What Paulson Is Trying to Do

Banks need a capital injection before they take their lumps.

Less than two weeks into it, the $700 billion Troubled Asset Relief Program (TARP) is stuck between a rock and a hard place. Next week, several hundred billion dollars of credit default swap (default insurance) payments on Lehman’s debt default are due. No one quite knows who owes what and if they’re good for it. Hence the urgency in Henry Paulson and Ben Bernanke’s plan to inject $250 billion directly into bank balance sheets, which seems a necessary evil to get capital to the right place and help weaker banks save face. The credit markets agree — so far.

[Commentary] Chad Crowe

Wall Street and banks live by short-term loans. But as a loan shark might say, right now, nobody wants to lend to nobody. The rate that banks charge each other, the London Interbank Offered Rate (Libor), has been trading so high above three-month Treasury-bill rates (on Monday it was 4.75% vs. 0.11%) that no one is lending. This so-called TED spread — the difference between what banks pay and what the Treasury pays to borrow for three months — signals the health of credit markets and has rarely been over 1% since the 1987 crash. The Treasury is clearly focused on this metric and needs to get it down to historic spreads. First it has to change the current mentality of “who wants to lend to the next Lehman or Wachovia?”

The original TARP plan was to buy all the bad loans, mortgage-backed securities and collateralized debt obligations (CDOs) currently weighing down bank balance sheets. That is still the right (and profitable) thing to do. History shows that well-capitalized banks eventually do lend since hoarding doesn’t make money.

But here’s the current dilemma: If Treasury pays more than market price for these distressed securities, it would look like a taxpayer gift to Wall Street. That’s politically unfeasible. So Treasury has to pay the current distressed prices. (Despite this week’s stock-market bounce, prices are still dropping on toxic CDOs.) But if Treasury pays current, fire-sale prices, it would lead to major write-downs at banks. Since most of these securities are collateral for other loans, and regulators force banks to have minimum capital requirements and cash on hand, any write-down in value immediately means new capital needs to be raised.

And then who would throw good money after bad? Sovereign wealth funds have already been burned. Dubai invested in Citigroup less than a year ago via preferred shares that convert into Citi stock at $32 to $37 per share. Citi is now around $18.

Other banks are still scrambling. Morgan Stanley’s shares bottomed under $7 last Friday on fears that Mitsubishi UFJ Financial Group, a Japanese bank with $1.8 trillion in assets, would pull out of a previously announced deal to buy 21% of the company for $9 billion. Luckily for Morgan Stanley, the Japanese think long term and did the deal anyway, even though it makes no economic sense at the moment. Other U.S. banks wouldn’t be so lucky.

So here we are with no interbank loans and no equity financing. Treasury would bankrupt banks if TARP buys securities at market prices, forcing them to do the impossible task of raising capital in an ugly environment.

The direct capital injection is a way to get unstuck. In effect, first Treasury injects money into bank’s balance sheets, then buys the toxic loans at market prices. Even if there are write downs, banks will have enough capital to live. What about healthy banks like J.P. Morgan, Bank of America and perhaps Goldman, which don’t need capital? They get it too. The Treasury is forcing every top bank to take the government investment. Why? Because if they didn’t, the ones that do take the capital would look weak and loans to them would remain dry.

Is this the right thing to do? Probably not. Despite some limits on compensation, bad management stays in charge. Government investment in financial institutions will raise a gazillion temptations and conflicts of interest. Politicians won’t be able to help themselves and will inevitably meddle. Just look at the pork loaded into the TARP bill. But it’s the only thing to do at this stage. Next stop is full nationalization and no one wants that. Already the TED spread is coming in, dropping to 4.36 from 4.64. The market likes the plan, at least for now.

One concern: Won’t cranking the monetary printing presses to finance all this lead to runaway inflation? Probably not. Remember that after the 1929 market crash and subsequent bank runs, 10,000 or roughly 40% of banks failed, $2 billion in deposits were wiped out and 30% of the money supply disappeared. So did a similar percentage of GDP. Today, bank deposits are mostly safe, but with $1 trillion in bank and Wall Street writedowns taken or soon to be taken on bad real estate securities, some multiple of that in money supply will vanish with the stroke of an accountant’s pen. Restarting bank lending is the only way to top it back up.

Many questions remain: When will Libor rates and the TED spread go back to normal so lending can restart? Then, when does the government sell the preferred shares so we can return to a market economy? Can we put an expiration date on government programs? (Most New Deal institutions are still around.) Furthermore, what do we do with the returns on investment?

Thanks to deposit insurance, there are no huge bank runs going on. There is, however, a “loan run,” meaning no one will lend to weak banks. Yes, it’s distasteful for government to own any private enterprise, especially in finance. But if you hold your nose, the new TARP seems like a way to end this loan drought. There is no economy until this is fixed. Then we can start arguing about the inevitable reforms to come.

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