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Paulson's New Plan to Buy Equity Stakes in Banks and Unfreeze Credit Markets

Companies / Nationalization Oct 15, 2008 - 07:56 AM GMT

By: Money_Morning

Companies Best Financial Markets Analysis ArticleJason Simpkins writes: The U.S. government yesterday (Tuesday) announced plans to invest $250 billion, more than a third of the $700 billion congressional bailout allotment, into nine of America's largest banks in an effort to bolster confidence in the financial system. Similar to steps taken by European governments earlier this week , the government will guarantee new debt and take equity stakes in the participating banks.

"Government owning a stake in any private U.S. company is objectionable to most Americans - me included," U.S. Treasury Secretary Henry Paulson said announcing his decision to effectively nationalize the nation's banking sector. “Yet, the alternative of leaving businesses and consumers without access to financing is totally unacceptable.”

A government investment of $250 billion amounts to about 25% to 30% of the market capitalization for publicly traded banks , Rajiv Sobti, chief investment officer at Nomura Global Alpha, a unit of Nomura Asset Management U.S.A. told BusinessWeek . 

The $250 billion investment will be allocated as follows:

  • Citigroup Inc. ( C ) JPMorgan Chase & Co. ( JPM ) and Bank of America Corp. ( BAC ) each get $25 billion.
  • Wells Fargo & Co. ( WFC ) will receive between $20 billion and $25 billion.
  • Goldman Sachs Group Inc. ( GS ) and Morgan Stanley ( MS ) each get $10 billion.
  • The Bank of New York Mellon Corp. ( BK ) and State Street Corp. ( STT ) receive between $2 billion and $3 billion apiece.

The remainder, between $124 billion and $131 billion, will be dispersed among smaller banks and thrifts.

Each bank will issue preferred stock to the U.S. government that will pay special dividends at a 5% interest rate, which will increase to 9% after five years. Additionally, the government will receive warrants worth 15% of the face value of the preferred stock.

Participating banks will also have to accept limits on executive pay, the abolition of so-called golden parachutes and improper bonuses, and may be forced to reduce or eliminate dividends.

The government, so far, has insisted that the banks will not have to cut their dividends, nor will any executives be forced to resign. The chief executives of Royal Bank of Scotland Group PLC (ADR: RBS ), HBOS PLC (OTC: HBOOY ), and Lloyds TSB Group PLC (ADR: LYG ) were all forced to resign Monday during the British government's nationalization process.  

While the original U.S. bailout plan indicated that banks would be encouraged to participate on a volunteer basis, the chief executives of the nine largest U.S. banks were summoned to Washington and convinced to take part in the recapitalization effort, as a way to avoid stigmatizing any one bank.

Had any one bank asked for help, it would have been a signal to the world that it couldn't survive, said Daniel Clifton, an analyst for institutional broker Strategas Research Partners.

Therefore, the Treasury had little choice but to "jawbone them into taking the money in a coordinated fashion all at the same time.” 

“These are healthy institutions, and they have taken this step for the good of the U.S. economy,” Paulson said of the financial firms.

Afterwards, Paulson further elaborated on the role these institutions must play in restoring liquidity to the market.

“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Paulson said.

In addition to $250 billion recapitalization effort, the U.S. Federal Reserve will start a program to become the buyer of last resort for commercial paper and the Federal Deposit Insurance Corp. (FDIC) will offer an unlimited guarantee on bank deposits in accounts that do not pay interest. The government will also expand deposit insurance to cover all small business deposits.

Over the past several months, small businesses, which typically maintain balances well above insurance limits, have been withdrawing their money in record amounts. The Fed initially tried to solve this problem by raising its deposit insurance limit from $100,000 to $250,000, but that only extended coverage to about 68% of all small business deposits, according to financial services consulting firm Oliver Wyman Group .

Abolishing deposit insurance limits for small businesses altogether would cover the remaining 32% , the New York Times reported.

“Imposing unlimited deposit insurance doesn't fix the underlying problem, but it does reduce the threat of overnight failures,” Jaret Seiberg, a financial services policy analyst at the Stanford Group in Washington, told the NY Times . “If you reduce the threat of overnight failures, you start to encourage lending to each other overnight, which starts to restore the normal functioning of the credit markets.”

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