Markets Forcing Nationalization?

Will the bond markets force the administration's hand when it comes to nationalizing banks? Bloomberg reports that:

Citigroup Inc. and Bank of America Corp.’s bond prices are sliding on concern that owners of debt issued by U.S. financial firms will be forced to swallow losses if the industry needs another bailout.

While there has been speculation for some time now that unsecured bondholders might take a loss in any future bailout, analysts are now openly questioning just how safe supposedly ultrasafe senior debt is as well. Again from Bloomberg:

“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” Mehernosh Engineer, a London-based strategist at BNP Paribas SA, said this week. “There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”

James Kwak over at Baseline Scenario observes that

this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.

There is the potential for this fear to become self-justifying. Since Citi and BoA are more or less insolvent, loans to them are only worth as much as investors think the government will guarantee. If investors become convinced that some sort of government receivership is inevitable, despite the government's protestations to the contrary, then not only will bank bonds trade at distressed levels, but the banks themselves will have a harder time raising private capital than they already do. Cut off from private capital, the government will then be forced to nationalize the banks.

The risk, of course, is that a panic develops beyond merely Citi and BoA, and that solvent banks find themselves unable to finance themselves, as investors flee from all bank debt. To avoid this, the government must decide who needs to be nationalized rather than the markets. To this point the Treasury has tried to encourage private capital to flow back into the banks to no avail. It has not worked. The markets are not buying it. Treasury needs to finish its stress tests, determine which banks cannot be saved, and then nationalize them all at once. It will be messy and enormously challenging. But it's better to proactively address the problem, rather than have policy reacting to panic.