An Explanation Of the Treasury's Debt Purchase And Equity Injection Program

From the WSJ:

The U.S. government is expected to take stakes in nine of the nation's top financial institutions as part of a new plan to restore confidence to the battered U.S. banking system, a far-reaching effort that puts the government's guarantee behind the basic plumbing of financial markets.

To kick off Tuesday's expected announcement, 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., according to people familiar with the matter.

Some of the big banks were unhappy about the government taking equity stakes, but acquiesced under pressure from Treasury Secretary Henry 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.

Other elements of the plan, which will be announced Tuesday morning, include: equity investments in possibly thousands of other banks; lifting the cap on deposit insurance for certain bank accounts, such as those used by small businesses; and guaranteeing certain types of bank lending. It builds on an earlier plan to buy up rotten assets dragging down banks, which failed to calm investor fears, and follows similar moves by major European countries.

Let's look at the two different ways the Treasury Department is looking at helping the banking sector.

Here is how they were recently described:

1) Mortgage-backed securities purchase program: This team is identifying which troubled assets to purchase, from whom to buy them and which purchase mechanism will best meet our policy objectives. Here, we are designing the detailed auction protocols and will work with vendors to implement the program.

2) Whole loan purchase program: Regional banks are particularly clogged with whole residential mortgage loans. This team is working with bank regulators to identify which types of loans to purchase first, how to value them, and which purchase mechanism will best meet our policy object

.....

4) Equity purchase program: We are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

Buying Debt/Loans/Mortgages

Under this plan, the government will purchase problem assets from lenders. Let's look at the pros and cons of this program:

Pros

-- It gets the assets off the books. This prevents the assets from further hurting the financial institution.

Cons

-- Define "troubled mortgage/loan".

-- The only way for this program to work is for enough of the bad mortgages/loans to be purchased to convince lenders that problem mortgages can't hurt the system. Put another way, the government has to purchase enough of these asset to inspire intra-institution confidence. I have no idea what amount that would be.

-- The only assets the institutions will sell are the ones that are probably going to remain depressed in value for the duration of their existence. No one is going to sell an asset that is or has a higher probability of making them money. This means the government stands a higher probability of taking most of the losses.

Equity Injections

Under this plan, the government will buy preferred shares with cash.

Pros

-- The institutions gets cash immediately. In theory, this should encourage the institutions to start lending again.

Cons

-- Why would they want to start lending? We're at the beginning of a recession, defaults are increasing and other lenders have assets on their books that are increasing the possibility of default. This is not a pro-lending environment.

-- With housing values still decreasing in value, anything related to mortgages will also be dropping in value. That means loans and bonds tied to loans will continue to drop forcing institutions to continue writing down the value of these assets. As a result, equity may go loan loss reserves. This means the government will have to buy a large enough amount of equity to encourage lending and possibly the increase in loan loss reserves coming down the pike. Put another way -- expect multiple injections over the coming year or so.

-- The government says it isn't buying an ownership interest that will lead to directing bank policy. I'm finding that a bit hard to believe. Call me cynical. I don't see how an investment of over a billion dollars in some institutions will not lead to meddling in the internal workings of these institutions.

Guaranteeing Lending

Pros

-- Provides a seal of approval for intra-institution lending. This should help a great deal. So far this year we've seen 15 banks go into receiver ship. Remember -- this does not mean the bank ceases to exist. It means the FDIC essentially runs the bank with an extremely conservative agenda. Therefore, loans taken out will still get paid.

-- Other banks that are in trouble have been purchased quickly. The FDIC and the Federal Reserve are (so far) staying one step ahead of the problems.

Cons

-- This could lead to big payouts in the event of systemic problems. My best guess right now is -- given the other parts of the plan put in place -- guaranteeing loans is largely symbolic.

Conclusion

It's really looking as though it's going to take a combination of both of these ideas to take care of this mess. Buying the worst assets will prevent them from hurting the balance sheets of these institutions anymore. Basically sequestering these assets in the long-term is a way to contain the damage.

Buying equity shares gives the banks money upfront which they can with use to bolster their balance sheets and/or make loans. But given the current macro-environment, don't expect a plethora of lending to take place. We are in the middle of a recession after all.

The bottom line is this combined program has the potential to stop the bleeding.

Comments

[hellinabucket]

So why not create the United States Bank with the taxpayers as stakeholders? Let us decide where the $ will go! Why are the irresponsible ones getting rewarded? This BUSH Administration proposal is NOT to be trusted! Why cant they tell us our return on investment?

