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Mandatory Acceptance of Federal "Investment" in Leading Banks:

N.Y. Times:

Treasury Secretary Henry M. Paulson Jr. outlined the plan on Monday to nine of the nation's leading bankers at an afternoon meeting, officials said, in which he essentially told the participants that they would have to accept government investment for the good of the American financial system. This capital injection plan will use a huge chunk of the money authorized for Troubled Assets Relief Program.

Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion each (plus an additional $5 billion for their recent acquisitions); Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York Mellon and State Street each receiving $2 to 3 billion. Wells Fargo will get $5 billion for its acquisition of Wachovia, and Bank of America the same for amount for its purchase of Merrill Lynch.

The goal is to inject massive liquidity into the banking system. The government will purchase perpetual preferred shares in all the largest U.S. banking companies. The shares will not be dilutive to current shareholders, a concern to banking executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings. The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.

If any of the relevant banks is already well-capitalized, I hope its CEO tells Paulson to take his capital injection and shove it up his you-know-what.

winstontwo (mail):
I believe that Ilya is arguing in the thread below that he fears that Obama may have socialist tendencies.

If so, what does that make Paulson/Bush?
10.13.2008 11:32pm
Cornellian (mail):
I hereby declare that if Mr. Paulson shows up at my door with a multi-billion dollar capital injection, I will not complain in the least if he describes it as involuntary. I'll be happy to issue him all the preferred shares he wants.
10.13.2008 11:34pm
Cityduck (mail):
If a bank is well-capitalized, I'd hope that it wouldn't be out to take money it doesn't need, diverting it from being used to solve this problem.
10.13.2008 11:34pm
jccamp (mail):
This has certainly been the weirdest few weeks of Capitalist Economy 101 I've ever seen.

I have the sense that some of this Federal intervention is something akin to using a gun to highjack an elevator. After all the drama, one will end up in the same place the elevator was going to anyway.
10.13.2008 11:35pm
DavidBernstein (mail):
Duck, apparently Paulson has decided that the issue is not banks that "need" the money, but that the feds need to inflate the money supply, and pronto, and the mechanism to do so is by giving money to major banks. If a bank has to pay, say, a 7% dividend on the gov't's $25 billion in preferred shares, it will have to find a way to lend out that $25 billion to get sufficient return to pay the gov't. The problem: what if there aren't sound investments out there that will pay more than the banks have to pay the gov't?
10.13.2008 11:37pm
Christopher M (mail):
I don't claim to know much about finance, but it seems like the non-voluntariness of this program might be an important part of its structure. If the investments are voluntary, then taking the money could be a signal -- an admission that the bank is otherwise undercapitalized or in bad shape. If everyone has to just take the money, there's no signaling problem. Yes?
10.13.2008 11:40pm
Cityduck (mail):
David,

Thank you for the clarification.

So we've already moved beyond recapitalizing banks to overcapitalizing the chosen few banks we want to thrive?

Is this the same solution that the Brits are using? I thought we were looking more to the Swedish solution than some sort of bank trickle down theory.
10.13.2008 11:44pm
John (mail):
Bizarrely, the Times article noted that "The shares will not be dilutive to current shareholders, a concern to banking chief executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings." Huh? Where else will the banks get the money to pay the dividend on the preferred except from their earnings? Further, where the dividend money comes from (earnings or somewhere else) has nothing to do with whether the preferred shares are "dilutive to current shareholders." They are not dilutive because they are not common shares, and therefore do not participate in the firm's profit growth--they are stuck with their fixed preferred dividend.

Finally, injecting this much money into the banks will have the predictable result of the banks having to move the money out into the world. This will inevitably result in loans to poor credits. Gee, how did that work out the last time we tried it?
10.13.2008 11:50pm
Nunzio:
I'm with Cornellian.
10.13.2008 11:50pm
Elliot123 (mail):
"The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept."

That sentence doesn't compute. If he wants everyone to accept, then it is voluntary. If it is not vountary, then there is no acceptance. Whata's he going to do if they say NO?
10.13.2008 11:50pm
Vera Baker:
because perpetual preferred stock holders are paid a dividend, not a portion of earnings

Maybe someone can explain how dividends are not paid from earnings.
10.13.2008 11:52pm
Malvolio:
Am I the only person start to wonder if "Henry Paulson" in Spanish is "Hugo Chavez"?
10.13.2008 11:55pm
Calderon:
Does anyone know what penalties Paulsen (or Bernanke) could impose to punish a bank that flat out said, no, we're not accepting your money? I'd be surprised if Paulsen was relying solely on the threat of public criticism, since a lot of the public would support a bank that refused to accept taxpayer money.
10.13.2008 11:58pm
Cityduck (mail):
Does anyone really believe that Paulson is not acting in the best interests of the banks? The notion that the banks don't want the money is unbelievable to me. And why do they have to loan the money, can't they use the money to fund acquisitions?
10.14.2008 12:00am
Nunzio:
Calderon,

The government could just flat-out buy the bank for fair-market value. This seems less intrusive.
10.14.2008 12:01am
Automated Robot (mail):
I wouldn't call this a sign of a turnaround in the economy.
If I believed in holding equities long term before I'd be looking to dump them in a rally.Of course, silly me,my money doesn't count.
10.14.2008 12:03am
Calderon:
Calderon,

The government could just flat-out buy the bank for fair-market value. This seems less intrusive.


