Tuesday, October 14, 2008

The Government to Take Equity Positions in 9 Financial Institutions

Unlike my "totally free market" brethren, I totally agree with the US government taking a preferred stock position in the the banks. Now is not the time to cling to some ideology. It is time to move to save and restore the banking system. The question I have is that US Bank is conspicuous by its absence from the list. Maybe they get an equity injection when they have to pick up one of the large regionals that is in bad shape. This is just round 1 of a 100 round fight. In 5 - 10 years the banking system will look completely different from what it looks like today. Text in bold or para thesis is my emphasis. From the WSJ:

U.S. government officials released a plan to take stakes in nine large financial institutions in an effort to help revive the banking sector and fight the global credit crunch.

In one of the most dramatic actions taken by regulators to address the financial crisis, officials plan to funnel up to $250 billion from the $700 billion financial rescue package into potentially thousands of banks through the new, voluntary program.

The government is set to buy preferred equity stakes in
Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. -- including the soon-to-be acquired Merrill Lynch -- Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp.

Banks have a month to join Treasury's capital purchase program. They must elect to participate before 5 p.m. on Nov. 14.

"The efforts are designed to directly benefit the American people by stabilizing the financial system and helping the economy recover,'' President George W. Bush said in a morning announcement.

Additionally, federal regulators announced that they'd guarantee new bank debt and expand insurance for non-interest-bearing accounts. They also issued new details on a plan to backstop the commercial paper market, where major corporations go for critical loans to fund their daily operations.

"They've exposed the whole toolkit," said Vincent Reinhart, former head of the Fed's monetary affairs division. "What do you do if this doesn't work? You do more of it."

Under the last step announced by Mr. Bush, the Federal Reserve will finalize a program to serve as a buyer of last resort for commercial paper, an important source of short-term financing for businesses banks.

Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben Bernanke, and FDIC Chairman Sheila Bair also made comments Tuesday.

Mr. Bernanke said the U.S. will not "stand down" until financial system and prosperity restored. Mr. Paulson, in his own remarks, said financial institutions in the new program will limit executive compensation. He said that "government owning a stake in any private U.S. company is objectionable to most Americans," but said the alternative "of leaving businesses and consumers without access to financing is totally unacceptable."

Some of the big banks were unhappy about the government taking equity stakes, but acquiesced under pressure from Mr. Paulson in a meeting Monday. During the financial crisis, the government has steadily increased its involvement in financial markets, culminating with a move that rivals the breadth of the government's response to the Great Depression. It intertwines the banking sector with the federal government for years to come and gives taxpayers a direct stake in the future of American finance, including any possible losses.

Formulated jointly by the Treasury, the Fed and the FDIC, these moves announced Tuesday are designed to keep money flowing through the financial system, ensuring that banks continue lending to companies, consumers and each other. A freeze in these markets rippled through the economy and helped cause stocks to crater last week.

"Government owning a stake in any private U.S. company is objectionable to most Americans -- me included," Mr. Paulson said in a statement Tuesday. "Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable."

Along with the government's involvement come certain restrictions, such as caps on executive pay. For example, firms can't write new employment contracts containing golden parachutes and their ability to use certain executive salaries as a tax deduction is capped. These restrictions are relatively weak compared with what congressional Democrats had wanted when they approved this spending, a potential flash point.

Some critics also say Treasury should have formulated a comprehensive plan earlier in the crisis. Even if this move helps mend credit markets, the economy is likely to suffer in the months ahead from the aftershocks of the recent turmoil. (It is easy to Monday morning quarterback in a crisis. It is much more difficult to join them shoulder to shoulder on the firing step.)

A central plank of these new efforts is a plan for the Treasury to take about $250 billion in equity stakes in potentially thousands of banks, using funds approved by Congress through the recently approved $700 billion bailout plan.

Treasury will buy $25 billion in preferred stock in Bank of America -- including Merrill Lynch -- as well as J.P. Morgan and Citigroup; between $20 billion and $25 billion in Wells Fargo; $10 billion in Goldman and Morgan Stanley; $3 billion in Bank of New York Mellon; and about $2 billion in State Street.

The government will purchase preferred stock, an equity investment designed to avoid hurting existing shareholders and deterring new ones. Such shares typically don't come with voting rights. They will carry a 5% annual dividend that rises to 9% after five years, according to a person familiar with the matter. By investing in several big firms at once, the government hopes to avoid placing a stigma on any one firm for getting government help.

The plan will be structured to encourage firms to bring in private capital. For instance, firms returning capital to the government by 2009 may get better terms for the government's stake, a person familiar with the discussions said.

Among the other key components of the plan is the FDIC temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts. This would apply to debt issued by June 30 with maturities up to three years. One problem plaguing credit markets has been a fear among financial institutions that it is unsafe to lend to each other even for periods of a few days. U.S. officials hope this guarantee removes that fear, which could bring down short-term lending rates, such as the London interbank offered rate, or Libor, a benchmark for consumer and business loans.

The FDIC is also temporarily offering banks unlimited deposit insurance for non-interest bearing bank accounts typically used by small businesses, through 2009. This would be voluntary for banks, and would extend the $250,000 per depositor limit lawmakers agreed on two weeks ago. To use these new powers, the FDIC is invoking a "systemic risk" clause in federal banking law that allows it to take extreme steps to prevent shocks to the economy.

The FDIC's central role in the plan is consistent with its presence during past banking crises, the Great Depression and the savings and loan crisis. Each crisis sparked a major boost in the agency's power.

