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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

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On February 23rd, 2009 06:23 am (UTC), psychohist commented:
When you are looking at real preferred stock and at longer term bonds, the appropriate TARP interest rate for comparison is the 9% rate that kicks in at 3 years, and not the short term 5% rate. Preferred stock counts sort of as capital because the principal need never be repaid; if the banks do something similar by hanging on to the TARP funds indefinitely, they're going to be paying 9% for most of that period.

Also, the other limitations that harrock mentions become much more important if the funds are held and the restrictions stick around indefinitely. Not being able to raise your dividend for three years isn't that big a deal; never ever being able to raise it is a very big deal.

this is like a methadone clinic for leverage addicts

Except that it isn't. The leverage addicts are the investment banks like Goldman-Sachs and certain credit corporations like GMAC, and they weren't included in the original TARP group. Citi is borderline - and TARP may be a wash for them - because they have an investment banking arm as well as a commercial banking arm. Stable commercial banks like Wells Fargo and Bank America are getting the short end of the stick.
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