Shortly after the FDIC took control of Washington Mutual and handed its assets over to the politically well-connected JPMorgan Chase (NYSE:JPM), the debt market froze solid. That freezing was a very rational act of self-preservation by bond investors who were financially terrorized by the tyrannical way in which Washington Mutual was seized.

Behind the ice storm was the fact that in the seizure, only WaMu's assets moved to JPMorgan. Many of its liabilities -- including the debts it owed to bondholders -- were left to rot in bankruptcy court. That made a mockery of the concept of Absolute Priority and rendered moot bondholders' claims on the company's assets. That seizure did tremendous damage to the debt market. Until such dictatorial powers are reined in, the lending market simply cannot recover.

Nationalization makes it worse
The core of the problem is simple. Bondholders look for two very critical things when they invest money. First, they want to assure a return of their capital. Second, they want to try for a return on their capital. Whether it's the WaMu way or the Swedish way, if bondholders lose their ability to attempt to recover their capital in a seizure, they've lost all incentive to loan again at anything below usurious rates.

Think about it this way. With good credit and decent income, you might be able to get a 30-year mortgage on your home for about 5.27%. A three-year car loan could run you closer to 6.91%. A loan on your credit card would likely cost you over 10% annually if you don't pay it in full every month.

The only reason banks will offer you that low rate on your mortgage for that long a period of time is because it's secured by the value of your home. If you don't pay, the bank forecloses. Or at least it used to, until Uncle Sam stepped in to help. When the government takes away bondholders' claims on a seized company's assets, it converts those bonds from loans secured by bankruptcy recovery rights into the equivalent of unsecured credit card loans.

Let's face it. These days, nobody other than Federal Reserve Chairman Ben Bernanke is willing to lend money at cheap rates on a mere promise to repay. The government froze the private debt market by the way it mishandled Washington Mutual. Nationalizing the banks without protecting their bondholders will turn that freeze into permafrost.

Bankruptcy is better
Don't get me wrong. Many of these heavily damaged banks need to fail. Citigroup (NYSE:C) comes to mind as one that looks to potentially be on the verge of collapse. Thanks to its overpriced acquisitions of damaged businesses, Bank of America (NYSE:BAC) may fall by the wayside as well. But the way they fail makes all the difference between a market-based recovery and the wholesale destruction of the American economy.

In Chapter 11 bankruptcy reorganization, a business can keep operating, and bondholders retain their claims on a company's assets. If the company successfully emerges from Chapter 11 bankruptcy, those bondholders are made mostly whole, either through repayment of the debt or the receipt of newly minted stock. And if the company doesn't emerge successfully, then Chapter 7 bankruptcy assures that those bondholders receive as much as practical from the liquidation.

Either way, bankruptcy will do a much better job of helping the debt market thaw out than nationalization ever will because bankruptcy preserves the rights of bondholders.

If the government wants to help reduce the panic and stave off bank runs, it can announce that the FDIC will maintain its coverage on insured deposits at bankrupt banks. Even that help would only be temporary, as it could stand in line ahead of other creditors to be made whole in a bankruptcy proceeding.

Success through reorganization
Bankruptcy does not automatically mean the end of the world. Chiquita (NYSE:CQB) lived through bankruptcy and continues to operate its global produce business. Sears Holding (NASDAQ:SHLD) was formed when K-Mart, itself newly emerged from bankruptcy, gobbled up Sears. Delta (NYSE:DAL) is now the world's largest airline, even though it got out of its own bankruptcy less than two years ago. Even Winn-Dixie (NASDAQ:WINN) managed to survive its reorganization process, in spite of the sorry state in which it kept some of its Thriftway stores.

If the government's goal is to help the debt market -- and by extension, the overall economy -- recover, assuring an orderly and controlled bankruptcy process for failing banks would be a great first step. As politically expedient as nationalization might be, the bone chilling effects that poorly executed seizures would have on the debt market would make the recession we've lived through so far seem like child's play.

At the time of publication, Fool contributor Chuck Saletta owned shares of Bank of America as well as some essentially worthless stubs of Washington Mutual. Chuck's wife owns shares of Chiquita. JPMorgan Chase is a Motley Fool Income Investor pick. Sears Holdings is a Motley Fool Inside Value recommendation. The Fool's disclosure policy is hoarding gold bullion under its mattress until the insanity stops.