The federal government's plan to make $250 billion in equity investments in the ailing bank sector is being lauded by experts and industry professionals for one simple reason: It gets more bang for the buck.
Initially, the government had intended to use the entire $700 billion in the financial rescue package recently enacted by Congress to buy the bad mortgage-related assets that have clogged up banks' balance sheets and frozen up the credit markets. Instead, the Treasury will have a significantly lower amount of up to $450 billion for those purposes, once it receives $250 billion worth of preferred stock from the banks, which reportedly include Bank of America (STOCK QUOTE: BAC), JPMorgan Chase (STOCK QUOTE: JPM), Citigroup (STOCK QUOTE: C),Wells Fargo (STOCK QUOTE: WFC),Morgan Stanley (STOCK QUOTE: MS), Bank of New York Mellon (STOCK QUOTE: BK) and State Street (STOCK QUOTE: STT).
But, by and large, the financial industry is not worried about holding onto a portion of those assets, if it means getting access to fresh capital. And from the regulatory side, pouring hundreds of billions of dollars into equity stakes makes more sense than buying troubled assets and leaving banks to fend for themselves, experts say.
It all comes down to a simple ratio: Every dollar invested in troubled assets equates to one dollar, unless the assets appreciate, but every dollar put toward a capital infusion has ten times as much value through leverage. The funds can be used to expand banks' business, free up credit markets and provide a cushion for immediate losses on bad loans. In addition, bank stocks have already surged in market value on word of the revised plan, and taxpayers' preferred shares will pay healthy dividends as well.
UBS analyst Glen Schorr says the capital injection is "better than asset purchases," for those reasons. Deutsche Bank analyst Mike Mayo expressed similar sentiments, calling the revised plan a "significant and momentous event" that "carries much more heft" than the initial strategy. Mayo notes that banks have struggled to obtain such capital from private investors recently, and that the government can inject these funds more quickly than it can structure a program to buy bank assets, providing an immediate solution for an urgent problem.
The government's strategy has shifted drastically over the past few weeks, with Treasury Secretary Henry Paulson initially opposing the notion of acquiring equity stakes. The Bush administration then agreed to allow the government to receive warrants for equity stakes in banks that take part in its program, as a compromise to assure the bill's passage.
But once the U.K. announced last week that it would inject capital into three of the country's biggest banks, the U.S. was left with little choice, says Adam Lerrick, a visiting scholar with the American Enterprise Institute for Public Policy Research. A blanket approach is the only kind that will keep financial services firms on the same competitive footing across the globe.
"If bank deposits in Europe are guaranteed, but not in the U.S., large investors will move their money out of U.S. banks and into the European banks," says Lerrick. "The global financial system is now totally interconnected and therefore one country cannot take measures that differ from those of other nations. The U.S. is being forced by competition from other governments to replicate their policies."
William Isaac, former chairman of the Federal Deposit Insurance Corp. under President Ronald Regan, calls the shift in strategy a "big positive" that was "long overdue."
"If you give $250 billion for new loans, they get $250 billion," says Isaac. "If they get the capital infusion, they can leverage it 10-to-one. I am thrilled with that because I don't think they ought to use any of the $700 billion fund to buy the loans. It's an extravagant waste of taxpayer money and it won't help."
Isaac, who has been critical of the government's plan since Paulson first outlined his proposal in early September, says he is still disappointed that the U.S. has not mimicked its European counterparts by suspending mark-to-market accounting rules -- a move that has been endorsed by accounting standards boards on both sides of the Atlantic.
He also thinks that none of the remaining $450 billion should be used to buy bad assets. Instead, the feds should use the $450 billion for fiscal stimulus plans and direct aid to families who want to stay in their homes. One idea he suggests is providing tax credits for families to purchase homes over the next few years, which could in theory stimulate the housing market, boost prices and support household wealth.
The financial-services industry begs to differ with that view. Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association, an industry group, says that while bank recapitalization is a "necessary component" to restore confidence, it is only "one of the vital fronts of a multi-pronged strategy."
"Our credit markets are the very engine of America's economic growth, and any larger program which aims to restart this economy must also provide these markets liquidity and price discovery for the frozen assets which remain on balance sheets," says Ryan. "Until we have an idea what these assets are worth, loans will remain hard to come by, whether they are between businesses or for average Americans."
Scott Talbot, senior vice president of government affairs at another industry group, the Financial Services Roundtable, says the government has begun to make the right moves. He expects the "multiplier effect" of a capital injection, combined with the remaining funds to buy troubled assets and other measures the Federal Reserve has instated, to be effective in boosting liquidity in the capital markets.
The easing up of credit markets, along with a record 936-point gain in the Dow Jones Industrial Average on Monday, are indications that the plan will be effective, Talbot says.
The $450 billion "may not be enough to buy all the bad assets," he says, "but that's not our goal. Our goal is to restore liquidity."