One of the big headlines driving the stock market deeper into the ground over the past week or so has been the issue of bank nationalization. Major banks such as Citigroup, Bank Of America, and Wells Fargo have seen their stock prices tumble as investors sold on fears that the government was going to nationalize these banking giants. Why would the government consider taking over these troubled banks or others?

Billions of taxpayer dollars have been poured into the financial system to prop up banks that are sitting on a mountain of “toxic” assets that are being written off of balance sheets quarter by quarter. The main problem is that no one knows just how bad the problem really is. We have seen giant financial institutions like Bear Stearns, Lehman Brothers, and Washington Mutual, who a year ago seemed relatively healthy, go out of business.

The argument for nationalization stems from the fact that the banks have already received billions in public dollars in the form of bailouts, but there has not been a noticeable increase in liquidity in the credit markets. Nationalization would allow the government to make decisions on how the banks recover from a year that has left the industry financially crippled. It would also allow the government to sell assets that have worth to recover some of the funds that have been poured into bank coffers.

The argument against nationalization is that in a free market system, companies should be left to sink or swim on their own, with the belief that the system will correct itself. There could be more short term pain for banks without government intervention, but the banks that have been financially responsible would survive and those that mismanaged their assets would disappear. Opponents of nationalization fear the precedent that a government takeover would set for other industries that might experience hardship in the future. It’s hard to believe that an entity running a deficit in the trillions would be a more effective manager of assets than the banks have been on their own.

So far, the government is not committing to any future plan, although it seems that all options are still on the table. Banks are set to release quarterly earnings beginning in a couple of weeks, which could mean more massive losses and asset write-downs. If nationalization happens, it will probably occur gradually, and in a way it is already-it was reported today that the government is in talks to increase its stake in Citigroup to 40%.

The next step that could lead to further government intervention is the “stress test” that Treasury Secretary Geithner has announced for financial institutions. The results of this test will go a long way in determining whether banks can continue operating on their own, or whether more intervention is needed.

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Tags: bank nationalization, Bank of America, Bear Stearns, Citigroup, federal government, free market system, Lehman Brothers, Treasury Secretary Geithner, Washington Mutual, Wells Fargo

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