Paulson Lacks Leverage to Make Banks Put Cash to Work (Update1)

Oct. 15 (Bloomberg) — Treasury Secretary Henry Paulson persuaded nine major U.S. banks to accept $125 billion in government investment. Getting them to lend it out may prove a tougher sell.

The equity stakes the government is purchasing in Citigroup Inc., Morgan Stanley and seven other big institutions come with no guarantee that the investments will spur lending and unfreeze credit markets. Nor do they give the government board seats or any other leverage to demand that that the firms actually use the money to help the economy.

“The truth of the matter is, they can’t put a gun to their head and say you have to lend this money,” said Charles Horn, a former official at the Office of the Comptroller of the Currency, part of the Treasury Department, and now a partner at the Mayer Brown law firm in Washington.

Treasury officials acknowledge they can’t force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government’s investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.

“It’s in their economic interest,” said David Nason, the Treasury’s assistant secretary for financial institutions, in an interview with Bloomberg Television. “When you give them a stronger capital position and you also provide a certain amount of government backstop to their funding sources, it’s incumbent upon them to go out and continue to lend.”

Powerful Incentive

Tim Ryan, head of the Securities Industry and Financial Markets Association and a former bank regulator, said the sheer scale of the capital infusion banks are receiving is in itself a powerful incentive to put the funds to work in the economy.

“The bully pulpit doesn’t really work with banks, but capital does,” said Ryan, who directed the U.S. Office of Thrift Supervision in 1990-1992.

The government is providing banks with “quite a war chest that they were not expecting,” Ryan said. “They need to put it to work. The only way you put it to work is to lend.”

The Bush administration’s rescue, part of a $700 billion bailout passed by Congress this month, is raising questions about what role the federal government will play as it becomes a leading investor in the financial sector. Already, companies that accept the taxpayer money are required to submit to restrictions on their top executives’ pay.

Government Involvement

“Obviously there is a danger” of increased government involvement in banks’ corporate affairs, said Martin Baily, a senior fellow at the Brookings Institution in Washington and former chairman of the Council of Economic Advisers under President Bill Clinton.

Still, Baily said that the equity purchases are set up to minimize government intervention.

Treasury has “been telling these institutions what to do in the last couple months, so they’ve exercised a good bit of control,” Baily added. “I think they’d like to get out of that business.”

Senator Charles Schumer, a New York Democrat, called on the Treasury to issue guidelines on how banks should use the new funding, saying he’s worried institutions may put the extra money into “exotic financial instruments and experiments” rather than consumer loans.

Schumer’s Concern

“If the capital injections into these institutions help with student loans, help with auto loans, help with small business loans, help with credit card loans, then I think the American people will think this is a worthwhile program,” Schumer said at a Capitol Hill press conference today. “On the other hand, if they benefit executives, shareholders or the bank balance sheet, and don’t get money churning out into the economy, the program will be regarded as a failure.”

The Bush administration is counting on agencies that already regulate the banks, such as the Federal Reserve, to keep an eye on daily operations. Those agencies can encourage firms to keep credit flowing to businesses and households.

“The regulators can do a lot to give the signals to the bank,” said finance professor Len Rushfield of Pepperdine University in Los Angeles.

Pressure Has Limits

Even so, subtle government pressure on banks may not make much difference. Unlike with the recent federal takeovers of Fannie Mae, Freddie Mac and insurer American International Group Inc., the U.S. won’t take a major share of the banks they invest in. Also, the Treasury has said it won’t seek voting rights when it buys stakes.

The Treasury said it would dedicate $250 billion to boost bank capital through preferred stock purchases. Bank regulators estimated yesterday that “thousands” of financial companies would participate, although the program will begin with the nine big banks.

“What you’ll see most large institutions saying is, `We will certainly listen to the government but our decisions are what’s in the best interest of our shareholders,”’ said John Coffee, a securities law professor at Columbia University.

Financial companies that accept government investments also are counting on Paulson’s pro-market philosophy to keep the government out of their boardrooms. The secretary, announcing the capital injections yesterday, said that he regretted having to make such a move.

Alternative `Unacceptable’

“Government owning a stake in any private U.S. company is objectionable to most Americans — me included,” he said. “Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable.”

Bank executives know that the Treasury and members of Congress are going to monitor the situation, said Scott Talbott, chief lobbyist for the Financial Services Roundtable.

“Policy makers will watch closely to insure that the money is used for credit,” he said.

The one unknown that makes Wall Street nervous, several industry executives said, is what the next Treasury secretary will do. The U.S. presidential election is less than a month away.

“You’d probably want to have Hank Paulson, more than a lot of other people” overseeing the bailout, said Edward Fleischman, a Republican Securities and Exchange Commissioner from 1986 to 1992, and now a senior counsel at the Linklaters law firm in New York. “But you’re not going to have any choice who takes his job.”

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