Is nationalization contagious?

One problem that the proponents of nationalization have sometimes considered, but never really addressed, is the possibility of contagion:  capital drying up for banks that are still solvent, forcing them to be nationalized too.  Kevin Drum thinks he has the solution:

This is a real issue, but there's also a fairly straightforward answer: do all the nationalizations at once.  The Treasury Department is already moving ahead with its "stress tests" of large banks, and if they chose to, these tests could be used to decide which banks need to be nationalized and which ones don't.  Then, once the tests are done, the findings are announced at a stroke.  Banks A, B, and C are being taken over.  Everyone else gets a clean bill of health.

With respect, that won't work.  Nationalization implies more than merely wiping out the shareholders, who are virtually wiped out anyway, in stocks like Citibank.    The way it is being talked about now, it also implies cramming down many of the creditors--if it didn't, there wouldn't really be any reason to do it.  It is easily possible to operate with a stock trading for pennies.  It's cash flow that brings companies down.

Creditors, naturally, will not want to lend to any bank that might be nationalized.  Even in today's more stringent environment, banks still depend on access to credit in order to run their operations--especially because without profits coming in, the banks need to roll over their outstanding debt.  If no one will buy their paper or their bonds, they will suffer a collapse that will not look substantially different from a bank run.

Once you nationalize any banks, creditors have to alter their models to take into account the risk that if things go badly, the government may step in and cram their debt down.  This is a fundamental change in US policy, which has always striven to protect at least senior debt holders of distressed financial institutions.  The market for bank capital may not dry up, but it will shrink.

Now, it is possible that the credit markets will believe the government when it says that everything at JP Morgan and Wells Fargo is hunky dory, and these are not the toxic mortgage assets you're looking for.  European countries have managed to nationalize a few banks without nationalizing them all, which is encouraging.  On the other hand, they might not.  In financial markets, because of the high leverage ratios that are inherent in any fractional reserve system, appearance is pretty close to reality.  You may be perfectly solvent, but if the market thinks you're not, suddenly you aren't any more.  It is less important to know whether JP Morgan's books warrant nationalization, than to know whether potential lenders think they do.

There's another issue:  the banks that aren't nationalized will suddenly be competing with banks that are.  Those banks will have access to capital on government-guaranteed terms, which is to say, very cheaply.  That will further stress the healthy institutions.