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
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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.