A $250 Billion Dollar Investment

Some details on the bank bailout plan:

U.S. Investing $250 Billion in Banks, NY Times: The Treasury Department, in its boldest move yet, is expected to announce a plan on Tuesday to invest up to $250 billion in banks... The United States is also expected to guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers...

And the Federal Deposit Insurance Corporation will offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses...

Treasury Secretary Henry M. Paulson Jr. outlined the plan to nine of the nation’s leading bankers at an afternoon meeting, officials said. He essentially told the participants that they would have to accept government investment for the good of the American financial system.

Of the $250 billion, which will come from the $700 billion bailout approved by Congress, half is to be injected into nine big banks, including Citigroup, Bank of America, Wells Fargo, Goldman Sachs and JPMorgan Chase... The other half is to go to smaller banks and thrifts. The investments will be structured so that the government can benefit from a rebound in the banks’ fortunes. ...

Bringing together all nine executives and directing them to participate was a way to avoid stigmatizing any one bank that chose to accept the government investment.

The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock. For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.

The next immediate step is to begin purchasing distressed assets:

As Treasury embarked on its recapitalization plan, it offered some details on the nuts-and-bolts of the broader bailout effort. The program’s interim head, Neel T. Kashkari, said Treasury had ... named an investment management consultant ... to help it select asset management firms to buy distressed bank assets. And it plans to announce the firm that will serve as the program’s prime contractor, running auctions and holding assets, within the next day. ...

Other government interventions:

Intervention is Bld, but Has a Basis in History, Steve Lohr, NY Times: ... The government’s plan to prop up banks large and small ... is an exceptional step, but not an unprecedented one.

The United States has a culture that celebrates laissez-faire capitalism as the economic ideal, yet the practice strays at times. Over the last century, the federal government has occasionally taken stakes in railways, coal mines and steel mills, and has even taken a controlling interest in banks when it was deemed to be in the national interest.

The corporate wards of the state typically have been returned to private hands after short, sometimes fleeting, stretches under federal stewardship. ... In 1917, the government seized the railroads to make sure goods, armaments and troops moved smoothly in the interests of national defense during World War I. After the war ended, bondholders and stockholders were compensated and railways were returned to private ownership in 1920.

During World War II, Washington seized dozens of companies, including railroads, coal mines and, briefly, the Montgomery Ward department store chain. In 1952, President Harry S. Truman seized 88 steel mills across the country, asserting that unyielding owners were determined to provoke an industrywide strike that would cripple the Korean War effort. That nationalization did not last long, though, because the Supreme Court ruled the move an unconstitutional abuse of presidential power.

In banking, the government took an 80 percent stake in the Continental Illinois Bank and Trust in 1984. ... As the nation’s seventh-largest bank, Continental Illinois was deemed “too big to fail”... In the end, the government lost an estimated $1 billion on the bad loans it bought as part of the takeover...

The nearest precedent for the Treasury plan, finance experts say, are the investments made by the Reconstruction Finance Corporation in the 1930s. The agency, established in 1932, not only made loans to distressed banks, but also bought stock in 6,000 banks, at a cost of $1.3 billion, said Mr. Sylla, the N.Y.U. economist. A similar effort these days, in proportion to today’s economy, would be about $200 billion.

When the economy stabilized eventually, the government sold the stock to private investors or the banks themselves — and about broke even...

Comments

[esb]

If the USA does not experience double digit inflation in 2011 and 2012 (measured fairly) I will eat my hat (or any other object that you care to suggest).

Several eight and nine figure net worth investors whom I respect have gone 15-25% into goldminers.

Lacking the courage of my convictions, I have only gone in 6% deep.

Inflationary depression, inflationary recession, stagflation, inflationary substandard growth, or inflationary growth, it is the inflation part that is now assured.

[esb]

http://globaleconomicanalysis.blogspot.com/
2008/10/essence-of-rescue-plan-in-comic-form
.html

Lovely.

[James]

Does this equity injection plan give the banks a way to buy the preferred equity shares back from the government? Or, will the banks be forced to pay out hefty 9% dividends to the government for eternity?

