The Weakness of the Treasury's New Bailout Plan

The scorpion, it seems, is staying as true as he can to his nature. And although I'm the first to admit that this is no time to worry overmuch about moral hazard concerns, the slowly-emerging shape of Treasury's plan to recapitalize the banking system worries me.

The idea seems to be, in the first instance, that Treasury will buy nonvoting preferred stock in America's nine largest banks. They surely include the ones whose CEOs met with Hank Paulson in Washington today: Bank of America (BAC), JP Morgan Chase (JPM), Goldman Sachs (GS), Morgan Stanley (MS), Citigroup (C), and Bank of New York Mellon (BK). Wells Fargo (WFC) will be on the list too, and a couple of others.

In the case of the most solvent banks, this is a necessary annoyance. They might not like raising equity at these levels, but they need a working banking system as much as anybody else, and if that involves destigmatizing Treasury capital, then so be it. Note that in the UK, the two biggest recipients of government capital, RBS and HBOS, both saw substantial falls in their share price today, while Barclays (BCS), which said thanks-but-no-thanks to the government, rallied impressively.

It's not entirely clear what Treasury's capital injections are for, however. On the face of it, since they're aimed at all banks, not just those in trouble, they're not an attempt to restore solvency. But that might change when we see the numbers: If Morgan Stanley ends up getting much more cash than Wells Fargo, the impression will change.

There's a symbolic element to the recapitalization: With the government buying preferred shares, it's essentially saying that it has no interest in supporting the stock price, but that there's no way it will allow sub debt or any other bondholders to suffer. And that symbolism is backed up by explicit intent:

The FDIC is expected to temporarily extend its backstop from bank deposits to new funds raised by banks and thrifts for three years. That would be an aid to companies that have had a hard time raising capital without government assistance.

This bit of the plan, incidentally, I like. With Frannie (FRE, FNM) buying up toxic assets and the FDIC insuring bonds, that frees up most of the TARP funds to be used for recapitalizations.

But the broad-brush approach of the proposed plan, with no voting rights and seemingly very little due diligence, worries me. Pricing the Treasury's preferred stock will be a bugger; I have a feeling they might just make all the banks pay them a nice round 10% and leave it at that, with the banks having a call option after, say, three years.

But that one-size-fits-all approach, especially when it's combined with the present bank management which got us all into this mess to begin with, is a recipe for hail-mary passes and other forms of counterproductive risk taking.

If you're running an insolvent bank, and you get a slug of equity from Treasury, your shareholders will thank you if you use that equity to take some very large risks. If they pay off and you make lots of money, then their shares are really worth something; if they fail and you lose even more money, well, there was never really any money for them to begin with anyway.

Brad Setser has it right, I think:

A world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

I asked Brad to clarify, and he wrote back:

If the guarantee is credible then an institution with little or no equity has the capacity to raise wholesale funds to gamble for redemption.

And those bets are a potential source of instability.Regulation theoretically can limit this risk, and right now there is enough fear that I am not sure that it is most immediate risk -- but conceptually, the incentive to make big bets with the government's guaranteed money is there.

This is a real risk, I think, especially when you're talking about banks like Morgan Stanley whose books are very opaque and which can lever up substantially within minutes should they feel like it.

There's no sure way to prevent such risk-taking altogether. But if you go the UK route and insist on board seats and the ouster of failed executives, it helps. That's what Treasury did with AIG, and they should do the same with the banks they're rescuing. If they don't, they're basically getting all of the downside of nationalization with none of the upside.

I'm quite sure that Paulson hates the fact that he's semi-nationalizing the banking system. But he needs to get real and accept it, rather than trying to brush it under the carpet. Otherwise he's putting hundreds of billions of taxpayer dollars at unnecessary risk.

Update: The Big Four banks get $25 billion each. That's $100 billion gone right there; I hope it's worth it.

Comments

[prescient11]

Felix, the resident genius with "concerns". Really, man, why don't you just own up to it. No plan would be perfect. And they're taking preferred shares so they do not dilute the common. While it's not as much oversight as one would like, what do you expect them to do, FORCE healthy banks to accept this capitalization and then FORCE them to accept new board members, someone probably as dense and bureaucratic as yourself.

Listen, despite your constant cabal-like effort to communicate "concerns" about everything, this is the government giving you a big middle finger, saying, listen skippy, we, the Euros, everyone is backing our banks and that's it. So move along Felix, just move along man. You've been out of your league for some time.

The financial system will not fall, it appears, based on these broad guarantees, and I think the governments of the first-world nations should be applauded for their efforts in this regard. Let's just hope the lesson has been learned and once the bleeding is stopped they fix the disease.

[marvinthemartiansdog]

I have been reading your blog the past few weeks, and it seems to me you are seldom right.

[marvinthemartiansdog]

BTW, they had already stated what amount of money each bank will receive.

"The Treasury plans to spend $25 billion each for stakes in Citigroup and JPMorgan, people said. Another $25 billion will be divided between Bank of America and Merrill, which agreed last month to be acquired by Bank of America. Wells Fargo is to get at least $20 billion, Goldman and Morgan Stanley will each get $10 billion, and State Street and Bank of New York will get about $3 billion each, people said."

[phat cat]

One thing I learned from the '97 Asia financial crisis is not to bet against the government. The date the HK government intervened in the stock market was the date the market hit the bottom.

Now we have a concerted effort by virtually all the governments in the world (minus iceland) on board to fight this beast, it'd be foolish to bet against them. I don't care how much the hedge funds have in their control, you are fighting against the guy with the money printing press. And where can you go if you don't like what the US is doing? Everyone is on the same boat this time! Look around, the Europeans are in even deeper, and the Asians are panicking even more because they need customers who buy their products!

