The banking sector keeps hitting new lows every day, led by Citigroup (NYSE:C) and Bank of America (NYSE:BAC), as rumors continue to sweep the market that the government will nationalize two of the largest banks in the world and wipe out stakeholders. Can the government do this? And would it work if it did? What would come next? Nationalization probably wouldn't solve our financial crisis.

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The word "nationalization" itself conjures up images of the tired old stereotype of the leader of a Banana Republic seizing Yankee property and chasing the imperialists out of the country at gunpoint. Unfortunately for the U.S. financial system, this is not the United Fruit Company and Guatemala, or Fidel Castro marching into Havana on New Year's Day in 1959.

Can The Government Do It?
Absolutely. The two institutions are bank holding companies that, depending on their charters, are regulated by either the Federal Deposit Insurance Corporation (FDIC) or the Federal Reserve. The government could nationalize the banks officially by seizing them late on a Friday evening, which the FDIC has done many times over the last year. Alternatively, it could do it unofficially by browbeating management to take more dilutive capital infusions, or by setting up a conservatorship in the manner of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Either way, equity and bond holders would be wiped out. (To learn more about the FDIC, be sure to read our related article The History Of The FDIC.)

Would It Work?
This is a more difficult question, because I am not sure what would be accomplished by nationalization. The so-called toxic assets would still be on the balance sheet of some entity, whether it's the government or the private sector. If the government did a typical bank seizure, it would try to sell the deposit base and the loan assets to another institution. Due to the size involved, this may not even be possible. The government would be stuck with billions of dollars in non-performing loans and billions more in toxic securities. When the government sells these at fire sale prices, imagine how badly that would make other financial institutions mark down their security portfolios.

What Would Come Next?
Right behind these two institutions are two other large banks, Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM). Wells Fargo bought Wachovia, so some issues are probably lurking there, and while Jamie Dimon at JP Morgan established a reputation for managing his institution the best during the crisis so far, the bank is not immune from the issues facing the rest of the industry. It also has toxic assets and deteriorating loan asset quality. So, once the Obama administration panders to the market and feeds it the carcasses of Citigroup and Bank of America, why stop there? Should it throw the next two banks to the market to be torn apart? Why not the entire banking system? Perhaps the president should realize that the market is not a God, and as a value investor would say, it is irrational in the short term.

Managements of both Citigroup and Bank of America tried to downplay the nationalization talk. Citigroup cited its high Tier 1 capital of 11.9%, and Ken Lewis, the CEO at Bank of America, said the talk "is based on a lack of understanding of our bank's financial position as well as a lack of appreciation for the adverse ramifications for our customers and the economy".

Nationalization Is Not A Panacea
However the situation resolves itself, it is clear that the financial crisis has a long way to go, and the new administration was not the panacea that everyone thought it might be. Neither is nationalization.

To learn more about the financial crisis and what you can do to make it through, check out our Financial Crisis Survival Guide Special Feature.

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