Risk Management

Capitalist’s Tool? The U.S. Purchase of Private Bank Stock

To quell the credit crisis, the Bush Administration begins detailing its plan to use public money to shore up private financial institutions.
Marie LeoneOctober 14, 2008

Corporate borrowers may see a loosening of credit markets if the Bush Administration’s plan to buy an equity stake in at least nine private banks works as expected. In a press conference Tuesday morning, Treasury Secretary Henry Paulson described more about the “unprecedented measure” of federal government’s offer of $250 billion to financial institutions in exchange for preferred stock.

He emphasized that the action was not something “we ever wanted to do,” but rather something that “we must do” to jump-start the credit markets. Indeed, Paulson expects that the cash infusion will free up the banks from regulatory capital requirements and allow them to make loans to consumers and businesses across the nation.

The voluntary program is open to qualifying U.S.-based banks, savings associations, and certain banks and savings and loan holding companies that elect to participate. The deadline for subscribing to the facility is 5 p.m. (Eastern Time) on Nov. 14. The share plan is part of the $700 billion Emergency Economic Stabilization Act Congress authorized 10 days ago. “Congress gave important new tools [to the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corp. to meet] challenges by working creatively and collaboratively,” stated Paulson.

The eligibility and final allocations for the share purchase program will be determined by Treasury after it works with banking regulators to sort out the final plan details. The equity investment program comes on the heels of two other government programs — from the Fed and the FDIC — to help prop-up the failing economy with taxpayer money.

Federal Reserve chairman Ben Bernanke, who appeared with Paulson at the press conference, talked briefly about the Fed’s efforts to shore up the commercial paper market. He noted that beginning on Oct. 27, the Commercial Paper Funding Facility program will begin buying short-term corporate debt with three month maturities from high-quality issuers.

In addition, Sheila Bair, FDIC chairman, announced at Tuesday’s press conference that her agency will temporarily guarantee the senior debt of all FDIC-insured banks and their holding companies, as well as payroll accounts — which are non-interest bearing — regardless of the dollar amount.

The FDIC-guaranteed program expires on June 30, 2009, and the full protection for deposits in payroll accounts would revert back to the statutory limits on December 21, 2009. To participate, banks will be charged a 75-basisi point fee to protect new debt issued on or before June 30, 2009, and a 10-basis point surcharge will be added to their current insurance assessment to fully cover the payroll accounts.

The federal agencies are working together after President Bush “made clear that we are committed to using all necessary tools to support our financial markets and institutions, so they can finance the U.S. economy,” the three officials said in a joint press statement. Indeed, banks have been unable make loans to businesses or other since the subprime mortgage crisis drove down their regulatory cash cushion — a reserve banks are required to maintain to stay in the business of making loans. The cash cushions dwindled after the values of subprime mortgage assets — including securities based on the high-risk mortgages — dropped precipitously because of mortgage defaults. As a result of the short-term drop in asset values, banks were forced to bolster cash reserves or stop lending.

“We must restore confidence [in the U.S. financial systems]…and make capital available on attractive terms to a broad array of banks and thrifts so they can provide credit to the economy,” noted Paulson, asserting that the infusion of public money into the private banks was done so banks could “deploy” capital, not “hoard” it.

The share-purchase program offers banks a minimum subscription of 1 percent of their risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or 3 percent of risk-weighted assets. The shares will qualify as Tier 1 capital and rank senior to common stock in the capital structure, but will have equal payment rights to most existing preferred shares.

Further, the government-held shares will pay a cumulative dividend rate of 5 percent annually for the first five years, and will reset to a rate of 9 percent annually after that. However, the shares will be nonvoting shares — although they retain class voting rights on matters that could adversely affect the shares. In conjunction with the share purchase, which will be completed by the end of the year, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment.

As long as the government holds a bank’s equity, the bank must adopt the Treasury’s standards for executive compensation and corporate governance. For example, the participating bank must ensure that incentive compensation for senior executives — primarily the CEO, CFO, and the next three senior officials — does not encourage unnecessary and excessive risk that threatens the value of the bank. What’s more, participating banks must institute a clawback provision that authorizes repayment of any performance-based bonus or incentive compensation awards that are later proven to be based on gains or earnings that are materially inaccurate.

The Treasury also requires that participating banks ban golden- parachute payments, and forfeit payroll tax deductions for executive compensation that is in excess of $500,000 per employee.

In delivering the news, Paulson — the former chairman of investment bank Goldman Sachs — seemed far from comfortable personally with the idea of the government intervening in the capital markets. He commented, in fact, that allowing the government to own stakes in private companies is “objectionable to most Americans, me included.”

But, he added: It is the kind of “decisive action” needed “to protect the U.S. economy.”