Gnarly nationalization

When Royal Bank of Scotland Group plc's new CEO Stephen Hester forced the resignation of most of his board in early February, clearing out some of the names most associated with the blunders that led to its nationalization last year, he must have hoped for some relief from his critics.

Even so, Hester could not have expected to escape the firestorm that followed a few hours later. Once news leaked that he planned to pay bonuses worth millions of dollars, it was open season on Royal Bank and its new 68% owner -- Her Majesty's Government.

Chancellor of the Exchequer Alistair Darling quickly responded that Royal Bank could pay bonuses to retain its best staff. But even in Darling's own party the notion of paying big bonuses at failed banks arouses anger and revulsion. "We are all shareholders now," former Deputy Prime Minister John Prescott told executives at Royal Bank and other state-financed institutions, "and the shareholders demand you should give up the bonus."

The nationalization, in October, was a dramatic outcome for the U.K. bank which, barely a year before, had led the world's most expensive financial services takeover to date -- the €72 billion ($93 billion) acquisition of Dutch bank ABN Amro Bank NV. Now it expects to suffer a 2008 loss of up to £28 billion ($41 billion), including £15 billion to £20 billion of goodwill impairments, mostly due to the ABN Amro disaster. It will be the largest loss in U.K. corporate history.

The Edinburgh-based bank's swift downward spiral, following both its leading role in the ABN Amro acquisition and its huge bets on extending leveraged debt to private equity, has cost the British taxpayer £19.97 billion in share acquisitions alone. Add to that the drop in the bank's stock, which has fallen dramatically below the 65.50 pence per share at which the government subscribed to its capital increase. Not to mention further write-downs as the bank's toxic assets continue to erode.

And the bank still must repair its balance sheet with asset sales. Having failed to find a buyer for its insurance arm, it has sold its 4.3% stake in Bank of China Ltd. for £1.6 billion and has reportedly put a portfolio of 1,000 pubs and its aviation leasing unit on the block. It remains to be seen whether they will fetch better valuations than the insurance unit.

Royal Bank may suffer further humiliation. ABN Amro Nederland, the businesses the Dutch government acquired when Royal Bank's consortium partner Fortis Bank SA/NV was nationalized in October, has expressed interest in buying some of the operations owned by the Scots. No one expects a capital gain.

In stepping into the breach, Darling could not have been fully aware of what he was letting British taxpayers in for. The government made its move relatively soon after the collapse of Lehman Brothers Holdings Inc. sucked the entire banking sector into its vortex. Clearly there would be further trouble ahead, as former Royal Bank CEO Fred Goodwin admitted during a Jan. 10 grilling by a parliamentary committee of inquiry, but it was impossible at that stage to quantify the likely damage. The government's approach, Goodwin said, had been less a negotiation than "a drive-by shooting," with no time to haggle over the details. "It was very clear to everyone," he added, "that [a rescue] had to happen there and then."

Goodwin and his former chairman, Tom McKillop, are still on the rack over their past involvement. But it is Hester and new chairman Philip Hampton who must work with the majority shareholder that makes its home in Whitehall.

The initial deal gave the government 58% of the bank's voting shares and £5 billion of preference shares. It stipulated that the bank must pay no dividends on its ordinary shares until it had paid off its debt to the state. When Royal Bank issued its profit warning in January, those shares were converted to ordinary shares, freeing up cash for lending. It was a tacit admission by Darling that the government would not be able to get away with conflicting demands on its expanding stable of state-financed lenders.

The government expects to be a hands-off, arm's-length proprietor. Yet it is continuously pressuring the banks to meet its political objectives of supporting small businesses and the housing market, avoiding repossessions and bankruptcies and cracking down on bankers' pay. The conflicts inherent in the government's new role are many and won't be easily -- or quickly -- resolved.