U.S. Considering U.K. Style Banking Bailout - Why Wasn’t It Done In The First Place?

In “well duh” news, recent comments by Treasury Secretary Henry Paulson suggests that the U.S. is considering implementing a bank recapitalization that is very similar to the British one, namely the exchange of cash infusions for preferred shares:

From the FT:

The US could soon follow the UK down the path of using public money to recapitalise weakened financial institutions in return for preference shares.

In Washington on Wednesday, Hank Paulson, Treasury secretary, highlighted the fact that the $700bn rescue legislation passed last week allowed the government to recapitalise banks in addition to its core purpose of buying troubled assets.

“We will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalisation of financial institutions of every size,” he told a press conference.

This change in tone from the top follows a shift in the debate within the US administration, which is increasingly sympathetic towards the idea of government-led recapitalisation.

The Federal Reserve - while very supportive of the asset purchase plan - has believed for at least four months that recapitalisation of the banking system is the most potent way to fight the credit squeeze.

But the Treasury has hitherto been skeptical about recapitalisation, in part because of concern over the degree of government intervention this would imply.

Now the Treasury seems to have come round to the view that direct recapitalisation makes sense on economic grounds - though the US is certain to tailor its approach to its own domestic conditions.

One person who discussed the issue with the administration this week said there appeared to be sufficient consensus for such a move to happen as early as next week, depending on market developments. The asset purchase plan is scheduled to be launched next month.

Advocates of this approach within US policy circles argue that the government should go beyond recapitalisation of failing companies and inject public capital into institutions that have been weakened by market stress but are not on the brink of bankruptcy.

This would allow such companies to resume more normal lending activities and thereby moderate the credit squeeze. The model would be Warren Buffett’s investments in Goldman Sachs and General Electric. In effect, Mr Buffett sold Goldman and GE an insurance policy against the possibility that their existing equity would not be enough to meet potential losses.

This insurance policy came in the form of a purchase of preferred shares, which pay out ahead of common stock, with a high yield - the “fee” on the insurance.

Goldman and GE can buy back the preferred stock at a premium - terminating the insurance policy - once the crisis is over.

Assuming that this isn’t just talk and the U.S. actually goes through with this, why didn’t they just do this in the first damn place especially when participating banks could’ve already have started receiving cash infusions and TARP isn’t scheduled to kick-off until next month? The whole thing is pretty ridiculous when TARP was just signed into law last week, and now the government is already considering planning and executing TARP II before TARP I even gets started.

SO let’s say that TARP II is executed next week and the Government proceeds to pour 100s of billions of dollars into the banks, what exactly would be the point of TARP I at that point, would it truly be a tool to help the economy or does it become an even more glaring “gift” to the banking system? Better yet why execute TARP I at all if the option of injecting cash into the banks in exchange for preferred shares is now on the table? Aren’t preferred shares a markedly superior investment in comparison to overpriced MBSs, considering that the former locks you into any upside and the latter is highly speculative and may not turn a profit at all?

I.e. isn’t spending the initial $250 billion of the fund from TARP I on preferred shares instead of the mortgage securities the banks don’t want a more responsible use of taxpayer dollars?

After all if the mere fact that the Treasury is going to overpay for the mortgage securities it buys from the banks means that the chances of making profit on these securities is greatly reduced just due to the price being paid; last time I checked: “buy high and sell higher” wasn’t exactly a solid investment strategy.

Yet, that’s what the government is trying to sell us on: “buy high and sell higher”.

The whole thing makes one wonder on a whole host of fronts.

You can read more here.

Source:

The Financial Times: “US may follow UK on bank bail-outs” — Krishna Guha, James Politi, October 8, 2008.

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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