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.
Formulated jointly by the Treasury, the Fed and the FDIC, these moves announced Tuesday are designed to keep money flowing through the financial system, ensuring that banks continue lending to companies, consumers and each other. A freeze in these markets rippled through the economy and helped cause stocks to crater last week.
Along with the government's involvement come certain restrictions, such as caps on executive pay. For example, firms can't write new employment contracts containing golden parachutes and their ability to use certain executive salaries as a tax deduction is capped. These restrictions are relatively weak compared with what congressional Democrats had wanted when they approved this spending, a potential flash point.
Some critics also say Treasury should have formulated a comprehensive plan earlier in the crisis. Even if this move helps mend credit markets, the economy is likely to suffer in the months ahead from the aftershocks of the recent turmoil.
A central plank of these new efforts is a plan for the Treasury to take about $250 billion in equity stakes in potentially thousands of banks, using funds approved by Congress through the recently approved $700 billion bailout plan.
Treasury will buy $25 billion in preferred stock in Bank of America -- including Merrill Lynch -- as well as J.P. Morgan and Citigroup; between $20 billion and $25 billion in Wells Fargo; $10 billion in Goldman and Morgan Stanley; $3 billion in Bank of New York Mellon; and about $2 billion in State Street.
The government will purchase preferred stock, an equity investment designed to avoid hurting existing shareholders and deterring new ones. Such shares typically don't come with voting rights. They will carry a 5% annual dividend that rises to 9% after five years, according to a person familiar with the matter. By investing in several big firms at once, the government hopes to avoid placing a stigma on any one firm for getting government help.
The plan will be structured to encourage firms to bring in private capital. For instance, firms returning capital to the government by 2009 may get better terms for the government's stake, a person familiar with the discussions said.
It's a sort of interesting quandary for libertarians, and indeed most proponents of regulation, who want the government to enhance transparency. In this case, the government is specifically fighting to keep the market from getting information about whose balance sheets are shakiest. And I'm not sure they're wrong.
quote:
"because recapitalizing only the weak ones would send a message about their balance sheets that might trigger the run he is trying to prevent."
Can you explain to me how this message was avoided by this? Isn't the logical conclusion that all the non-paulson capitalized banks are weak? What reason can you give for NOT moving your money to one of these banks? How do you find out how healthy your bank is if your bank is NOT one of the banks on Paulson's list?
You would rather trust one person in the government rather than the collective intelligence known as the market? This isn't a quandry for a libertarian; it's an abandonment of principle.
Megan,
Well, I am not sure of anything. When you get right down to it, only fools are; but it's no a quandary for me.
Re-read your Hayek, particularly "The Use of Knowledge in Society".
There is absolutely no way a central planning body (which is what this is rapidly becoming) can compete with the collective and dispersed knowledge of millions of individuals.
Additionally,
The moral hazard argument outweighs all competing concerns about short term market volatility. A market correction is required. Pain is inevitable. There is no magic solution that will make this go away - as much as so many Americans wish there was (on far too many issues).
Good to have you back and healthy! Have a great day.
Megan and Paulson both seem to believe that this crisis can be solved by technical changes to the system.
I propose that we don't have a credit problem, but that we have a credit repayment problem. Lots of money is looking for a home. One month ago, we assumed that loaning the money to major US banks was a safe bet. Now we have less confidence in them. The fact that the US government wants partial ownership does not improve my perception of the banks. The government is known to a) change the rules as it goes along and b) screw those considered "rich".
The entire financial sector works on trust. And that trust has been badly shaken. When I don't trust you, the bank or the government, I won't put any money into it's care.
If I don't trust the other party, I won't loan money on at 5% or 15% interest rate.
If I don't trust the other party, I won't loan money on a handshake or a 20 page contract.
If I don't trust that the rule of law will be enforced, I won't loan money even with adequate collateral.
Long ago, I asked a small town banker about his loan process. He told me that most people would do everything in their power to pay back the loan, but that some would do everything to avoid paying it back. He stated that everyone knew who fell in each category.
Currently, there is a long list of people and companies that fall into the second category. They get no more money until they regain our trust.
Isn't the logical conclusion that all the non-paulson capitalized banks are weak?
