Assessing the US Treasury’s bail out plan

It had to happen. In the face of catastrophic losses, massive unemployment and an economy that is still scratching its head as to how the whole crisis unfolded, the US government has stepped into the breach in an effort to bail out the country’s banks, protect consumers, and restore investor confidence so that the economy can pick up some momentum and leave the dark days of the sub-prime mortgage crash behind.

In February Treasury Secretary Timothy Geithner unveiled his raft of measures aimed at restoring investor and consumer confidence in the country’s banking sector, while also curbing executive pay in those financial institutions which the government was forced to bail out.

Mr Geithner’s Financial Stability Plan aims to assure taxpayers that every dollar used in the bank bail out is directed toward lending and economic revitalisation, and that there will be a new era of accountability, transparency and conditions on the financial institutions receiving funds.

He said: “The American people will be able to see where their tax dollars are going and the return on their government’s investment, they will be able to see whether the conditions placed on banks and institutions are being met and enforced, they will be able to see whether boards of directors are being responsible with taxpayer dollars and how they’re compensating their executives, and they will be able to see how these actions are impacting the overall flow of lending and the cost of borrowing.”

“We believe that access to public support is a privilege, not a right. When our government provides support to banks, it is not for the benefit of banks, it is for the businesses and families who depend on banks… and for the benefit of the country. Government support must come with strong conditions to protect the tax payer and with transparency that allows the American people to see the impact of those investments.”

A key aspect of the plan is an effort to strengthen financial institutions so that they have the ability to support recovery. This will be achieved through a number of measures. Firstly, the plan will create a comprehensive stress test, which is a forward-looking assessment of what banks need to keep lending even through a severe economic downturn. Mr Geithner believes that the test will succeed for a number of reasons. Firstly, increased transparency will facilitate a more effective use of market discipline in financial markets. The Treasury Department will work with bank supervisors and the SEC and accounting standard setters in their efforts to improve public disclosure by banks.

Secondly, all relevant financial regulators – the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) – will work together in a co-ordinated way to bring more consistent, realistic and forward looking assessment of exposures on the balance sheet of financial institutions. And thirdly, all banking institutions with assets in excess of $100bn will be required to participate in the coordinated supervisory review process and comprehensive stress test.

Testing stress
As well as a bank stress test, the US financial stability plan will create a capital assistance programme. Once a financial institution has undergone a comprehensive “stress test” it will have access to a Treasury-provided “capital buffer” to help absorb losses and serve as a bridge to receiving increased private capital. Added to that, any capital investments made by the Treasury under the capital assistance programme will be placed in a separate entity – the Financial Stability Trust – set up to manage the government’s investments in US financial institutions.

The US government says that the plan will also herald a new era of transparency, accountability, monitoring and conditions as firms will be required to show how assistance from the financial stability plan will expand lending. The new rules state that all recipients of assistance must submit a plan for how they intend to use that capital to preserve and strengthen their lending capacity. This plan will be submitted during the application process, and the Treasury Department will make these reports public upon completion of the capital investment in the firm.

It also states that firms must detail, in monthly reports submitted to the Treasury Department, their lending broken out by category, showing how many new loans they provided to businesses and consumers and how many asset and mortgage-backed securities they purchased, accompanied by a description of the lending environment in the communities and markets they serve. This report will also include a comparison to their most rigorous estimate of what their lending would have been in the absence of government support. For public companies, similar reports will be filed on an 8K simultaneous with the filing of their 10-Q or 10-K reports.

Furthermore, all information disclosed or reported to Treasury by recipients of capital assistance will be posted on – the government’s dedicated website on the issue – because taxpayers have the right to know whether these programmes are succeeding in creating and preserving lending and financial stability.

The plan also aims to put strict limits on the “bonus culture” that is seen by many as being at the root of the crisis. The government says that limiting common dividends, stock repurchases and acquisitions provides assurance to taxpayers that all of the capital invested by the government under the Financial Stability Trust will go to improving banks’ capital bases and promoting lending. All banks that receive new capital assistance will be restricted from paying quarterly common dividend payments in excess of $0.01 until the government investment is repaid. That presumption will be the same for firms that receive generally available capital unless the Treasury Department and their primary regulator approve more based on their assessment that it is consistent with reaching their capital planning objectives.

Shackled assets
Banks will also be restricted from repurchasing any privately-held shares, subject to approval by the Treasury Department and their primary regulator, until the government’s investment is repaid. They will also be restricted from pursuing cash acquisitions of healthy firms until the government investment is repaid. Exceptions will be made for explicit supervisor-approved restructuring plans. Firms will also be required to comply with the senior executive compensation restrictions announced on February 4, including those pertaining to a $500,000 total annual compensation cap plus restricted stock payable when the government is getting paid back.

Mr Geithner has stated that transparency and greater accountability are at the heart of the newly launched plan, which has prompted the Treasury Department to announce measures to ensure that lobbyists do not influence applications for, or disbursements of, Financial Stability Plan funds, and will certify that each investment decision is based only on investment criteria and the facts of the case.

