Updated from Thursday, Oct. 9

As Treasury Secretary Henry Paulson formulates a plan that could essentially nationalize a large swath of the U.S. banking industry, shareholders have become inevitably spooked.

But some experts say there are few other palatable options to shore up the financial sector.

The government already has the right to receive warrants for equity stakes in companies that participate in its plan to purchase $700 billion worth of illiquid mortgage holdings. Those assets are clogging banks' balance sheets and sapping investor confidence, and they have caused the demise, rescue or takeover of several firms in the past several weeks.

Paulson, who first opposed the inclusion of such a measure in the bailout bill, said on Wednesday that the government would "use all of the tools we've been given, including strengthening the capitalization of financial institutions."

Reports suggest that he is now deciding how the government's equity injections would be structured, and White House spokeswoman Dana Perino said on Thursday that Paulson is "actively considering" such a plan.

The Bank of England announced a similar plan this week, pledging billions of dollars in capital in exchange for preferred stock in banks. The obvious losers in such a strategy will be existing shareholders, whose stakes will be significantly diluted.

The stock performance of Freddie Mac ( FRE), Fannie Mae ( FNM) and AIG ( AIG) provide ample evidence. Share prices of those companies dropped to a mere fraction of their former worth on the first trading day after the U.S. announced plans to take over those firms, and had fallen precipitously in the previous days on fears that such a bailout would occur.

Freddie and Fannie are now down about 98% from year-ago levels, while AIG has lost 95% over the same time frame.

"Think about it this way," says Robert Ellis, a senior securities and investments analyst at Celent. "What they did in Britain is they took preferred. The shareholders, who have very little confidence in the stock anyhow, have got someone stepping in front with a 20, 30, 40 billion dollar stake. Those values are not going to hold up."

Still, policy advisers and economists say there aren't many alternatives. Banks need capital, and the only other way for the government to provide it would be to buy troubled assets at levels far above the market price. Such a strategy wouldn't dilute shareholders, but it would leave taxpayers holding the bag -- a tactic the public and many politicians wouldn't support.

Stifel Nicolaus analyst Christopher Mutascio says that buying assets at a fabricated price alone would neither restore confidence in the markets nor provide banks with the capital they need to start lending again.

"Does anyone really believe that if the U.S. Treasury buys these assets for 80 cents on the dollar that they are really worth 80 cents on the dollar?" asks Mutascio. "We don't think so. If not, will the banks really be able to recapitalize after selling a portion of such assets to the government?"

Furthermore, other countries have successfully taken a similar tack of nationalizing their banking sectors in times of crisis, then selling it back to the private market when conditions stabilize. Sweden did so in the last decade, as Chile did in the 1980s.

But comparisons are hard to draw, since the U.S. is the world's largest economy, and its problems and banking sector dwarf emerging economies, or even many established nations, such as Sweden. Ellis also notes that Swedish society is "much more egalitarian" than the U.S., which places greater importance on wealth and entitlements.

Barry Bosworth, a senior fellow at the Brookings Institution, and a former economic adviser to President Jimmy Carter, says that one way or another, banks will need to acquire fresh capital. He believes, however, that once bad assets are removed from their books via the rescue plan, faith will be restored in their operations and viability. The transparency would perhaps allow for big investors to inject private capital into the companies, rather than the government.

"There are going to be other Warren Buffetts in this world who are going to be fighting to get a good deal," says Bosworth, noting the Berkshire Hathaway ( BRK.A) CEO's recent decision to acquire major stakes in Goldman Sachs ( GS) and GE ( GE).

Robert Shapiro, chairman of economic advisory firm Sonecon, and former undersecretary of commerce in the Clinton administration, says that the government will face several challenges in structuring a capitalization plan, including how to distinguish financial from nonfinancial companies. He believes the government should have instead started "jawboning" private investors into buying large equity stakes before injecting capital on its own.

"Is this the best course?" says Shapiro. "No, it's the course you go to when all others have been exhausted."

While the government could have waited to sniff out private investors' appetite for dirt-cheap financial stocks, some say that time is of the essence. Steven Kyle, a professor at Cornell University who specializes in macroeconomic policy, says that confidence in the government's ability to handle the crisis has already been sapped by its "piecemeal" approach to fixing the financial system, rather than outlining a comprehensive plan at the start.

"There are a lot of people who are averse to anything that smells like nationalization. And let's face it, that's what it is," says Kyle. "While as a trained economist I do sympathize with that view, there are times, and this is one of them, where you just have to step in and do it. What we're doing now is piecemeal, which erodes people's confidence that the government can solve the problem."

Ellis agrees, adding that the hodgepodge approach of rescuing some firms while letting Lehman fail, and unveiling new initiatives each day, has created considerable uncertainty about what's next. The congressional hearings on the bailout plan and its initial failure in the House of Representatives also gave the impression that those charged with solving the crisis don't have a good handle on the problem and can't agree on a solution.

"I think the general feeling out there in the stock market is this thing is just being abysmally handled all the way down the line," Ellis says.

Paulson acknowledged on Wednesday that more financial firms will inevitably crumble, despite the failure, bailout or takeover of several of the country's largest institutions. First Bear Stearns fell in March, then Freddie, Fannie and AIG were rescued by the government last month.

Soon after, Merrill Lynch was acquired by Bank of America ( BAC), Washington Mutual failed, with its branches scooped up by JPMorgan Chase ( JPM), and Citigroup ( C) and Wells Fargo ( WFC) became embroiled in a fight over Wachovia ( WB).

Donald M. Raftery, a banking consultant with Greenwich Associates, said several of the firm's "banking clients havetold us about very nervous business owners. One banker today told us their clientwas "wigging out" over access to working capital to keep their business going."

"They are looking for reassurance," he says. "They are looking for consistency, they are looking for stability in this turmoil."

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