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The · Psychohistorian


Undermining the banking system

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We've heard a lot about government bailouts in the past few months. So what exactly are these bailouts? After hearing some more griping about one of them - the part of the Troubled Assets Relief Program (TARP) that was devoted to stable banks like Wells Fargo and Bank of America - I decided to read up on some of the details.

It appears that this $250 Billion program works as follows. The federal government purchases preferred stock from the banks for cash. The banks then pay the federal government interest at an annual rate of 5% for the first three years, and 9% thereafter. That's a pretty high interest rate when the discount rate - the rate at which banks can borrow from the Federal Reserve - is running at less than 1%, but if a bank is in trouble, the money might help them survive a run by depositors. The banks are allowed to pay the money back, but not until the first three years are up.

Most of the funds weren't used to help banks that were in trouble though. Rather, stable banks were pressured into the program. Assuming that this was not just a cynical way for the government to extract above market interest rates from successful banks, what were Bernanke and treasury department trying to do?

Well, one clue comes from an exchange that happened during that meeting was when one of the bank presidents asked if the government "investment" was to be treated as debt on their balance sheet. According to normal accounting rules it is: it's money that has to be paid back eventually, and on which interest is paid in the meantime.

Bernanke and Paulson, however, agreed it should be treated as equity, and that they would change the rules if necessary to do so.

Why is this important? It's important because there are rules governing banks that require them to maintain debt to equity ratios within certain limits. Adding money to the "equity" side of the balance sheet allows the banks to pile up more debt - that is, lend more money. Adding money to the debt side of the balance sheet would do the opposite: it would constrain lending further. The government wanted the banks to lend more, not less, to avoid an economic downturn, so the money was categorized as "equity".

Of course, calling it equity doesn't make it so; the banks still have to pay interest on it, and they still have to pay it back after three years. Some investment banks might have lent to the limits of the regulations anyway, but those banks are, not coincidentally, bankrupt now. The banks that got the first round of TARP funds were some of the stablest and most conservative banks in the country - and those banks are likely to act as if the funds are debt, even if their balance sheets list them as equity. They're not going to use the money to extend even more loans that put them closer to going under.

What's the net result? The big, stable banks are burdened with interest payments to the government that restrict their lending just when it's thought the economy needs easier money. Plus they get tagged with the "bailed out" label when the reality is closer to the banks propping up the government.

Emergency Economic Stabilization Act / TARP

http://www.dpw.com/1485409/clientmemos/EESA.US.Gov.Cap.Injts.pdf
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On February 19th, 2009 02:19 am (UTC), harrock commented:
Yeah, the nature of the so-called "investment" comes as a vast surprise to everyone who hasn't noticed it yet. And I find it pretty depressing how much even the financial press continues to get the details, as far as I can tell, very wrong.

I realized what was going on after I read State Street's 3rd quarter 10-Q filing, under the heading "Capital Purchase Program". Here's the summary as I understand it: (And I assume that the other big banks that were in the initial $125 billion had the same provisions; not sure about everyone who came after that)

State Street issued $2 billion worth of preferred stock, which was bought by the Treasury. This Preferred stock has no voting rights (typical of preferred stock, but not universally true), but in the event of a liquidation, preferred shareholders get money before common shareholders get it. (That's what Preferred means). There is a set liquidation value on each share; i.e. each share was sold to the Treasury for $100K and can be redeemed by State Street for $100K, under certain conditions. And there are the interest rates as noted above. Also, the company is prohibited from raising its dividend or doing a stock buyback while the Treasury owns preferred shares. (More of a comedy item at the moment, since we just cut our dividend to a penny a share...) In addition to this, the Treasury has options to buy 5+ million shares of State Street stock at over $50 a share, which isn't too interesting right now. Those 5+ million shares would be a little more than 1% of State Street's outstanding shares. I've read some news talking about the possibility of the Treasury converting its preferred shares to common stock, but as far as I know, the shares aren't convertible. (Though, as it turns out, the Treasury can invite the CEO to a meeting and then refuse to let him leave the room until he's agreed to something, so, YMMV.)

One may wonder how this Preferred Stock is different from a loan or a bond (i.e., as noted above, *debt*). The answer is, not very--there are some technical differences, but this particular preferred stock appears to me to be much more like a bond than like common stock. Unlike a bond, it will never come due, so in that sense it's a better deal for the company than a bond. But then, there's that spike in the interest rate, which is not a feature of most bonds, even in this environment.
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