The shift brings U.S. policy more in line with that of other countries. Monday, the U.K., Germany, France, Spain and Italy provided further details of measures to buy stakes in struggling banks and offer lending guarantees. The U.K., which first formulated such a plan, is planning to issue some £37 billion ($63.1 billion) in new government debt to pay for purchases of the common and preferred shares of three big banks.

The U.S. plan to inject capital into banks is expected to be open to almost all such institutions, with a focus on getting the participation of the firms most important to the financial system, according to people familiar with the matter. Treasury's main goal is to attract private capital. To make sure private investors aren't scared away, it is expected to structure its investment on terms favorable to the banks and will inject capital in exchange for preferred shares or warrants, these people said.

The government's new focus is raising questions about why it didn't adopt such an approach sooner. Mr. Paulson actively opposed the idea of investing in banks because he worried about picking winners and losers, though Fed Chairman Ben Bernanke was an early advocate. Mr. Paulson was also concerned banks wouldn't participate because of the perceived stigma and the potential for the government to meddle in their affairs, according to people familiar with the matter.

Senior executives and advisers to some of the nation's leading banks pitched such a plan at various points earlier this summer but were rebuffed by officials at Treasury and the Fed, according to people familiar with the matter. Instead, Treasury initially marched ahead with a plan to buy distressed assets directly from banks.

House Democratic leaders, including Speaker Nancy Pelosi and House Financial Services Committee Chairman Barney Frank, held a closed-door session Monday with 11 economists and other advisers. The group threw its weight behind Treasury's decision to inject capital into the banking system.

"The consensus was so strong towards direct equity injections that there was literally no dissension on the point," said one of the invited economists, Jared Bernstein of the liberal Economic Policy Institute. "The only head-scratching is why did it take us so long to get here?"

Officials at the Treasury and Federal Reserve have been looking for a comprehensive approach to the credit crisis after a series of ad hoc interventions and say they didn't have the authority to make such a comprehensive move until Congress passed the bailout bill. The government's various moves, from saving mortgage giants Fannie Mae and Freddie Mac to letting Lehman Brothers Holdings Inc. fail, have confused investors and frozen many in place at a time when the banking system was desperate for fresh capital. That contributed to what in essence was a high-level run on Wall Street banks, with funding drying up overnight.

The government's hope is that the new plan will more thoroughly address the problems of ailing financial institutions and persuade private investors that government involvement won't come at their expense.

For troubled assets there is the Troubled Asset Relief Program, created by the $700 billion bailout bill, which gives the Treasury Department authority to acquire bad assets from banks and other financial institutions. TARP will also be used by Treasury when it puts new equity into banks.

The other steps, including the FDIC's role in guaranteeing new funds raised by banks and thrifts, are designed to address the way banks fund themselves, freeing them to start lending again.
Meanwhile, the Federal Reserve announced that beginning Oct. 27, a new program will be open to fund purchases of commercial paper of three-month maturity from high-quality issuers. It will cease purchasing commercial paper on April 30, unless the program is extended.

Unsecured commercial paper will be priced at the three-month overnight index swap rate plus 100 basis points with an additional 100-basis-point surcharge. Asset-backed commercial paper will be priced at the OIS rate plus 300 basis points.

Libor rates, which are set daily in London, fell in anticipation of Tuesday's announcement. The largest decline was in overnight Libor rates, though one- and three-month rates also fell. Prices of U.S. Treasury bills, which usually benefit from flight-to-quality buying, fell Tuesday -- a sign that investors are willing to take on more risk. (The spread between short term Treasury and LIBOR rates are probably still too high.)

Mr. Ben Bernanke on Tuesday made clear that regulators will keep taking actions until the turmoil in financial markets eases. "We will not stand down until we have achieved our goals of repairing and reforming our financial system and thereby restoring prosperity to our economy," he said.
William Poole, former president of the Federal Reserve Bank of St. Louis, was a fierce critic of Treasury's initial plan to buy up distressed mortgage-backed securities. Such a scheme, he said, would lead banks to dump their worst assets on the taxpayers.

But Treasury's new tack may well do the trick, said Mr. Poole, now a senior fellow at the free-market-oriented Cato Institute.

"Investors need to be confident that the banks they're dealing with are unquestionably solvent, and it's in the interest of banks to assure investors that that's the case," he said. "One way banks can provide that assurance is to raise additional capital, in some combination of private and government capital."

Dean Baker, co-director of the left-of-center Center for Economic and Policy Research, argues the country may have turned a corner on the financial panic -- the fear that has kept banks and investors from making even the most prudent loans. "I think we're through the worst on that," he said. "Maybe I'll be proven wrong, but it really was at an extreme last week."

Blanket guarantees, however, might inspire banks to take unnecessary risks, warned Frederic Mishkin, a Columbia University economist who stepped down as Fed governor in August. "You don't want to give a guarantee to banks that are in trouble" that might try to gamble their way out of problems, he said. He says offering broad guarantees will require that U.S. officials more aggressively act to sort out good banks from bad banks.

One sticking point could come from Congress, which wrote into the original bailout bill requirements that Treasury tamp down executive pay. Rep. Frank said Monday he wants the government to set tough conditions for any company that receives a capital injection. If Mr. Paulson didn't enforce such rules, Mr. Frank said the Treasury secretary could be "making a big mistake." (Maybe they should roll AIG executives into this as well.)

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