of straightforward preferred shares, can also be exchanged into these new-fangled mandatory converts.

The idea is that this new class of capital will be converted into ordinary shares only if the bank needs it. The government may yet end up owning big chunks of the banks, but it is doing everything it can to put off the evil day. Given the dangers of political meddling, it is right that nationalization should be a policy of last, rather than first, resort.

The mandatory aspect of the conversion might suggest that shareholders will get thwacked. But that seems unlikely -- at least if Tim Geithner is sticking to what he announced earlier in the month. The Treasury secretary said then that the price at which the new capital would convert into ordinary shares would be a modest discount to the share price on February 9.

Citi's (C, Fortune 500) share price on that day was $3.95, while BofA's (BAC, Fortune 500) was $6.90. In both cases, that is roughly double where the stocks stood on Friday. A conversion of the government's $45 billion stakes in each bank at that price would still amount to a massive dilution for ordinary shareholders. The U.S. would end up with 68% of Citi and 51% of BofA. But if the banks' ordinary capital is wiped out, selling shares to taxpayers at twice Friday's price will seem a positive bargain.