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Stop the Federal Guarantees

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The Obama administration is proposing a tax on large banks as a way of "ensuring that the money that taxpayers put up to rescue our financial system is paid back in full", according to a White House spokesman. The design of such a tax will present major challenges since many banks will not be paying corporate income tax for several years due to the carry-forward of huge losses from prior years. Although an excise tax could be levied on the assets or liabilities of each bank, either approach would raise questions of fairness because the amount of the tax would not be related to each bank's role in the financial crisis. As a result, legislation taxing large banks could take a long time to get through Congress.

Without legislation, the administration can partially achieve its objective by recouping billions of dollars from the large banks that were allowed to sell federally guaranteed bonds during the financial crisis, but have never been asked to repay those bonds. Although most of these large banks are now profitable, they have continued to benefit from the federal guarantee of their bonds -- worth at least $6 billion over the next two years.

Consider the benefit of this federal guarantee to a Wall Street bank that sold $30 billion of 3-year bonds with a federal guarantee at an interest rate only slightly higher than the rate on US Treasury bonds because of the federal guarantee. Without the federal guarantee, the interest rate on these bonds would have been at least 2.75% higher than the rate on US Treasury bonds of similar maturities.

The Wall Street bank will continue to benefit from the federal guarantee on $30 billion of its bonds for another two years -- until these bonds mature. This means $600 million less in interest payments each year -- based on a 2.75% lower interest rate minus a yearly fee of 0.75% charged by the government for the federal guarantee. In two years, the continuing federal guarantee of $30 million in bonds is worth $1.2 billion.

All the large US bank holding companies took advantage of the federal guarantee in selling 3-year bonds during late 2008 and the first half of 2009. During this period, the total amount of federally guaranteed bonds sold by financial institutions exceeded $300 billion. This means a total savings of at least $6 billion in interest payments on the federally guaranteed bonds over the next two years -- assuming the net interest rate on these bonds is 2% lower than bonds of similar maturities because of the federal guarantee.

Most of the large banks are no longer subject to any restrictions on executive compensation because they have repaid the federal capital provided to them during the financial crisis. However, these banks are still receiving a very valuable form of assistance through the continuing federal guarantee of their bonds. In other words, these large banks are enjoying the benefits of government assistance without the burdens.

Since these large banks were quite profitable by the end of 2009, they should no longer be allowed to rely on the government support provided during the financial crises. The administration could give the big banks a choice -- replace your guaranteed debt with newly issued non-guaranteed bonds, or pay the US Treasury $6 billion representing the remaining value of this federal guarantee over the next two years. This would not be a punishment; it would be the fair thing to do for US taxpayers.