Thursday, October 9, 2008
Nationalize to privatize: US considers taking equity stakes in the banks
It's not too late to enact a better plan than the one the Treasury has put on the table. Peter Lee looks at alternative strategies that might prove sharper than Paulson's bailout plan.
If the federal government believes that it must recapitalize the banking system, then it should do so directly by investing equity in the banks. Buying troubled assets at above market prices achieves much the same thing – it hands capital to the banks and transfers risks of loss to the public purse. Surely there is no need to make things more complicated than they need be by creating a false market in hard-to-value securities.
Having urged Congress to pass Tarp in September with warnings of financial meltdown if it did not, Paulson was forced to admit on October 8 just how unprepared the US Treasury is to implement it. He says: “We expect it will be several weeks before our first purchase.” In the meantime, he points out that the Emergency Economic Stabilization Act empowers the Treasury to “inject capital” as well as to buy bad assets from banks and provide guarantees. “We will use all of the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.”
It is perhaps understandable that the government of the country previously regarded as the champion of free markets should be reluctant to build a portfolio of majority and minority equity stakes in banks. However, doing so might encourage more private-sector investors to follow as co-investors.
The first sovereign wealth funds that sought to recapitalize US banks in late 2007 and early 2008 have suffered some losses, but that’s not the end of the world. There is still plenty of cash and risk capital on the sidelines that could be put to work, once markets stabilize: a point that Paulson surely grasps intuitively.
Look at how Goldman Sachs and JPMorgan swiftly raised billions of dollars from the equity capital markets in accelerated book builds – typically aimed at existing shareholders – following Goldman’s shift to bank holding company status and the injection of capital from Warren Buffett and JPMorgan’s acquisition of a large share of the assets and deposit liabilities of Washington Mutual. Goldman set out to raise $2.5 billion, covered its book in 20 minutes and knew it had enough to double the capital raise in a couple of hours. JPMorgan announced its Washington Mutual deal on Thursday evening and raised $10 billion on Friday morning. And Morgan Stanley received an equity injection from a strategic investor, selling a 21% stake in the company to Mitsubishi UFJ of Japan for $9 billion.
Injecting equity directly would reek of partial nationalization and an explicitly government-backed banking system through partial state ownership would be anathema to many Americans. That doesn’t make it the wrong thing to do, though. The public sector might lack individuals capable of conducting the kind of highly complex banking that has just brought the system to its knees but it could recruit more moderately paid individuals with the basic skills to conduct individual loan credit analysis based on character, collateral and capacity and to manage loan portfolios at state-owned banks engaged in low-risk, low-return banking. This would be designed to move money around the system and produce low, stable, utility-like returns to the shareholder.
Germany had a banking system like this for years, until it ran into trouble competing against the investment bankers for higher returns.
Taking equity directly might be better than tying the sale of troubled assets into some kind of bail-out fund – which in itself is likely to create an artificial non-market price in the toxic assets and crowd out private risk capital – with the handing over of contingent equity to the government either through warrants or some form of clawback of future earnings of cleaned-up banks.
It might be far harder for banks to recapitalize by attracting conventional equity investors while these investors fear that the government has an unquantifiable prior claim on the company’s earnings and de facto equity. If government equity stakes bring stability, it might be easier to sell these stakes down in future and ultimately repay the associated public debt from privatization proceeds.
Paulson's bailout plan is not the only option