In short, people, let's quit the doubting and move on try to make the plan work.

[Robert Silvestri]

The banks can raise capital and help the economy at the same time by selling $1,000 CDs to older peopleat a 8 or 10% rate. This would be a special CD that woould do twos things--one give the banks a chance to raise capital to settle some of the problems that they are in and give seniors or people who buy these CDs a chance to earn something extra with their social security or pension. The interest can be sent to the CD purchasers and the banks will have the initial infusion of capital at the cost of the interest over a much longer period until the present economic situation can be handled.

[David D]

When The First National Bank of Ben and Hank decided to let Lehman go, the brainthrust did not completed understand the consequences. Had the decided to follow the Barclays Capital plan, they would have given the same program as JPM/Bear, except $40 billion. AIG would have only needed a loan of about $40 billion, not $122 billion. The FNB Ben and Hank would not be shoving capital up the banks rear, and the credit markets would have still been trustworthy. Finally, had Lehman survived, the $700 b would be going to fix the troubled assets, not the troubled financial system.

I hope Ben and Hank will no be remembered as saviors, but as the one that created the problem with letting Lehman go.

I don't work at lehman and I did not own lehman. I have no personal ax to grind, but that is the reality of the situation!

[ashizashiz]

I sit here at my desk at work---for now---and gawk wide-eyed in utter amazement at the depths to which human beings will go in order to satiate their lust for power and their Midasian greed. Paulson, Bush, Bernanke: soucndrels, one and all. Scumbags of the highest order. Liars who would sell their souls to the devil, who would swear on the lives of their families, that they are telling the truth. But no amount of dissembling or obfuscation can change the laws of nature: reality, in the end, always wins out.

Toxic “assets” in the tens of TRILLIONS of dollars fill the casks and vaults and safes and basements of the world’s major financial institutions. Worthless pieces of paper that, when exposed to the light of day, will bring the global economy as we know it to its knees. There is no escaping this reality. None. The laws of nature will eventually pull the curtain back on the Oz-like charade that is being played out in Washington and Paris and London and Berlin, and the global economy will shatter.

And so in the intervening days/weeks/months, Paulson and Bush and all of their minions pump trillions of dollars of “money” into these so-called “healthy” institutions in order to loosen the credit market so that, at least for the time being, things regain the appearance of a recovery. And an election takes place next month, and the DOW “rebounds” to about 10,400 give or take, and a few of the largest banks begin easing credit restrictions and reluctance to take on risk, and all seems to be moving in the direction of eventual better times. And yes, recession exists, and the economy is tight, and jobs are lost, but the new President goes on TV and tells the people that, while times are tough, we are a strong people, and we will recover. (Meanwhile Bush and Paulson and their minions have moved to a small island off of the coats of Costa Rica and hired Blackwater to protect them from the rest of the world.)

But soon thereafter, at some unknown moment in time, all of the fake money, the supposed assets and capital that the Bushies have pumped into the system---all of the trillions of dollars in guarantees promised by the countries of the EU to their financial institutions---all of these monies become exposed for what they really are---MORE DEBT. More lies, falsehoods, specters. Trillions of dollars THAT DO NOT IN FACT EXIST, loaned to banks and insurance companies and auto makers in “hopes” that they, somehow, will be able to make some money and build capital that, at this point, is simply a wraith in the night. But of course this plan fails. It must fail. It is just another layer of the grand ponzy scheme of the millennium, perpetrated on the people of the Earth by a handful of greed-mongering bastards and sons-of-bitches.

By way of metaphor, this situation is akin to building a tower on unsteady ground, and instead of deconstructing the tower and starting again, you simply make the tower taller and claim to the people that this truly is the most wonderous tower in the world, a monument to the strength and resolve of the people. But it must fall. The laws of physics demand it. And the same is true of our current economic joke.

And so I sit here and watch economist after economist, legislator after legislator, president after prime minister after finance minister, claim that the plan “will” work. And they are all lying.

[anarchist]

I am not so sure all the legislators, economist, Prime Ministers, etc. are lying. I think they are in a state of panic and don't know what to do. Maybe they are limited by what they think the people will accept? In SA one sees comments demonstrating a resistance to "socialism", regulation and "nationalizing&qu... which I must assume is the rallying point of Americans in general. So instead of doing any of the above they piece-meal it to death, always behind the curve with no imagination. I have heard how smart Paulson is as well as the Fed. Chairman but smart people do dumb things when in a panic.

[mcgilla]

Reverse debenture structure/s, as opposed to outright equity purchases, for longer-term FED de-leveraging of banks?

[M.Adeel Qureshi]

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[M.Adeel Qureshi]

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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

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Muhammad Adeel Qureshi,
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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
Karachi University,
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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
Karachi University,
Students Advisor and Scholarship coordinator for Higher Studies,
Carrer planing and Local GRE type test guide and
Educational consultant

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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
Karachi University,
Students Advisor and Scholarship coordinator for Higher Studies,
Carrer planing and Local GRE type test guide and
Educational consultant

Online help providoer by email or Tele-Help for Pakistani callers only

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[M.Adeel Qureshi]

Its nice to have debate on this importnat topic to avoid ' The Grat depression' again,

Regards,

Muhammad Adeel Qureshi,
M.A. History,
M.A. International Relations,
PhD fellow,
Lecturer,
Karachi University,
Students Advisor and Scholarship coordinator for Higher Studies,
Carrer planing and Local GRE type test guide and
Educational consultant

Online help providoer by email or Tele-Help for Pakistani callers only

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