[dd]

Notice again this all comes on the heels of the Lehman bankruptcy and the CDS unwind. 250 Billion in cash settlement on the naked positions seems about right. Hedge funds liquidation on increased margin calls from the very entities receiving the injection plus the AIG positions (big naked writer) finds the government stabilizing the opaque market for now and by purchasing an equity stake will be the backstop for further unwinds. Then again this is just a guess as the information must be ferreted out as there is no public market, the public reporting is deeply obtuse and mostly blogged based. This is absolutely ridiculous and an anathema to transparency.
Notice too that if this is a CDS unwind cover, then money has yet again been misallocated as it does nothing to alleviate indebted consumers/homeowners or stabilize all the associated debt.
As stated many times, there is a template for dealing with a housing/banking crisis but that template is not being followed at all. Instead there is a desperate rush to save unregulated financial instruments and opaque markets while decimating designated over-leveraged hedge funds "losers" under the cover of a credit crisis. This is deregulation at its finest, where favored parties use taxpayer money to underwrite their private follies and employ government power to designate favored winners. Bush administration policy in a nutshell.

[skeptonomist]

Preferred stock at 5% interest and warrants for only 15% of investment? This is a giveaway, not a takeover.

[W.C. Varones]

Taxpayers get hosed again:

Warren Buffett got 10% perpetual preferred, plus tremendously valuable warrants, for investing in the cream of the crop, GE and Goldman Sachs. The taxpayers are getting 5% and only token warrants for investing in the stinkier banks. That's a direct transfer of wealth from current and future taxpayers to Wall Street fatcats.

I suggested last week that the Paulson should lock in today's ultra-low interest rates on the liability side of the balance sheet by doing a massive 30-year Treasury auction. What he's doing now is the opposite: locking in ultra-low rates on the asset side of the balance sheet. Yes, the rate purportedly rises to 9% after five years, but that still may not be enough to compensate for one or two bank failures and/or long-run inflation. And can anyone doubt that the 9% rate will be renegotiated when the banks cry poverty and donate to Chris Dodd and Barney Frank's campaigns? Locking in low rates on assets takes inflation off the table and leaves default as the only solution to unsustainable government debt. Now, $250 billion of low-rate assets isn't enough to do it, but I suspect this is only the beginning.

[baileyman]

As skeptonomist said,

and that deal is equivalent to taking 15% of the total contribution in common with a put at par, 85% in straight preferred. Seems like it meets the letter of the market's demand, but mostly provides low cost leverage. Woohoo! Roll the dice again, boys!

[tinbox]

This is just more of the delusional "liquidity problem" approach Paulson is scamming the public with. If Paulson believes what he says, he wants to turn back the clock so banks can lend again. That won't happen, and shouldn't happen. If he is misrepresenting his actions, then it's just a big fat inefficient giveaway. But worse than just being unfair now, it will more unfair down the road as it will impair and constrain any possible useful government action in the future.

[James Kroeger]

Now that people are starting to get used to the idea of the government owning at least a part of the troubled banks, maybe they will be able to get their heads around the idea of having the Treasury Secretary buy up all of the assets of some ailing bank (the very next one in great need of a cash infusion to avoid bankruptcy) at fire sale prices. Let the taxpayers' get as good a purchase price as the Bank of America got when it purchased Merill Lynch.

After buying the bank outright in the name of the Taxpayers, the managing directors of this bank should be sacked unceremoniously, replaced with top-notch academicians who teach finance. Using the existing staff, the new bank managers would fully capitalize the bank with taxpayer funds after writing off all of the 'toxic paper' that the bank had been carrying on its balance sheet. Then, within days, the new bank could begin providing all of the loanable funds that Main Street needs in order to keep humming along while Wall St. and the private banks are writing off trillions of dollars of worthless paper.

This way, you cross the nationalization line just as Paulson has, but you also open the lending tap for Main Street at the same time that gamblers and speculators in the [privately-owned] financial sector face the full consequences of their risk-taking sins. Why is this important? Because it would restore moral hazard as THE deterrent to excessive risk-taking in the private banking industry. Shouldn't that be one of our primary goals in trying to fix this whole mess?

After the big shakeout has finally run its course Congress could re-privatize the Taxpayers' Bank if that is what it decides it really wants to do.

[Alex Tolley]

James Kroger: "...managing directors of this bank should be sacked unceremoniously, replaced with top-notch academicians who teach finance."

You mean like LTCM? :)

[swells]

Having tucked away cash profits from my bottom feeding in the financials today, I think it is time to be really, really careful about what to do next. While I understand that shareholder dilution is preferrable to shareholders being wiped out and that a taxpayer funded bailout is preferrable to a thoroughly broken financial system, this seems like the least evil option where there are only evil options to hand. It's going to take some time to sort out what the results will be but I think they have to be inflationary in a rather large way.

Looking at this skeptically I think the massive collapse all at one time has been avoided but the slide will continue rather inexorably for some time. This is truly a mess that admits of no easy solution.