Recap Plan: Better? Maybe, for the Right Banks

The US Treasury’s plan to inject cash directly into banks may be more effective in battling the credit freeze than having the government buy the banks' troubled mortgage debt ... provided the right banks get the cash.

Financial Crisis
Financial Crisis

“I think this plan is far superior to the asset acquisition plan which I never believed made any sense at all, so I think (Treasury Secretary Henry Paulson) is on the right track,” said Richard Bove, banking analyst at Landenburg Thalmann.

And the capital injections, which could begin by the end of October, should also be better for taxpayers, proponents add.

Better, that is, if the Treasury moves quickly and decisively enough.

"We've loaned a lot of money to the banks but I think a capital injection is what's needed, probably should have been done earlier, in which the Treasury actually buys equity stakes in the banks that are important to the stability of the economy," said Martin Baily of the Brookings Institution on CNBC.

Last week, Congress approved a $700 billion financial rescue plan, allowing the Treasury to buy up bad mortgage debt from troubled banks in the hopes of unfreezing the credit markets. The rescue plan also allows the Treasury to put cash directly into banks, although that provision—which Congress insisted on—hadn't gotten much attention until Wednesday when Paulson alluded to it as an option.

Critics of buying up troubled assets, including Bove, said that strategy would actually worsen the capital structure of banks by forcing write-downs. It also would stick taxpayers with $700 billion worth of illiquid assets, he said.

On the other hand, putting cash directly into banks would allow the government to earn interest income and possibly even reap profits when the banks eventually recover.

“This is a win-win for the taxpayer, for the economy," Bove said. "Great Britain is already moving in that direction and that it is absolutely the way the $700 billion should be used.”

Of course, the Treasury could easily end up doing both. And even if just 25 percent of the $700 billion went to capital injections, it “would have a very dramatic positive impact on the market,” Bove said.

Treasury Fully Stepping Up to The Plate?

Some question whether Treasury is being bold enough with recapitalization even now, and they warn that continuing the pattern of incremental measures could do considerable damage to the financial sector and the broader economy.

"They have been behind the curve from day one. They have to get bigger and larger, and to get out in front" of this crisis, said Robert Johnson, a former Bankers Trust managing director as well as ex-Soros Fund manager.

In Johnson's view, Treasury will very shortly need to assume the power to decide which financial institutions can't be saved and which are too big to fail, and force the rest to take substantial write-downs so the bad news is finally put behind the market.

But Treasury's record to date shows it is reluctant to impose those kinds of measures.

"This is a dysfunctional and broken system that requires leadership that does not pander to those that have broken it," says Johnson, who as chief of economist in the Senate Banking Committee did preparatory work for the government's Savings and Loan Crisis rescue in the late 1980s. "For that to happen means Treasury will have to to some degree frustrate the will of the financial sector, which would prefer to come out of this not paying for the consequences of their actions."

A key consequence of the government buying direct equity stakes in private banks is that investors would see the value of their shares diluted. This is a key industry objection to Treasury's emerging recapitalization plan, as is the perceived stigma of weakness as the government invests in those specific institutions that presumably need help.

To get around that, Johnson suggests that there be a rights issue at the same time that the government buys in, although this would require investors to pony up more money to maintain their stake.

(John Browne of Euro Pacific Capital argues the government should go further and think about nationalization of certain banks. See Video.)

He also said that in order to ensure the stability of the system, the government should insist that all banks allow government buy-ins—a notion bound to be anathema to most banks.

Banking industry sources, who insisted on anonymity, contend that the resources of the FDIC are sufficient to work through banks' current problems.

However the details are worked out, a dangerous uncertainty rises as Treasury delays more radical steps, Johnson said.

"The more they advertise that it’s [recapitalization] on the way [but don’t deliver], the more dangerous it is for existing stock shares; if they diddle around for weeks, who is going to want to buy bank shares? Because you are just waiting to be diluted," said Johnson.

He added that making the partial nationalization compulsory is necessary in order to avoid a "free rider" problem in which large banks "have an incentive to lay back and let everybody else get recapitalized, and as the economy comes back...they have preserved the upside because they did not have their shareholdership diluted."

More Capital Doesn't Necessarily Mean More Lending

Even with new capital injection, there's no guarantee that banks will start lending again, especially if there are prospects of liquidation.

With a capital injection, “the first thing you are doing is de facto guaranteeing the existing debt, so a lot of the value you are putting into the company is not going to make new loans,” said Luigi Zingales, a financial scholar at the University of Chicago. "It is transferred to the existing debt-holders."

Protecting Your Portfolio - An Investment Guide
Protecting Your Portfolio - An Investment Guide

If that happens this becomes a bailout not of the bank itself, but debt-holders, Zingales said.

“I don’t see any reason to bail out debt-holders with taxpayers money," he added. "They earned nice yields because they took risk and now when the risk materializes you want the government to bail them out. It doesn’t make any sense.”

For that reason Bove said there would have to be stipulations that the new capital would be used to make more loans, especially to small and medium-sized companies that are responsible for the lion’s share of job creation in the country and are most immediately in danger of going belly-up.

That would mean targeting capital injections to banks that are most heavily involved in servicing this market, Bove said, including Bank of America, which has the country’s largest bank retail operations, and JPMorganChase, another big player among the larger banks.

It would also probably cover Wells Fargo and a slew of middle-range banks such asPNC, BB&T and US Bancorp.

Direct capital injection into banks could be done virtually overnight but Bove said the government would need to provide a “rationale” for the unprecedented government intervention.

“In my view, you select the banks where you are going to get the biggest bang for the buck in terms of job creation, and those would be the banks that make the largest amount of loans to mid and small-sized companies because they are the ones that create the most jobs,” said Bove.