The Bailout: More Changes, More Questions

by David Bogoslaw
Tuesday, November 4, 2008

Some critics wonder if the financial rescue plan may prove more costly to taxpayers than expected and delay the financial stability it was supposed to foster.

Is it too soon to wonder whether the government's $700 billion financial rescue program has gone off track? The U.S. Treasury has taken a lot of flack in the past few weeks for shifting the focus of the plan from buying distressed assets off banks' balance sheets to direct capital injections into financial institutions that may or may not need it, Meanwhile, critics say there are no indications that lending has increased, which was the original objective of the whole plan.

Indeed, some financial institutions that have received government money seem to be using the capital for other purposes, such as acquisitions of other banks, while the methods used in the rescue—and the purpose behind it—seem to be changing every week. And that has made even some of the legislation's original champions take notice.

Representative Barney Frank (D-Mass.), chairman of the House Financial Services Committee, went so far as to say on Oct. 31 that any use of the cash from the rescue plan by banks for acquisitions, executive bonuses, or other purposes besides lending is "a violation of the terms of the act."

Paulson Forced Capital Injections

The first indication that the bailout game plan was changing: In early October, Treasury Secretary Henry Paulson called a meeting with the leaders of nine of the largest U.S. banks and forced them to take a total of $125 billion in capital injections. In return, the government received preferred stock and stock warrants in each bank.

It's true the original intention of the Troubled Asset Relief Program (TARP) was to promote lending activity, which had frozen up by the end of August as financial services companies became more concerned about capital preservation, rising default rates on loans, and unknown risks involving trading counterparties. But in rethinking its methods, the Treasury still seems to have the same end result in mind, despite what its critics say.

Here's why. Buying $1 billion worth of distressed assets such as mortgage-backed securities from financial institutions provides those firms with $1 billion that can then be used to buy other assets or debt. That same $1 billion, when injected directly into a bank in exchange for preferred shares and stock warrants, adds to existing capital and can generate up to $10 billion worth of lending at a conservative debt-to-equity ratio of 10 to one, says Gerard Cassidy, an equity analyst who covers regional banks for RBC Capital Markets . "The impact of TARP going into equity is much greater because of leverage, and therefore over a longer period of time it will have a more stimulative effect to the economy," he says.

The Reason Treasury Shifted Gears

The benefit of buying troubled assets off banks' books under the TARP's capital purchase program is an increase in liquidity that can facilitate broader trading activity in the short term, but it won't produce as big a bang for the buck in terms of generating lending activity as the equity program, he adds.

Cassidy believes criticism of the Treasury's moves to directly inject capital into banks has stemmed from the fact that many people are focused more on short-term solutions and aren't ready to accept that while the government has managed to calm the crisis down, a full resolution of the problems will take a lot longer.

Why did the Treasury shift gears? Blame the problems around the pricing of the troubled assets, says Professor Cornelius Hurley, director of the Graduate Program in Banking and Financial Law and its related Morin Center for Banking and Financial Law at the Boston University School of Law. Paulson and his staff decided they would be damned for overpaying for assets and for underpaying, because buying the assets at a lower value than what the banks were carrying on their balance sheets would cause a corresponding hit to equity, reduce the amount of lending that would be possible off the revised equity, and defeat the whole purpose of the program, says Hurley.

Reason for Banks to be Cautious

And what about the notion that banks remain reluctant to lend even after the government's capital injections? Contrary to the prevalent belief, commercial banks have been lending since the TARP was implemented. Large banks increased their outstanding loans by $45.2 billion, or nearly 3.5%, in the five weeks ending Oct. 22, while outstanding loans at small banks rose $5.7 billion, or about 0.74%, during the same period, according to a Federal Reserve statistical release on Oct. 31.

Bert Ely, a principal at Ely & Co. an Alexandria (Va.) consulting firm for financial institutions, says it would be a mistake to force banks to make more bad loans right now. Cassidy at RBC Capital agrees, saying that during a recession. banks need to be extra-cautious about lending.