Well, there seem to be two classes of banks we're talking about here. 100% of the biggest are part of the plan, but with regard to smaller banks, it's not clear to me from the above whether the the govt plans to acquire the equity stakes in weak banks or strong banks or both or what.
So, no, I don't think that's a logical conclusion.
What reason can you give for NOT moving your money to one of these banks? How do you find out how healthy your bank is if your bank is NOT one of the banks on Paulson's list?
Insofar as the govt cares what invidual small depositors do at all, they want you to stay put while they fix the system, and therefore telling you whether your bank is strong or weak is not part of their plan.
You would rather trust one person in the government rather than the collective intelligence known as the market? This isn't a quandry for a libertarian; it's an abandonment of principle.
The market seems to respond to sudden changes in its estimation of its own knowledge by self-destructing. Not exactly an inspirational principle.
Megan,
Speaking of situations where increasing transparency appears to make the system less stable, isn't the question of abandoning or keeping mark to market accounting another example?
Henry Paulson and Goldman Sachs:
Scattered from California to New York: The judgments from the Department of Labor, tax liens against 401-K plans, state tax liens, mechanics lien, judgments from other companies.
Henry Paulson, 5 weeks before he became Treasury Secretary, got a FANNIE MAE/FREDDIE MAC 30 year fix mortgage/loan for his 82 year old mother in May 2005 for 5.37%, (below rate)
webofdeception.com
because recapitalizing only the weak ones would send a message about their balance sheets that might trigger the run he is trying to prevent
==========
Believe it or not, this is something that has been an topic, time and again, within the Federal Reserve and elsewhere.
Should policy/actions be constrained/designed so that they benefit all banks, systemwide, or should they reward those who are 'doing a good job' only (usually the strongest are the largest, complicating things ... politically).
In a system that is not dependent on any one player, the answer is always to strengthen the strongest hands, if you want a healthy system that rewards good risk management, etc.
One complication, during times of crisis, is that the transition points get ... amplified, messy, disorderly, and appear to be causing instability, instead of producing it (like letting Lehman fold).
So, in the end, it is an art to manage the path toward "equilibrium", not a science, I guess.
But, whatever moves are taken, failing to tilt to the board toward transparency and quality, even if done gradually, is a big mistake, both in the short-run and the long-run. If you take your eye off the ball that way, you end up with a terrible system of mediocrity, and arguably. more systemic risk.
Megan,
While I try to keep up with financial matters, I'm a little fuzzy on how, exactly, preferred stocks work. As I understand it, preferred equity pays a guaranteed dividend and, in the event of liquidation, is behind bondholders and ahead of common stock. What is the virtue of using preferred equity rather than a loan? It seems as though we're taking a rather large risk for a paltry 5% return, and I'd like to at least not be so close to the first-loss position. Could you maybe post a quick primer on why the deal would be structured this way?
The British went for a variation on the tune: a list of those willing to take the Queen's billions which soon boiled down to a much shorter list of those who had to. The share prices of those who had to were given a floor of how much the Government would pay, and existing shareholders have the option of taking up the new shares at that price (i.e. if the private sector wants to pay more, well and good.)
Doing that for the much larger and more varied set of US banks was probably impractical. So everybody has to take Federal money. However, I suspect that it will soon emerge that it is easy and profitable to repay quickly any Federal money you do not need. The net result seems likely to be very similar except that a leagl quirk will probably leave the British authorities with more ordinary equity and less preference shares than they would like.
Megan,
Then why not just outlaw balance sheets. Just change the laws so that banks don't have to disclose anything about their assets and liabilities.
And welcome back to blogging. You have been missed.
Clinton’s solution is a 90-day moratorium for foreclosures on sub-prime occupied homes, and a five-year rate freeze on sub-prime adjustable rate mortgages. The Bush administration has already responded with a 30-day cooling period on foreclosures; Clinton and her aides insist a longer freeze is essential for stabilizing a precarious situation for homeowners.
But according to some economists and officials grappling with the crisis, her proposal, which also offers a $30-billion foreclosure fund that is triple the size of Obama’s, might only prolong the agony for homeowners.
