14 October 2008

Bailout Begins

After the purchase of preferred stock in nine large banks, the new program is expected to be expanded to many others and in fact thousands of banks and savings and loans will be eligible to participate.

The nine initial banks participating are Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase, Bank of America Corp, including the soon-to-acquired Merrill Lynch, Citgroup Inc., Wells Fargo & Co, Bank of New York Mellon and State Street Corp.

At a briefing, Treasury officials said that the first purchases of stock from the nine major banks will begin within days and will total $125 billion. The government expects to spend the entire $250 billion slated for the bank stock purchase program by the end of the year.

In addition to the stock purchases, the Federal Deposit Insurance Corp. will temporarily provide insurance for loans between banks, charging the banks a premium for doing so.

This FDIC program would take the form of providing insurance for new "senior preferred" debt that one bank would lend to another.

This debt would be insured by the FDIC for three years, helping to unlock bank-to-bank lending, which has fallen dramatically because of fears about repayment in the face of billions of dollars of bank losses because of bad loans, primarily in mortgages.

The FDIC will also remove temporarily the current $250,000 limit on FDIC insurance on bank deposits for non-interest-bearing accounts. This primarily would benefit businesses who use non-interest-bearing accounts to run their companies. That money now would be insured, removing the need for companies to juggle funds among multiple bank accounts to stay under the $250,000 limit.

Congress, as part of the bailout bill, temporarily boosted the deposit insurance cap from $100,000 to $250,000, an action that will not be affected by the new program. . . .

Treasury officials said today that they still plan to buy troubled assets and that this program would start as soon as possible. To move that effort ahead, Treasury announced today that it had selected Bank of New York Mellon to serve as the manager for the accounting portion of the bad asset program. It still must select the five to 10 big asset management firms that will run the purchase effort and manage the assets that are purchases.

From the Denver Post.

The Wall Street Journal adds that:

The Treasury said under the program, participating financial institutions will be subject to more stringent executive compensation rules for the period during which Treasury holds equity. Participating firms, for instance, are prohibited from making any golden parachute payments to senior executives. They must also agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. The department has already issued interim final rules for these executive compensation standards.

Banks have a month to join Treasury Department's capital purchase program. They must elect to participate before 5 p.m. on Nov. 14. . . .

Treasury will buy $25 billion in preferred stock in Bank of America -- including Merrill Lynch -- as well as J.P. Morgan and Citigroup; between $20 billion and $25 billion in Wells Fargo; $10 billion in Goldman and Morgan Stanley; $3 billion in Bank of New York Mellon; and about $2 billion in State Street.

The government will purchase preferred stock, an equity investment designed to avoid hurting existing shareholders and deterring new ones. Such shares typically don't come with voting rights. They will carry a 5% annual dividend that rises to 9% after five years, according to a person familiar with the matter. By investing in several big firms at once, the government hopes to avoid placing a stigma on any one firm for getting government help.

The plan will be structured to encourage firms to bring in private capital. For instance, firms returning capital to the government by 2009 may get better terms for the government's stake[.]

More detail is available at the Tax Profs Blog.

For these purposes, given that the federal government isn't concerned about the tax character of the payments it receives, "senior preferred stock" is the worst of both worlds for the American taxpayer. It will rank below even subordinated debt which is currently in distressed junk bond status in many of these banks, in priority of payment in the event of the failure of an institution, while not providing the taxpayers with an upside in the event that the company is successful, which is the reason that Congress insisted that equity stakes be taken in companies receiving assistance.

For all intents and purposes "senior preferred stock" is just another name for supersubordinated debt, except that unlike debt, senior preferred stock can't force a payment, if payments are made on time. In ordinary times, preferred stock is purchased almost exclusively by investors for whom there is a tax advantage to holding equity rather than debt, but the security of debt is what is really desired. Plain old loans would better protect taxpayers.

The initial participating banks also highlight that this bailout is targeted at the biggest enterprises on Wall Street.

There will be a real executive pay cut, although only a small portion of it will come from the bailout preferred stock terms. Indeed, it is possible that junior brokers will start marking more than senior executives do as a result of these restrictions.

The real CEO pay cut of 2008 has come from the collapse of stock prices. The vast majority of CEO pay comes from stock options, and a major bear market renders these options worthless, or nearly so.

I also note that the FDIC's "senior preferred" debt for interbank loans looks very much like a bankruptcy preference for trade credit, secured through the back door.

UPDATE: The buy also apparently includes warrants to buy common stock equal to 15% of the preferred stock, providing some upside to the transaction.

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