Some argue the Treasury Dept. should be forgiven for changing course since the TARP was first announced in view of how unprecedented many of the events and circumstances involving the financial crisis have been. "Remember that, like it or not, the government is frankly making it up as it goes along. There's no framework, no prior experience model that anybody can refer to," says Charles Horn, senior partner in the financial services regulatory and enforcement practice at Mayer Brown in Washington, D.C. Paulson and his team are discovering that there are many uses for the $700 billion and such great demand for it that they are in the position of having to determine whether or not there's enough to go around, he adds.

More Players Want In

Indeed, capital investments that were originally intended for the most important banks are now being sought by a much broader number of players. Insurance companies and even auto finance firms are rushing to turn themselves into bank holding companies in order to become eligible to apply for the program by the Nov. 14 deadline. The Treasury now estimates as many as 1,800 publicly held companies could queue up for the program in the weeks ahead and says the remaining $125 billion will be sufficient to cover their needs, according to The Wall Street Journal.

The use of taxpayers' money to accelerate consolidation within the banking industry is another example of how the TARP has gone off course, says Hurley at Boston University. PNC Financial Services Group's decision to use the $7.7 billion capital injection it got from TARP to acquire National City Corp., a Cleveland financial holding company, has rankled people who believe the government shouldn't be picking winners and losers in that industry.

"Consolidation may or may not be a good thing, but it can take a long time," to realize the cost savings that come with economies of scale and full integration of operations, says Hurley. "The whole bailout package was passed with very alarmist rhetoric about how the world was going to come to an end, not with the idea that we had months and months to work this thing through."

Gauging TARP's Success

But others see consolidation among banks as a valid use of the TARP funds to the extent that it eliminates the need to price distressed assets. Instead of overpaying for them or causing further equity destruction by undervaluing them, it's better to leave those assets with the banks that made the loans by allowing weaker banks like National City to be acquired by stronger ones like PNC, says Ely. With a stronger balance sheet as a result of the acquisition, and superior management skills, PNC should be in a better position to work through the problems concerning any distressed assets, he says.

As for how to gauge the success of TARP, Hurley believes there are better ways than by measuring the increase in bank lending.

It's hard to know what the baseline of lending would have been without the Treasury intervention, and it's virtually impossible to tag any number of loans directly to the new capital. Since lending contracts during recessions anyway, it may be that all the capital does is to limit the decline in credit and hence the severity of the recession, he says.

"What I'd look at is: Are these banks able to raise additional capital [from private sources] while the U.S. capital purchase program is in place?" he says. "How soon are these companies going to be able to buy the U.S. Treasury out of its investment?" The top nine recipients of the capital injections have five years to repay the Treasury before the 5% dividend the government is earning on the preferred shares jumps to 9%, which would be punitive, and it would be less onerous for these firms to raise capital sooner than later, he says.

Where Are the Strings?

That's one reason Hurley is critical of the government's decision not to attach more strings to the capital it's giving to banks. The British and Dutch governments insisted on getting seats on the boards of the financial firms in which they bought equity stakes, he points out. "One or two seats is not control, but it's another voice at the table" that could better ensure the money is being used in the most effective ways.

The likelihood that some recipients of capital won't be able to repay the government down the road is strong, given Treasury's willingness to distribute money to the strong and weak alike without apparent differentiation, says Joseph Battipaglia, market strategist at Stifel, Nicolaus & Co. in Philadelphia. He thinks it's a waste to inject capital into weaker banks that are inclined to sit on the money to bolster their balance sheets without increasing their lending. That only undermines investor confidence by allowing opaque asset portfolios to remain murky, and disrupts efforts by investors to seek the most appropriate rate of return for their money, he adds.

Although Treasury has a short-term preference for capital injections, those are nearly completed for publicly traded companies, and the Treasury said it will be releasing guidelines and a "reasonable" time frame for privately held financial institutions, says Horn at Mayer Brown. Presumably, Paulson & Co. still intend to use the remaining $450 billion in TARP to buy distressed loan portfolios and other assets, but there's been no indications as to when that will begin.

Reverse Auctions Ahead?

And that brings us back to the "TA" part of TARP. Nobody will fault government officials for trying to get the most bang from the taxpayer's buck by pumping money into the banks first. But since those troubled assets lie at the core of the current crisis, they will need to be tackled at some point, whether through reverse auctions or some other pricing method. The sooner they are, the faster the wheels of the capital markets will