Last week, former Merrill Lynch CEO John Thain faced six hours of questioning from New York Attorney General Andrew Cuomo regarding “the bonuses that were given out on the eve of Merrill’s merger with Bank of America (BoA).” Thain has evidently been directed by BoA not to discuss specific bonus details, so Cuomo has filed a motion in the Supreme Court of New York in order to get Thain to talk.

During the initial questioning, though, some other details about Thain’s attitude toward bonuses, and the financial crisis in general, were made quite clear. When Thain was asked if he ever considered “whether Merrill Lynch should disclose its [fourth quarter] losses to its investors,” he essentially said no:

THAIN: Merrill Lynch as a policy, doesn’t make projections; doesn’t give guidance and doesn’t disclose interim results.

Q: And a lot of firms have that and depart from that policy in times where there’s a serious deviation, and given the deviation that was occurring in the fourth quarter of 2008, did you consider whether or not it was appropriate to make a disclosure?

THAIN: The market conditions were generally known and we would not have disclosed interim results in that fourth quarter.

As for Merrill shifting when it paid bonuses, to have them out before BoA took over:

THAIN: I don’t think it’s necessarily the case that we can predict what was going to happen between December 8 and December 31. Again, I’m going to repeat what I said, that bonuses were determined based upon performance and the retention of the people, and there is nothing that happened in the world or the economy that would make you say that those were not the right thing to do for the retention and the reward of the people who were performing.

Remember, this is the same guy who “suggested to directors that he get a 2008 bonus of as much as $10 million” after Merrill incurred catastrophic losses and had to be salvaged by BoA.

As for rewarding “the people who were performing,” in the months before the merger between Merrill and BoA closed, “Merrill’s business deteriorated, resulting in a $15.3 billion post-tax loss in the fourth quarter.” This loss prompted BoA “to seek a second round of taxpayer money” just to stay afloat following the merger. That seems to fall short of a bonus-worthy performance.

The Wall Street Journal is reporting that Citigroup “is in talks with federal officials that could result in the U.S. government substantially expanding its ownership of the struggling bank.”

While negotiations are still ongoing, “the government could wind up holding as much as 40% of Citigroup’s common stock,” which would “give federal officials far greater influence” over the bank. The move would require no more TARP funds, but would instead entail the government converting preferred shares it has already bought into common stock.

These talks come at the same time that the Obama administration “will begin taking a hard look at the financial condition of the country’s 20 biggest banks”; this is the “stress test” that Treasury Secretary Timothy Geithner promised as part of the administration’s financial stability plan. Regulators today also “pledged to inject additional funds into the nation’s major banks to prevent their collapse.”

As we discussed earlier, a lot of the signs regarding the banking system are pointing towards nationalization, and the events around Citigroup are no exception. Thus, the same question comes up: if nationalization is not in the picture, then what is?

As Paul Krugman pointed out today, the stress test could be the key for an administration move towards nationalization:

All the administration has to do is take its own planned ‘stress test’ for major banks seriously, and not hide the results when a bank fails the test, making a takeover necessary. Yes, the whole thing would have a Claude Rains feel to it, as a government that has been propping up banks for months declares itself shocked, shocked at the miserable state of their balance sheets. But that’s O.K.

Krugman added that “once again, long-term government ownership isn’t the goal: like the small banks seized by the F.D.I.C. every week, major banks would be returned to private control as soon as possible.” Indeed, the Federal Deposit Insurance Corp. has placed 14 banks into receivership in 2009 alone, blunting the criticism of those who claim nationalization is too scary and can’t work.

As Models & Agents pointed out, we are currently operating in “the worst of every world” when it comes to the banks: injecting capital and essentially taking over firms, without exercising appropriate control. This is not a happy middle ground, but an ambiguous mess that will slow the banking system’s recovery. While there is political wisdom to not openly pondering nationalization, transparently going half-way will not deliver the system’s required fix.