How to Manage The Banks

The Treasury plans to invest up to $250 billion in individual banks and has already allotted half that amount to nine leading banks. For now, the key questions are: Will the plan work? And what consequences will it have for our financial system and our economy? Several issues bear examination.

First, is this enough money? Citigroup, for example, is getting $25 billion. As of June 30, it had $2.1 trillion in assets and just $136 billion in capital; the new capital is only 1.2 percent of its total assets. If the problem is that falling asset prices could put banks’ solvency at risk, the Treasury might have to commit more money.

In truth, no one knows how much funding is needed. The reduction in lending (known as “deleveraging”) underway throughout the world may lead to a sharp recession. Some European nations, which have large financial sectors and substantially greater leverage than in the United States, pose risks to all nations. The United States needs to be prepared to quickly shore up capital among banks, and potentially major insurance companies and other financial firms, if it appears the recession is deepening.

The Treasury should abandon plans to buy troubled assets (this can be handled by Fannie Mae and Freddie Mac, as necessary) and keep the full $700 billion from the Troubled Asset Relief Program for financial-sector recapitalization if needed. Congress should amend TARP rules so the full $700 billion is available at the discretion of the president.

Second, which banks should get new capital? Treasury official Neel Kashkari said Monday that equity injections would go only to “healthy banks,” raising the possibility that the Treasury would invest in a small set of protected banks and allow them to acquire the assets of banks that fail. Today’s term sheet, however, seems to open participation to any “qualifying financial institution.” We agree that the Treasury should invest in any bank that needs capital, an approach that is arguably fairer and will ultimately ensure a more competitive system. Some banks that receive federal funds may ultimately fail. But it is essential that the Treasury not favor a handful of large banks.

Third, how good an investment is this for taxpayers? The government is buying preferred shares, which carry a 5 percent dividend and do not dilute common shares, along with a small amount of warrants. In a narrow sense, the deal terms are much worse than the terms Warren Buffett negotiated when he invested in Goldman Sachs this month. (He received a 10 percent dividend and warrants to buy additional common shares at well below market prices.) But the Treasury has taken a sensible broader view — in leaving more for banks’ other shareholders and creditors, it has taken a major step toward restoring confidence in the global financial system.

Fourth, what role should the government play in managing the banks? A government recapitalization requires balancing the interests of the banks (or their shareholders), the taxpayer (as an investor) and the public good. The Treasury has deployed a relatively small amount of taxpayer money to a few banks, at least in the first phase, in a form that minimizes the impact on current shareholders and gives the government little influence on bank operations, since the new shares will have no voting rights. The British plan, by contrast, devoted more taxpayer money to gain a controlling interest in one major bank (RBS) and more than 40 percent of a newly merged bank (the combined Lloyds TSB and HBOS), with the right to appoint directors to both boards. It also imposed new controls over the banks, which risks politicizing operations: As Britain enters what could be a major recession, there will be large pressures on partly nationalized banks to channel credit according to government’s will. The United States, in contrast, is putting the full credibility of its balance sheet behind banks but giving them free rein to move on. Both plans have pitfalls. We taxpayers need to trust that the authorities are prepared to regulate the “ordained banks” with a much stronger hand than they have in the past.

Congress should create a consolidated and powerful regulator that can stand up to the banks. All regulatory rules have to be rethought, given that any sizable financial institution is now seen as too interconnected to be allowed to fail.

On balance, this U.S. (and European) policy is likely to restore immediate confidence in banks. This is a remarkable shift from the rough treatment of shareholders and creditors at Lehman Brothers and AIG, which helped create the panic of the past few weeks. These new policies correct those errors. Now, let’s hope the Treasury is done being fickle.

Originally published at the Washington Post and reproduced here with the authors permission.

4 Responses to "How to Manage The Banks"

  1. Guest   October 16, 2008 at 7:59 pm

    question:so the US government is changing the way to treat AIG like other banks now?

  2. Michael Cohen   October 17, 2008 at 1:40 am

    Here is a letter I sent to Barney Frank. I see at this point no reason to worry terribly much about the interests of large shareholders.I will try to keep it brief. I thank you for being a the Chairman of the House Financial Service Administration and for bailing out the banks. You were right that the system needed a bailout. It is no surprise that both you and Chris Dodd whose reelection campaigns were funded 40% and 90% by the finance/real estate/insurance industry would not pass legislation that specifically threatened the people who were financing your and Dodd’s Campaign to the tune of .7 and 8 million dollars respectively. These underestimates are facts not fiction documented by the Federal Election Commission. It is clear that these bills were written not with the best interests of the nation but with the interest of the shareholders of these institutions. Its no wonder, the person who originally drafted the legislation was the former head of Goldman Sachs.So far, the net effect of this bailout was to fatten the balance sheets of the major banks such as Citibank, Bank of America, State Street Bank, Wells Fargo, JP Morgan Chase, Merrill Lynch, Goldman Sachs, Morgan Stanley, Wells Fargo, Wachovia, and Washington Mutual many of which has combined will get aide. As the International Herald Tribune Wrote, “The US banks are hoarding the money invested by the state”, at least for a few quarters. The Federal Government without seats on the boards of directors have no way to force the banks to lend. No audit was taken place of the banks to determine whether or not they were solvent. The state did not purchase common stock, rather preferred which does not guarantee voting rights.Unless the banks act soon and credit for business is loosened the net effect will be similar to the Great Depression. While one can point fingers at the banks and argue corruption, the primary interest of each bank is to maximize its own profit irrespective of potential failure of the system. Indeed well established Law dating from the 1919 Dodge Brothers vs. Henry Ford decision which never has been overturned requires a firm to maximize its own profits even in the face of system risk. Current conditions require banks to lend but lending on the part of an individual bank will carry more risk than normal. Nothing will be ventured. Day after day while Wall Street goes up and down, Credit Conditions remain bleak.Here is what is necessary to do.1. Legal Langauge Needs to be Established Absolving the Boards of Directors of the Major Banks of the Dodge Brothers vs Ford Decision.2. Common Voting Stock, not preferred stock needs to be issued by each of the major banks to the governments. Each of the major banks need to have a government representative on the boards and on the operating committees to ensure that lending occurs. If the firms are insolvent, then they need to shut down.3. As Ben Bernanke did, the Federal Government may need to establish their own bank to lend the remainder of the 700 billion should the Banks fail to lend. This has to be done now. Every day the credit market for business remains shut is a day that will force the economy into deeper recession.It does not interest me or any other constituent that the Republican Party or the Democratic Party would not or could not enforce a workable plan. It would be better if one was openly discussed. If the US economy goes into depression, the impediments on action created by prior history will interest nobody. You and Chris Dodd will go down in history as the primary architects of the great depression of 2008. I really hope this will be resolved quickly but I have no reason to believe so. I you take this seriously, in fact I hope I am dead wrong but have no reason to believe otherwise.. We are all in the same boat

  3. Guest   October 17, 2008 at 4:24 am

    The real architects of the the great depression IS THE FEDERAL RESERVE BANK not Chriss Dodd or Barney Frank.In one fell swoop The Treasury and The FRB have obliterated the concept of the free market system and turned the financial system into a socialist agenda.The next objective will be to obliterate the U.S. constitution. The people are waking up.

  4. villager   October 17, 2008 at 8:45 am

    The title of the article must be a mistake. It should read “How not to Manage the Banks”.Over the past while, a lot of attention and commentary has been focussed on getting the correct policies and response from government and the Federal authorities. What has been overlooked is the need for those policies and responses to be implemented correctly. This is why Paulson should be fired. He can not be relied or trusted for proper implementation.