Added to that, the Treasury Department will post all contracts under the plan on its website within five to ten business days of their completion. Whenever the Treasury makes a capital investment under these new initiatives, it will make public the value of the investment, the quantity and strike price of warrants received, the schedule of required payments to the government and when government is being paid back. The terms of pricing of these investments will be compared to terms and pricing of recent market transactions during the period the investment was made, if available.

However laudable Mr Geithner’s efforts, his plans have received a very mixed response. The main problem with the financial stability plan is that it does not come clean to the American public about how the losses from the financial meltdown will be divvied up, say critics. The plan is deliberately short on detail, they say, especially on the much anticipated public-private partnership. While the Obama Administration hopes to get private investors to start buying up the toxic mortgage-backed securities that are clogging up banks’ balance sheets, it is not clear what would make those private investors suddenly want to buy assets that until now they have treated as radioactive. “I don’t see how you’re going to get confidence in the markets with a plan that’s so difficult to penetrate,” says Harvard University economist and occasional World Finance contributor Kenneth Rogoff.

Although Mr Geithner repeatedly promised that the new plan would be transparent, it was precisely the lack of detail of how the plan would work and be financed that contributed to the stock market’s negative reaction. US stock averages fell as Mr Geithner was speaking, and were down four to five percent in late trading.

“It was scary watching him,” says R Christopher Whalen, Managing Director of Institutional Risk Analytics, a consulting firm. “The markets are tough. As long as they sense that there’s bull – and indecision – they’re going to reject it.” Investors on both sides of the Atlantic immediately expressed disappointment following the announcement, sending markets into freefall. The FTSE 100 index closed down 2.2 percent or 94.53 points at 4,213.08 and the FTSE 250 index fell back 2.5 percent or 164.02 points at 6,495.66. “They were going to have to say something pretty special to kickstart trading today,” said a London-based trader.

Even the plan’s supporters are sceptical about how well it may work in practice – precisely because the Treasury has been so scant on details. Moody’s, the credit rating agency, supports the plan, but thinks that it may be of more benefit to larger banks than to smaller ones in the US. “Despite the lack of specifics… Moody’s views the Financial Stability Plan (FSP) positively for major banks’ depositors and debt holders, as it reflects the US government’s commitment to providing bridge capital and liquidity support to these institutions until the economy and capital markets recover,” it said in a statement.
Chairman and CEO of UMB Financial Corporation, a multi-bank holding company headquartered in Kansas City, Mariner Kemper, says that the plan remains too vague and lacks essential details on how the $2trn will be put to good use. As seen from the first round of the Troubled Asset Relief Program (TARP) devised by former President George W Bush and former Treasury Secretary Henry Paulson, actions taken to promote loan growth have essentially been ineffective as lending remains stagnant, he says.

“As is, the premise for the plan calls for pumping more capital into the system. However, this is somewhat flawed logic as financial institutions primarily loan against deposits, not capital,” says Mr Kemper. “More capital dollars won’t necessarily increase loan demand because the root of the problem is the fragile state of the economy that has people pulling back on consumption. By injecting capital, the plan does more to promote unsound lending practices than addressing the systemic problem.”

“To truly be productive in solving the economic crisis, it must be realised that the core issue is that we, the government, businesses and consumers, have overextended for several years. It’s counterintuitive to solve a leverage problem with more leverage. The principles that guide the free market must be allowed to unfold by letting the ‘problems’ within the system fail and the ‘successes’ thrive.”

As a result, Mr Kemper suggests that the Treasury should seek counsel for solutions in moving forward from those who operated soundly rather than from those who broke the system, and offer incentives rather than penalties for those not taking “oversized risks for oversized rewards”. He also believes that government intervention should become more of a last resort than an immediate backstop.

Many economists argue that some of the biggest US banks are in such bad shape that the only reasonable alternative is to nationalise them, which would mean getting rid of their top executives, wiping out their shareholders, and forcing creditors (other than government-insured depositors) to take a big hit. Once in full control of the banks, the government could strip out their bad assets for sale later, give them a huge injection of public funds, and then spin them back out to the public.

However, unlike the UK, this is not an option that the US wants to explore. But private investors remain well aware of the possibility; and as a result, they are unwilling to put more capital into banks if they fear they could lose it in future government takeovers. This means that the US plan may stall, or at least not create the desired economic stimulus, say some.
Charles Calomiris, a Columbia University economic historian who has studied banking crises, says that the key mistake of the Obama Administration is trying to come up with a plan that emphasises political palatability over economic reality. To buy support, Mr Calomiris says, the plan emphasises “very careful investments over a period of time with a lot of upside potential for taxpayers, and with all sorts of limits on what bankers can do.”

The problem with that approach, Mr Calomiris says, is that it does not do enough to really make the banks truly healthy, and just prolongs the crisis. He favours taking strong action to improve banks’ health dramatically and quickly by guaranteeing them a floor price on their real estate assets, even though such action would be criticised as a giveaway. Says Mr Calomiris: “What makes sense economically doesn’t make sense politically, so I’m not very optimistic.”


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