[Pdubya]

People highly underestimate the coercive "techniques" used when billions and trillions of dollars are at stake.

seriously folks.....you think these folks aren't capable of orchestrating hits?

know what eliot spitzer was about to do to the banking industry? know that the patriot act was used to nail him?

[sposton]

As I read it, no matter what, we are royally screwed. I don't understand why this crisis does not engender some robust questioning of our "free enterprise" system and our "democracy". Without a credible threat to it, these cats will never reform. This bailout is just another huge transfer of wealth from many to few. Perhaps something needed to be done, but I am sure we could have designed a better system if Congress decided to do their work and actually got some expert witness testimony. But no, they had to blindly pass yet another law that Bush administration handed to them. All they did was to add some pork to the original proposal, and some "gentle" persuasion in the form of a threat of martial law did the rest. Bravo Congress! Pelosi, Reid, & Co., do you care to know why your approval numbers look so great?

[Sauve qui peut]

8......7.6.5.4.3..2...1... OK GO >The BUSH U.S. Government official starts now as a "steakholder" in the 9 biggestest U.S. Banks ....opps wait a minute I just have to do this one thing first then we've off. I have to plug the biggest USB Port Plug in the world into the biggest USB Port Receptical in the world, then we'll be staked together. OK; That's it! Commence transfer of all personal banking records to the special place. Add this to the fully-identified protected health information (EHR) patient DB(s) which are now almost completely HIPPAA Compliant Unique Identifier Longitudinalized. This should complete the 9 (demographics) primary keys for the combined data set to link patient (citizen) records and de-identification of the combined records. All required by the Centers for Medicare & Medicaid Services (CMS). We don't need no stinking SS#. Your banking records + Med Recs (which are already in National Registries, Yes I do send them your SS# & MRN) + a bit of Iris scan, Fingerprints, DNA(any arrest), Face Recon... Think I'm making this up? Come with me to Orlando next week.

[realpolitic]

What is a "Bonddad Stewart article without graphs? I did not know words were allowed to explain economic principles!

[kimk3]

Buying the worst assets will prevent them from hurting the balance sheets of these institutions anymore.

Why do we care about their balance sheets? I don't think we should be giving money to the lenders -- but we should be giving money to the borrowers. The lenders care primarily about their balance sheets and secondarily about the well being of their borrowers (i.e., the people about to be foreclosed for example)

Plus, my understanding is that most of the "bad loans" have little, at this point, to do with mortgages, sub-prime or otherwise. The bad stuff, the toxic, worthless stuff, are the credit derivatives stuff, which are just bets and insurance, sort of, which all spun out of control. I have heard figures like $200 trillion of that crap is out there. I heard somewhere that Switzerland can not bail out UBS because UBS' exposure with its credit default swaps is about 5 times the gross national product of all of Switzerland.

It's really a pathetic mess.

[george99]

I think you and others have put out another unfair solution to the credit crisis that of also bailing out the borrowers. How do you separate the speculators (who should not be lent our money) from the few borrowers who didn't realize they were taking out unmanageable debt and these few borrowers include people who have unwisely taken out home equity loans in a falling housing market or hold 9 maxed out credit cards in their wallet or have bought a 10 mpg gas guzzler during the worst part of the oil crisis. I have done none of these. Why should I, who is not one of these borrowers, who is sliding down from the middle class to the lower middle class to the poor class because of the inflation caused by this crisis, who lives on a fixed income and can't pay my share of the price (which will be huge) to fix this economic crisis, why should I bailout the borrowers.

[americaforme]

How can this ever succeed with preditory lending still the order of the day. The get rich quick credit cards, that helped Banks buldge at the seams, is still propigating their interest scams via the US postal service. This outragious suckering of the average American, must stop. People are desperate no jobs, no medical, Banks doing business as usual. People in my small town recieved credit lines of 1,500, preapproved, whats with that? Redicules mind numming action in these perilous times.

[watchTVgetSTUPID]

Step 1, suspend short selling in Banking stocks for period of a week

Step 2, organize friendly hedge fund traders with billions of dollars in capital to Break a pre-coordinated set of Key Stocks to result in Climax Event

Step 3, Friday Market Opens to Massive NAKED SHORT SALE, hitting all stops on small investors and mutual funds of retirees.

Step 4, Engineered hoopla Friday as friendly hedge fund traders in 2 instances execute the Paulson Plan and scoop up the stopped out small investors to cover their NAKED SHORT SALE and Double and Tripple down on INSIDER INFORMATION PROVIDED BY TREASURY SECRETARY PAULSON.

