In praise of nationalizing banks

NEW YORK (Fortune) -- President Obama's key economic advisers are all highly experienced, intelligent and thoughtful people - and Tim Geithner certainly figures prominently in that group. Still, the outline of the bank rescue plan he announced last week was viewed as underwhelming and quickly attracted a fair amount of criticism. The disappointment with what Geithner had to say stemmed not only from a lack of important specifics but also a sense that its scope did not go far enough to confront a crisis of major proportions: a banking system that has been paralyzed for six months now.

The area that seemed to be startlingly off-limits in the administration's banking plan is the prospect that, given the current crisis, nationalizing a number of banks may be the best solution - in some cases, the only one.

The Treasury plan is an otherwise well-rounded one, in that it attempts to tackle the problem from several different angles: mopping up the toxic assets, injecting more capital, and encouraging consumer lending. However, embarking on a titanic struggle to revamp a banking industry that has come close to a meltdown without using all available options is like trying to do so with one hand tied behind the back.

The simple reality is that there is a steadily rising sense of urgency to take full stock of the extent of the damage already suffered by the banks - and then create a firewall to contain the crisis with measures that provide a sense of near-finality with regard to some institutions. The process of absorbing the toxic assets via a public-private investment fund may well get bogged down in the stubbornly elusive logistics of proper valuation of the assets involved, while measures to encourage consumer lending and spending have their own time-consuming and challenging logistics. As a result, injection of more capital becomes the weapon of choice over the near term.

The trouble with capital injection, as it has been implemented so far, is that funds are being given to banks with no control over their use and by allowing the same management - the ones who drove those banks into the ground - to stay in place and try to steer those banks toward a turnaround. So far it hasn't worked. Limited, repeated rounds of capital injections under the status quo have not only failed to produce any positive signs of stabilization to date but they seem to have been accompanied by a further slide into darker territory. For example, after two rounds of capital injection, totaling $94 billion between them, both Bank of America and Citigroup are in a more precarious position today than before the crisis erupted last September.

Which leads us to the nationalization option.

The concept of nationalizing banks, or any other industry, has a particularly strong negative connotation in this country. It's associated with socialism - another dreaded concept in a society deeply steeped in the worship of free markets. Driven by those strong cultural biases, two of the most frequently mentioned arguments against the very idea of nationalization are that a.) "we don't want Washington bureaucrats to run our banks," and b.) having banks run by the government would deprive the industry of the spirit of creativity and drive for innovation.

Actually, these are both specious and ill-conceived arguments. It is much preferable to have in place competent banking executives, people untainted by the recent debacle, willing to work in a once-in-a-lifetime turnaround situation for a healthy (but not obscene) compensation package, under the guidance of indisputably competent officials like Ben Bernanke and Tim Geithner, rather than CEOs full of "creativity" and "innovative" spirit that sank their institutions in the first place. There would be no love lost for some of the brainchildren of that idolized private enterprise spirit (like the unfettered proliferation of mortgage backed securities and CDOs) if they were brought under tight control in a context of greater restrictions and transparency.

While it is probably true that some of these excesses will now be addressed in the form of tighter regulation from Congress, having some seriously ailing institutions under the more direct supervision of the Fed, Treasury and General Accounting Office (the latter having declared last fall its inability to track down how the capital injection money was used by the recipient banks) can only be a positive thing.

Again, nationalization is not a blanket solution for the entire banking system, nor is it needed in many cases. Such decisions will need to be made on a case-by-case basis, the key criterion being the degree of viability of each institution. Nor should any such selective government bank-takeover plan be viewed as infinite in duration. If the banking system stabilizes gradually via a combination of direct management control and a tighter regulatory environment, then a carefully staged return of these institutions to private hands can become possible in a few years.

For the time being, though, it is a poorly kept secret that the viability of some of the major banking institutions is seriously doubtful and the real question is how soon this hard reality will be acknowledged. Differently put, it will become nearly inevitable before long that some banks cannot survive on an endless stream of band-aid measures; some will need to be taken over and others forced to merge. The critical question is how much effort, money, and precious time will have been wasted by the time the inevitability of that solution becomes more transparent.

Given the high level of sophistication of Obama's economic team, it is reasonable to assume that the prospect that the administration may ultimately need to nationalize some institutions has already been acknowledged and debated internally.

However, such decisions are not being made in a vacuum. There are political realities that get in the way and can make any such drastic measure difficult to implement. It would require the president to expend an enormous amount of political capital. He would need to educate the American people about what nationalization really means, and persuade a highly skeptical Congress that this is the best way to proceed in some cases. Achieving the latter may be an uphill battle at this point, judging by the unexpected opposition he faced in his effort to pass the fiscal stimulus bill - the need for which, in the midst of a severe recession, should have been more readily accepted.

The implication of those political realities is that the administration, and Tim Geithner being its most public face on this issue, may remain on an "anything-but-nationalization" path longer than the urgent nature of the problem requires. This would be an unfortunate development that may delay the prospect of stabilizing the banking system and setting the stage for a turnaround in the economy.

Anthony Karydakis is a former chief U.S. economist for JP Morgan Asset Management and currently teaching at New York University's Stern School of Business.