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Thursday, October 09, 2008


paulson to consider equity stakes in banks

one of the advantages of passing a non-plan plan in 72 hours is that you can do whatever you want with the money, even if it has little to do with how it was sold to congress and the people.

following the lead of the british, treasury secretary paulson is apparently considering direct capital injections into banks via equity stakes.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

some form of bank nationalization has seemed to me to be inevitable. but there are truths that, even on the adoption of such a plan, remain. one the times points out:

Yet behind the scramble for solutions lies a hard reality: the financial crisis has mutated into a global downturn that economists warn will be painful and protracted, and for which there is no quick cure.

i would add a second, corollary truth -- deleveraging will still be an imperative even after banks are stabilized. it is not simply the supply of credit but the demand for it that is on the wane as speculators are busted, securitization continues to slow, investment banks are downsized, securities fail to pay out, commerical banks continue writing down and consumers try to repair their balance sheet from an excessive binge.

this was one of the clearer lessons of japan following their massive bank bailout, or for that matter the nordic banking collapses of the early 1990s. recapitalized banks, while made at least temporarily stable, cannot be compelled to loan on former standards in former size to former boomtime sectors. indeed, we should not wish them to -- the lending orgy of 2005 was a diabolical thing that i for one hope never to see again.

and there is more. as delevering continues, the housing market -- where prices have not yet even adapted to normal credit conditions as a function of incomes -- will continue to deteriorate. asset performance for banks will therefore worsen. the size of the paulson plan is indeterminate on some level, the commonly cited restrictions of $700bn or the first trial limit of $250bn are not cost figures but balance sheet limitations. treasury could in theory launder purchased assets through the TARP by buying high at the front door and selling low out the back, perhaps even to the same party, taking losses all the way. but if either congress or paulson himself limit the extent of the treasury's activity, there exists a good possibility that funds will be insufficient to complete the job of recapitalization -- necessitating a further bailout down the road.

participation may be a problem as well.

One concern about the Treasury’s bailout plan is that it calls for limits on executive pay when capital is directly injected into a bank. The law directs Treasury officials to write compensation standards that would discourage executives from taking “unnecessary and excessive risks” and that would allow the government to recover any bonus pay that is based on stated earnings that turn out to be inaccurate. In addition, any bank in which the Treasury holds a stake would be barred from paying its chief executive a “golden parachute” package.

Treasury officials worry that aggressive government purchases, if not done properly, could alarm bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that target banks were failing.

and then there is the hazard of exogenous shocks in a global marketplace. no shortage of ideas here, from european bank failures to a fracturing of the EMU to a collapse in china (or, dare i say it, britain, who has all the american problems writ large).

nevertheless, this is probably the right way to proceed for treasury, mimicking more closely the RFC of the 1930s than any other bailout fund.

UPDATE: nouriel roubini examines how this shift from asset purchasing to recapitalization has come to be, including some chilling sloppiness of terminology on the part of members of congress and their aides, not to mention an obvious and sorry example of the cognitive capture of treasury and the fed by the banks.

Treasury formally resisted putting any explicit wording of public recapitalization of banks into the legislation. ... The 180 degree turn in the Treasury position is driven by the disastrous market reaction to the passage of this legislation and to the realization that US banks are in such a deep trouble that, absent a direct partial public takeover of the banks this severe financial crisis will get much worse. ...

When major policy actions for three days in a row fail to revive the stock market when such market is obviously oversold it is clear that there are no bottom buyers left and the risk of a 1987 like market crash is now at its highest level. So by yesterday Wednesday it was clear that we were on the verge of a systemic financial meltdown and that that flawed TARP has been effectively Tarp-edoed [lol -- ed.] by the market that realized that this approach to a systemic financial crisis was flawed. ...

So where did Paulson get the authority to do such capital injection when there was no such authority in the wording of the legislation?

At first, Congressional aides we contacted were confused on whether the wording in the legislation did allow such public recapitalization was permitted or not. ... senior Congressional aides argued that several sections of the bill could be used to argue that the purchased “assets” as used in these provision would include not only securities accounted for as assets on the balance sheet of the financial institution but would also include common and preferred share, warrants on common and preferred shares, as well as secured and unsecured and convertible debt in the financial institution itself, which would be accounted for as assets on the balance sheet of the US Treasury.

... we pointed out that this interpretation of “assets” as including preferred shares, left to itself, was a real stretch of the meaning of the legislation as preferred shares and common shares and sub debt are liabilities – rather than assets – of the bank. Thus, it was important to clarify that "any other financial instrument" was not limited to assets but also included institution’s liabilities such as stock, preferred stock, subordinated debt, senior debt. ...

... Since it was too late – by Wednesday last week - to explicitly modify the legislation to allow for explicit wording on this matter and since Treasury was resisting such late explicit changes (that would have jolted the banking industry) the tool that was used (in full agreement with the House and Senate leadership) to allow for such interpretation was to have Representative Jim Moran use the October 3rd House floor debate right before the final vote to put on the legislative record such interpretation. ... So, all is well that ends well.

It is a sorry reflection of the state of the US democracy that hundreds of Senators and Congressfolks did vote for the biggest bailout ever in US history ($700 bn) without even knowing exactly what they were voting for. They effectively and rightly allowed for a partial nationalization of the US financial system (the only solution that will prevent a systemic financial meltdown) without even exactly knowing that they were voting for this. So a huge plan that was sold as spending $700 bn to buy toxic waste of banks - and where the public discussion was all and only about this purchase of toxic assets – was finally and luckily rectified (with the hard and explicit efforts of many of us) to allow for a partial government takeover of such financial institutions.

Paulson should be lucky that his early opposition to such public capital injection in the financial system did not prevent Congress – via the back door – to do what was right. And he is now lucky that the first thing he could mention and did mention in his press conference yesterday was a plan to “inject capital into financial institutions” rather than the half-baked idea of spending most of the $700 bn to buy toxic assets.

can you imagine the gridlock that would have resulted on the hill had paulson been forced to go back up there this week to ask for explicit authority to inject capital via equity shares? we may have a total collapse yet, but such a stunning development would have been the trigger.

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