“A 90-day freeze is fine for what it is, but what happens on the 91st day?” Rokakis asked. “Why not a year? Or longer?”
In San Antonio on Tuesday, Obama said that Clinton’s foreclosure freeze was potentially “disastrous,” rewarding “people who made this problem worse” by benefiting banks that profit from high mortgage rates.
A “blanket freeze,” Obama added, might “drive rates through the roof for those trying to buy or refinance. Experts say the value of homes will fall even more, and even more families could face foreclosure.”
http://michellemalkin.com/2008/10/13/obama-proposes-90-day-foreclosure-moratorium/
Obama called Clinton's foreclosure freeze disastrous in the primaries. Now he says he is for it.
Talk about erratic.
This is Obama who is so out of it he said the banking committee is my committee when he has never been on it.
Yes, Obama is a politician. Quel horreur!
The question, Dan, is which has the most common sense, intelligence, and decency, given that they are all politicians.
A Credit Stimulus Package
As I understand TARP, it is essentially a credit stimulus package. The first part was forcing 9 large banks to jointly participate because:
http://www.nytimes.com/2008/10/15/business/economy/15bailout.html?hp
"Bringing together all nine executives and directing them to participate was a way to avoid stigmatizing any one bank that chose to accept the government investment."
I'm not so sure that this wasn't done to move the plan forward quickly and avoid negotiating with each bank, but I get the point, sort of.
Then, because each bank could use the money for something other than loans, the plan forces them to loan the money.
“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Mr. Paulson said, who offered some details of the plan along with the Federal Reserve chairman, Ben S. Bernanke, and the chairman of the Federal Deposit Insurance Corporation, Sheila C. Bair.
The problem here would seem to the quickness, intelligence, and risk of these loans.
"In a letter to Mr. Paulson on Monday, Mr. Schumer, chairman of the Joint Economic Committee, urged the Treasury to demand that banks receiving capital eliminate their dividends, restrict executive pay and stick to “safe and sustainable, rather than exotic, financial activities.”
I'm still not reassured.
foo
Here's something you can help me with. Why are we buying into investment banks? And what are we buying into? Their traditional fund-raising, market-making, broker/dealer operations? Or their hedge fund operations? Why would the former need help? Why would we want to support the latter?
"Henry Paulson, 5 weeks before he became Treasury Secretary, got a FANNIE MAE/FREDDIE MAC 30 year fix mortgage/loan for his 82 year old mother in May 2005 for 5.37%, (below rate)"
If he left Goldman with a ~$400 million+ net worth, why couldn't he just buy his mother's house for cash instead? What was the max for a conforming mortgage in '05? Probably less than $400k. That would have been about 1/10th of 1% of his net worth.
Because if the government (which has been infested with Goldman Sachs alumni for decades) just bailed out Goldman Sachs it would be too obvious.
Somewhat off topic but to the point of transparency vs stability, traffic engineers have created models that show traffic flow being optimized when only a small fraction of drivers have access to real-time traffic information. When everyone has the data, everyone rushes for the same exit at the same time.
Because the government would then be muscling aside other debt in the company. I'm certain the stable companies who maintain healthy debt could not allow this. Nor would shareholders tolerate a voting rights of the government thus no common stock stake.
As for 5%, I didn't think that it was that bad.
Jayson
"And I'm not sure they're wrong."
Because I'm a partisan GOP hack!
Two points need to be made.
The first is that preferred shares do not count on the balance sheet in the same way as do loans and other debt instruments. There is also the possibility of creating an exchange-based market for these securities. The interesting question is whether or not the Treasury is prepared to make it preferred shares available to the marketplace,in kind of a giant Paulson put. There might be a market interest in their acquisition at some point in the future.
The second point to be made is that the nine banks in question are among the very few for which the signally paradigm is irrelevant. The balance sheets of these firms are well known to most in the market place and represent perhaps the most transparent information in the banking sector.
It's the other 8400 where signaling is very germane to the average investor. I don't see how the Treasury meets its obligation to force the zombie banks out of business without signaling. Once it starts to buy their bad debt people will flee, on the theory that the Feds will never buy all of it. If they choose not to inject capital, the same thing will occur.