Step 5, Announce buying stock directly in Banks with 250,000,000,000 1/2 the budget for the Department of Defense

Step 6, Insider friends who have Temporarilly Cornered the FLOAT for PAULSON gap market up monday morning for massive short squeeze.

Step 7, Insider friends of Paulson distribute their weekend gain to covering shorts while 'FRONT RUNNING' the TRADE on the Government Money's comming into the market.

Net result

About a $50,000,000,000 Gain for 'Several' Individual pre-selected Hedge Funds.

Some good ol USA Patriot Act, eh?

Protecting People and Property, eh?

The next time they do it their Greed will be bigger and will attempt an enormous 'TAKE'. Give the entire US Treasury to Criminals, their bound to make a few hundred billion in a few days.

[Pdubya]

like pissing in a bucket with holes. until we eliminate the creation of paper money out of thin air, it will continue to devalue the dollar. we must return to our constitution, eliminate the federal reserve, return to sound money and only having Congress issue it. what moral authority does a private cartel have in deciding how much your currency is worth? tell me.

[iambusto]

People who are complaining that
* we are not getting majority control or significant control in the banks
* Not as good a deal as Warren Buffett did, have to realise

1) Warren Buffett invested capital in 2 companies that were DESPERATE for capital at that time. so naturally he got a great deal. The bigger banks are not desperate for capital (well not to the tune of diluting existing shareholders completely, hand over the ceo pay to govt. whim).

If Hank Paulson tried to strong arm the banks too much, they will just refuse to accept the bailout. How can the govt. Force the bailout on the banks that do not want it.

2) Paulson couldnt have gotten the 10% preferred deal for same reason.

Paulson has to incentivize the big banks to accept the bailout package too. I know a lot of posters here think that the banks should thank their stars that they are getting the capital, but you gotta realise that the bigger well run banks (JPM, BAC, USB and WFC in particular) its not in their interest to dilute out too much or give govt control.
they are well capitalized and if other weaker banks fail, its in their interest too.

btw, i think its another terrible example where the poor run banks were not allowed to die and better run banks be rewarded with their deposits/market share.

[worrierqueen]

"If Hank Paulson tried to strong arm the banks too much, they will just refuse to accept the bailout. How can the govt. Force the bailout on the banks that do not want it..........

btw, i think its another terrible example where the poor run banks were not allowed to die and better run banks be rewarded with their deposits/market share."

That's another bizarre twist in the new improved Paulson plan Mk II. Everywhere else in the world, none of the banks must be bailed out by the Central Bank, its all voluntary, and if you aren't going under you can carry on regardless (as Barclays are doing in England). Thus the better run banks aren't being diluted and are being rewarded for good behaviour.

It shows how little faith Paulson has in all the US banking bosses that he's moving in regardless of whether you like it or not.

[iambusto]

Excellent point worrierQueen. Paulson should have injected and bought equity (if you are in favor of common equity over pref. equity, thats fine too with me).

BUT only for banks that request the bailout. NOT forcing on the banks.

that just rewards bad behaviour and punishes good behaviour. Now the weaker poorly run banks get to shore up their capital and tier 1 ratio. RIDICULOUS.

[worrierqueen]

"If Hank Paulson tried to strong arm the banks too much, they will just refuse to accept the bailout. How can the govt. Force the bailout on the bank

[Halsey]

ha!...the banks got exactly what THEY wanted...and "ownership>....as the author notes..."we the People"...(via the Treasury)..bought PREFERRED...NON VOTING shares...big deal..

"We" should have insisted on Real equity!...voting equity....a stake and a VOICE in how the bank is run...only THEN...can we put a CAP on the millions the lucky lucky CEO's get...

hey...is there such thing as a civilian arrest of a CEO?...as I want to arrest..then sue...Fuld, etc...for economic terrorism...these guys did SO much more damage than Osama ever dreamed of....AND got paid hundreds of millions of dollars for doing it... I'm no attorney..but I don't think "intent" is necessary...how 'bout...depraved indifference?....

Gloria Allred...call me!

[Pdubya]

how can they force? simple: the federal reserve, who is accountable to no one, issues currency. they just grabbed more power with the bailout.

its a scam, and has been since 1913...but increasingly so since 1971 when we completely went off the gold standard and started "regulating" our jobs to go overseas. we stopped being a production/savings/creditor nation and became a debt/consumer based nation.

we haven't had free markets....we've had managed markets..increasingly stepping towards corporatism...aka, fascism.

