The case for nationalization rests on three basic observations.


First, Citigroup (C) and Bank of America (BAC) (along with many other smaller banks) are dangerously close to the edge would have failed already if the government hadn't made the investments it already has.


Second, C and BAC banks must be rescued. As seen last fall, the collapse of Lehman Brothers severely damaged the world financial system and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.


Third, while banks must be rescued, the U.S. government can’t afford, fiscally or politically, to bestow huge gifts on bank shareholders.


It's likely that C and BAC will lose hundreds of billions over the next few years as other types of loans such as credit cards and commercial mortgages go bad. Their capital base, the excess of their assets over their liabilities, isn’t remotely large enough to cover those potential losses.


They haven’t already failed because the government is acting as a backstop, implicitly guaranteeing their obligations. But they’re zombie banks, unable to supply the credit the economy needs and the longer they remain in this state, the harder it will be to end the economic crisis.


To end their zombiehood the banks need more capital. But they can’t raise more capital from private investors. So the government has to supply the necessary funds, which in this case means the government will convert a portion of its non-voting preferred share into voting common equity, wiping out current shareholders.


To that end, the U.S. Department of the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board today issued a joint statement today which said that the government will implement its Capital Assurance Program on Feb. 25 and describes how a temporary nationalization could occur.


Under this program, the capital needs of the major U.S. banking institutions will be evaluated under a more challenging economic environment, a reference to the so-called stress-tests that Secretary Geithner mentioned in his speech two weeks ago.


Banks that fail will need to find additional capital in the private sector but should such capital not be forthcoming, a temporary capital buffer will be made available from the government in order to provide a cushion against larger than expected future losses.


Such capital will be provided in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position, a provision which explicitly allows for nationalization. 


Regarding cash injections which have already been made under the TARP, those funds will also be eligible to be exchanged for the mandatory convertible preferred shares.


Large U.S. banks have alleged that the stress tests will essentially create new capital requirements for financial institutions, but regulators tried to dismiss that concern in their release.


This additional capital does not imply a new capital standard and it is not expected to be maintained on an ongoing basis, the regulators said. Instead, it is available to provide a cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers.


The regulators said they reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.


Meanwhile, billionaire investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.


Mr. Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union, according to Reuters.


He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.


“We witnessed the collapse of the financial system,” Mr. Soros said at a Columbia University dinner. “It was placed on life support, and it’s still on life support. There’s no sign that we are anywhere near a bottom.”


His comments echoed those made earlier at the same conference by Paul Volcker, a former Federal Reserve chairman who is now a top adviser to President Barack Obama.


Mr. Volcker said industrial production around the world was declining even more rapidly than in the United States, which is itself under severe strain.


“I don’t remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world,” Mr. Volcker said.