U.S. Investing In Banks To Free Up Lending

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke i i

Treasury Secretary Henry Paulson (left) speaks while Federal Reserve Chairman Ben Bernanke listens during a Tuesday news conference to outline a new government plan to stabilize U.S. banks by investing in them. Mark Wilson/Getty Images hide caption

itoggle caption Mark Wilson/Getty Images
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke

Treasury Secretary Henry Paulson (left) speaks while Federal Reserve Chairman Ben Bernanke listens during a Tuesday news conference to outline a new government plan to stabilize U.S. banks by investing in them.

Mark Wilson/Getty Images

The Bush administration's latest prescription for the ailing financial industry — a program that clears the way for the U.S. government to buy a $250 billion equity stake in the nation's banks — provided only the slightest glimmer of optimism in the U.S. financial markets Tuesday.

The Dow Jones industrial average rose nearly 400 points at the opening bell but ended the day 76.62 points lower, at 9310.99. Investors bid down stocks as they braced for what comes next: the bite the financial crisis is bound to take out of corporate profits.

On Tuesday morning, President Bush and Treasury Secretary Henry Paulson were careful to tiptoe around the idea that with the program they were nationalizing the nation's banks. Instead, they preferred to cast their decision to spend about a third of the $700 billion Congress provided as a "recapitalization" effort. The president said the decision to buy shares in the nation's leading banks was "not intended to take over the free market, but to preserve it."

The program is meant to be a straightforward way to beef up thinning bank reserves. Many banks have been running on fumes, working with less money because of their bad bets on mortgage-related investments. The concern about reserves is one of the reasons banks have been loath to lend to one another. They have been worried that once they lend out money, they won't get it back — a mind-set that has frozen the world's credit markets.

While the Treasury says the program is voluntary, there was some arm-twisting. Paulson met with banking executives at the Treasury on Monday and leaned on them to accept government investments even if they didn't think they needed the hand. The idea was to include healthy institutions in the recapitalization program so that banks that chose to accept the government's help wouldn't be stigmatized or seen as failing.

Paulson announced Tuesday morning that nine banks have already agreed to accept government investments "to help protect the economy." He didn't identify the institutions by name, but the group is expected to include Citigroup, Goldman Sachs, Wells Fargo, JPMorgan Chase, Bank of America, Merrill Lynch and Morgan Stanley. Executives from these banks were seen going into the Treasury to speak with Paulson on Monday.

The government will invest $125 billion in those nine banks and then make another $125 billion available to the nation's smaller, regional banks if they ask for it.

The last time the Treasury waded into the banking system in this way was in the 1930s. That's when the government set up the Reconstruction Finance Corp. to make loans and buy stakes in distressed banks during the Great Depression. The price tag at the time: $1.3 billion. The government eventually got out of the banking business when the economy stabilized. The government sold the stock it held to private investors and the banks themselves. That's expected to happen in this case, as well.

Loan Guarantees And Deposit Insurance

Under the new program, in addition to injecting some badly needed liquidity into the system, the government will also guarantee new bank debt for the next three years. That is meant to squeeze some of the uncertainty out of current lending and get credit markets moving again. For the man on the street and small-business owners, the Federal Deposit Insurance Corp. announced that it will provide unlimited insurance on non-interest-bearing accounts.

Tuesday morning, Paulson warned the bankers against stashing away the new cash infusions. They needed to actually use the money they were getting from the government, he said.

"We must restore confidence in our financial system," Paulson said. "The needs of our economy require that our financial institutions not take this new capital to hoard it but to deploy it."

He looked looked pained as he announced the government's decision to move into the private sector. "We regret having to take these actions," he said. "Today's actions are not what we ever wanted to do, but today's actions are what we must do to restore confidence in our financial system."

While investors seem cheered by the announcement, the U.S. is playing catch-up. Over the weekend, European financial officials had already made many of the same moves. Britain, France, Germany and Spain flooded the international banking system with liquidity in a bid to get credit markets moving again. They said they would guarantee bank debt, take ownership stakes in banks, and shore up ailing companies with billions in taxpayer funds.

The reaction in the markets overseas was immediate. European shares have been rising. By early afternoon in Europe, the pan-European FTSEurofirst 300 index was up 6.1 percent to 994.7 points. Banking stocks overseas surged. Barclays rocketed up 18.4 percent. UBS rose 13 percent.

The U.S. Plan

The government will buy nonvoting preferred shares in qualifying financial institutions. That means that the shares will pay annual interest. The preferred shares will pay a 5 percent annual dividend for the first five years and then will rise to 9 percent after that. The interest is structured that way to encourage companies to repay the government after three years.

The downside for shareholders is that it immediately dilutes the value of existing shares and limits some of the companies' future profits because some of the banks' revenues will have to go to the government. The stakes in each institution will be limited to $25 billion or 3 percent of risk-weighted assets. The Treasury set a Nov. 14 deadline for banks to apply for the government purchases.

The new program has some strings attached. Firms that have the government buy stakes will have to accept limits on executive compensation, including forfeiting tax deductibility for compensation above $500,000 for top executives.

In return for its help, the government will also receive warrants worth 15 percent of the face value of the preferred stock. If the government makes a $10 billion investment, then it will receive $1.5 billion in warrants. The idea is that if the stock goes up and the banks get back in the black, the taxpayers will be able to share in those profits. If the stock declines, the warrants will be worthless.

In a bid to thaw interbank lending, the FDIC will guarantee 100 percent of banks' senior unsecured debt. It will also guarantee all deposits held in non-interest-bearing transaction accounts until the end of 2009. That is meant to boost confidence in the banks to prevent a run on deposits.

"The overwhelming majority of banks are strong, safe and sound," FDIC Chairman Sheila Bair said. "A lack of confidence is driving the current turmoil, and it is this lack of confidence that those guarantees are designed to address."

Taxpayers won't be footing that bill. Bair said that the guarantees will be paid for by a 75-basis-point fee paid by banks to protect their new debt issues. The FDIC also added a surcharge on top of the banks' regular deposit insurance fees.

Bailout Focus Shifts

The $700 billion bailout program was originally sold to Congress as a way to buy toxic debt from beleaguered banks. The buyback program seems to have taken a back seat to the cash infusion announced Tuesday.

The Treasury has been making progress on setting up the agency that will take on some of the bad mortgages banks have on their balance sheets. It said that it has filled several senior posts. Simpson Thacher, a Wall Street law firm, will provide legal advice to the Treasury. Ennis Knupp, a Chicago-based investment management consultant, will help the Treasury select the asset management firms that will buy the bad mortgages. It is unclear which companies will conduct the auctions for the debt. That is expected to be announced soon.

While the headline number on the stock market seems to be saying the plan will turn the tide of pessimism that has driven investors in recent weeks, there are other barometers to watch. The London Interbank Offered Rate, or LIBOR, which is what banks charge each other to borrow money, has hardly moved. The so-called TED spread, which is the difference between what banks are charging each other to borrow money over the cost of Treasuries, also hasn't budged. Those are very good indications of whether the plan is inspiring the confidence it is intended to.

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