[wrabbitt]

The banks are only the tip of the iceberg that we are going to "Bail out" over the next few years. And now that my 101k has taken on the piggy bank look, it must be time to remove the golden parachutes from our elected officials too. With Congressional bribery being a federal offense, isn't it time to round up the lobbyists and their clients? Isn't it about time for Congress to feel the pinch of a failed economy? Americans are Very angry! John Q.Public is now John Q. Pissed. The Ballot box will be visited by many first time voters, and, many who ain't voted because it was a choice of lesser evils, and, we lost no matter who won! The last eight years of Bush and his puppeteer Chaney, have shown the American people just how far removed government is from the main stream. I do not support any kind of bail out, Congress and the rest of the crooks in Washington will find a way to profit from this! And, the taxpayer is getting the short end of the stick as usual! The less working people we have ,the less taxes being paid. This mess will end in a change of who we elect, and, who we hold responsible for this weight dropped on us taxpayers. Greed will not matter if the dollar ain't worth anything!

[LuckyBlessed]

I like how NBC news congratulated citizens about owning banks. Like the money won't float to the top like a golden life preserver.

The one problem is that the underwriting or lack thereof (I was there) is not being addressed. FHA,(per Republicans a Communist Garbage Government Run program) has been loaning to subprime borrowers (people who have credit issues) for decades. I haven't heard anything about massive amounts of FHA loans in default.

After the banks, we need to take care of the Pharm reps, and other corp welfare in Healthcare. Healthcare consumes 15% of our GDP and is rising, while we rank below 30 countries in mortality per the CIA's World Book. Deregulation, Privatization, Corporate Welfare, and the Republican party sure has done us proud.

[themodernleader]

Paulson's determination to put right a multi-year, multi-trillion dollar swindle is another river boat gamble. And this one will fail as dismally as Reagonomics. The real danger is that the stubborn squandering of dollars down the rotten corridors of doomed banks can so weaken the dollar that there is a run on the dollar. It becomes worthless. Then what shall we do?
It is our duty to preserve our currency, no matter the pain to institutions that should be dissolved or combined with other institutions. We must also reconsider the Federal Reserve and Central Banks as we learn how they have destroyed our economy and endangered our form of government.

[worrierqueen]

pt 2

Whereas the rest of the world is buying a controlling interest in their banks, sacking the clowns who caused all the mess and putting in treasury staff while retaining dividends for the taxpayer, under the US scheme the US is getting non-voting shares, the current clowns (all mates of Paulson) keep their ludicrously bloated salaries and they even keep the profits with the taxpayer getting a mandated 5% dividend (although how that is to be paid if the companies don't make profits is one of many details Paulson hasn't revealed yet).

In effect its just another way to give US$700 billion taxpayer's money to his banking mates in the biggest banking swindle in history. Luckily the rushed legislation that Paulson forced congress to pass is so open-ended, Paulson can completely change how he is spending the US$700 billion without any further approval. And this is the worst aspect of the bail-out, it has made absolute monkeys out of the majority of congresspeople including Obama and McCain (which may well have been Hank's intent). He has shown that not only are they as economically ignorant as he is, he has shown how easily they can be bullied into the most nonsensical legislation due to their complete ignorance of the subject matter.

If this is a sign as to the best the legislators can do, America has a very hard road ahead, at least in the short to medium term.

[worrierqueen]

After saying to a senate committee three weeks ago that buying banks was unthinkable, and shrieking that they pass his asset purchase plan immediately or face instant economic collapse, Paulson has thought the unthinkable and completely junked his silly little plan as unworkable. This is for many of the same reasons that we have been discussing (how does he tender out the asset purchases, how does he buy anything more than a minority of assets with the money he has, how does it help the economy or stop mortgage foreclosures etc). The Paulson plan was hopelessly complex, unworkable and would be too slow to implement so now he has decided that perhaps the rest of the world is smarter than him after all and he has come on board.

Sort of. Just as with many other issues such as the International Court of Justice, global warming, the UN convention on torture, the UN convention on land mines, and most perversely for the well-being of Americans, universal health care, in prudential regulation there are two schools of thought, the US government and the rest of the world.

[handyallen1]

stop the bleeding thats a good one,it reminds me of the monty python movie where the man has lost all his limbs and screams that its only a flesh wound and that he can still fight rofl.

[ReasonIsMyReligion]

But the fundamentals -- the knight's willingness to fight on -- are still strong.

[DrYRHead]

Oh my, McCain is that very same knight, and I guess that makes Palin the visious white rabbit.