‘Distasteful’ Capital

A dangerous if necessary moment for U.S. markets.

The government’s rescue plan moved into a new phase Monday night with the announcement that Treasury is injecting $125 billion into the country’s nine largest banks. This amount — as much as $25 billion each for the biggest — seems to have stopped the financial panic for now by easing fears of insolvency. Another $125 billion is on the table for other banks that need capital on the same terms offered to the big boys.

[Review & Outlook] AP

The good news here is that Treasury Secretary Hank Paulson has at last moved from promises to action, and credit markets have responded positively. But this is also a very dangerous moment. The government has taken ownership stakes in the largest banks in the land. This extraordinary intervention is perilous — not least to the banks themselves — unless it is limited in scope and time. Mr. Paulson called the capital injection “distasteful” but unavoidable, and we can’t disagree. The trick is to ensure that neither he nor his successors develop a taste for politically directed credit.

Despite the risks, directly recapitalizing the banks is likely to prove a better tool than buying up “troubled assets,” though the Treasury seems on course to do some of that too. Giving banks this additional capital cushion should give them some leeway to sell those assets at market prices without risking insolvency. At the same time, it avoids the vexing problem of how to price securities that the smartest minds in finance are having trouble assigning a value to.

And unlike buying dodgy mortgage paper, recapitalizing banks is something the government has done before and knows how to do, more or less. The FDIC has done so from time to time via open-bank interventions, and the Depression-era Reconstruction Finance Corp. recapitalized thousands of banks in the 1930s.

Under the program, banks that participate will pay 5% interest annually on nonvoting, senior preferred shares issued to Treasury. Treasury will also receive warrants to buy bank stock at the market price at the time of the capital injection. The warrants, equal to 15% of the face value of the preferred shares issued by the bank, offer some possibility of profit for the Treasury without being so dilutive to existing shareholders as to scare away private capital.

Most of the banks dragooned into participating Monday saw their share prices rise Tuesday on the news. J.P. Morgan Chase was the exception, reflecting a sense that it was forced to accept dilution that its balance sheet doesn’t warrant. This market reaction suggests that the capital is a better deal than most banks could get on the open market, but not so good as to be a giveaway. The pricing is somewhat more generous to the banks than outside investors such as Warren Buffett have recently demanded.

Forcing the big nine — Goldman Sachs, Morgan Stanley, Bank of America, Merrill Lynch, Citigroup, Wells Fargo, Bank of New York Mellon and State Street, in addition to J.P. Morgan — to go in as a group may have been necessary to reduce the stigma of being first to the window. But the Treasury program is supposed to be voluntary and should operate that way in practice going forward.

Meantime, for the program to do the most good, someone needs to make sure that this capital is used to shore up the larger system, not just any banks that wants it, while also protecting taxpayers. In that connection, Mr. Paulson still needs a heavyweight to run this thing. Acting Assistant Secretary Neel Kashkari seems smart and capable, but whether he can resist the imprecations of Congress to use this program to serve its parochial ends is another matter.

House Financial Services Chairman Barney Frank is on record as preferring financial institutions that he can bend to his will (see: Fannie Mae and Freddie Mac), and he can be nasty. It would be a disaster if Congress were able to bully banks into pursuing Congress’s priorities instead of rebuilding their balance sheets and exiting the program as quickly as possible.

On top of the capital injections, the FDIC announced it will guarantee senior, unsecured bank debt issued between now and June 2009. This will help banks roll over their “trust preferred” debt that would otherwise have no takers as it came due. And while this guarantee is designed to ease the crunch in interbank lending, it is precisely the kind of program that banks can easily get addicted to. Let’s hope it really does end next June.

The feds will also offer unlimited insurance on non-interest-bearing commercial deposit accounts, such as those used for payroll runs by businesses. This latter program, for which the FDIC will charge additional premiums, is a far sight better than Mr. Paulson’s original brainstorm of guaranteeing all deposits, period.

For those of us who believe in free markets, these interventions are unpleasant. These drastic steps might have been avoided had Treasury and the FDIC acted sooner, yet now they are necessary given the panic that threatens the larger economy. The goal should be to rebuild the financial system so Americans can once again trust their banks enough that government can then recede to its normal supervisory role. We are under no illusions that government will cede its new powers easily, but if it doesn’t the economic damage will be far greater than anything we’ve seen so far.

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