Really? To ask Prof. Eric Posner's favorite question, what statute gives the government the authority to cash out all the stockholders (or other owners) of a bank if they don't want to sell? (Serious question, is there really a statute that allows the government to forcibly purchase a solvent bank?)
10.14.2008 12:06am
gwinje:
Calderon,

Interesting question. I'm no expert, and I'm not claiming this is an answer to your question, but the first thing that pooped (yes pooped, not popped) into my mind was "there's no statute authorizing it, but the takings clause seems to presume they could yoink it and pay 'em after the fact"
10.14.2008 12:27am
Francisq (mail):
I suspect that the conversation sounded a lot like something from the Godfather.

"Before I leave this room, your signature will be on that contract or your bank will be seized by the FDIC."

At least, that's the way the banks will spin it. Then there's no risk of a run on the banks that voluntarily take the capital injection.

(If you think about it, the only way a bank could avoid being run on is to be able to claim that it was forced, FORCED! to take the government money. If a bank were willing to admit it needed the money, then a run would start the very next morning. Wachovia failed because of a run, not necessarily because it was insolvent.)
10.14.2008 12:31am
Harry Eagar (mail):
'If any of the relevant banks is already well-capitalized'

That's a mighty damn big if. At least several on that list are highly suspect.

Every time a bank manager sez we're well-capitalized and managing risk responsibly and tomorrow we are going to the markets for $10B to shore up our capital, what I hear is: we're $10B light.
10.14.2008 12:31am
PDXLawyer (mail):
Am I the only person start to wonder if "Henry Paulson" in Spanish is "Hugo Chavez"?

and


If he wants everyone to accept, then it is voluntary. If it is not vountary, then there is no acceptance. Whata's he going to do if they say NO?

Perhaps the Italian translation is "Vito Coreleone"
10.14.2008 12:31am
Fedya (www):
Calderon:

The feds could try claiming eminent domain, although I'm sure the result would be a legal mess. They'd probably claim Kelo as precedent.
10.14.2008 12:36am
Paul Allen:

Duck, apparently Paulson has decided that the issue is not banks that "need" the money, but that the feds need to inflate the money supply, and pronto, and the mechanism to do so is by giving money to major banks.

Huh? I think you have it wrong professor. If they wanted to inflate the money supply they could do so by other means. Most notably they need only withdrawal the SFP funds to buy-back Treasuries. That would certainly catch the Fed flatfooted and inflate the money supply.

Still I might wonder why you think they need a special way of inflating the money supply? The usual way is that Fed monetizes Treasuries.
10.14.2008 12:38am
Oren:
Christopher had the answer a while back -- the banks want it because they are undercapitalized but they cannot appear to want it, lest they appear undercapitalized.

By putting a fig-leaf on the program and calling it involuntary, the banks avoid having to ask for help which, in the current climate, would be worse that merely sitting pat.
10.14.2008 12:45am
GMUSL '07 Alum (mail):
Fedya, no. Kelo was an A->B transfer where both were private parties. It doesn't govern the hypo at all.

Berman v. Parker is where you want to focus on.

Even somebody who favors a robust takings clause have to concede that these banks are in a blighted industry.
10.14.2008 12:49am
Guest12345:
If it is not vountary, then there is no acceptance. Whata's he going to do if they say NO?


I'd imagine that the first thing they could do is close the federal reserve lending window to any bank determined to be "uncredit-worthy." Second they could perform a detailed audit on the bank, every quarter. Having worked for a bank there is significant overhead in the audit process. Third they could let Schumer publish a letter in the paper saying "Bank X is insolvent." Fourth (as a follow on to number three) the FDIC could take everything that has any value (all your deposit accounts and physical assets for example) and sell it to a competitor for a penny on the dollar.
10.14.2008 1:03am
Calderon:
On the takings clause issue, maybe I'm wrong, but it seems to me that clause is a limitation on government authority, not a basis of authority. That is, the takings clause says that if the government takes private property, it has to pay just compensation, but does not say that the government can take private property. Instead, some statutory authorization is necessary for the government's action. I looked at the bailout bill, and (again, unless I missed something) it would take a pretty strained interpretation on a couple of scores to say that it allows the Treasury to force sales of preferred stock.

Now, other commenters could be right that this is a coordinated action problem and all the financial institutions really wanted the infusions but didn't want to admit that to anyone else because of signalling effects. On the flip side, both Goldman Sachs and Morgan Stanley have solicited private infusions of capital, so I'm skeptical that fear of signalling effects would cause institutions to decline infusions they otherwise believe they need. Another recent example is the voluntary program for money market insurance. One could have made the same argument about coordination and signalling there (only money market funds at danger of breaking the buck would buy insurance, so buying insurance would cause customers to sell out from that money market fund), but that program was apparently voluntary and at least some major funds bought the insurance (e.g., Vanguard).

In any case, even if the signalling avoidance hypothesis is true, that doesn't answer the question of what power, if any, Paulsen has to force recalcitrant banks to sell preferred shares to the government. What if some smaller bank wants to decline the infusion for whatever reason? Where Paulsen's basis for demanding the infusion, or what punishments can he levy for the refusal?
10.14.2008 1:05am
paul lukasiak (mail):
If any of the relevant banks is already well-capitalized, I hope its CEO tells Paulson to take his capital injection and shove it up his you-know-what.

unfortunately, even the best capitalized big bank is likely to become under-capitalized if it were to resist Paulson's plan, because the US is taking an "ownership" stake in the other banks, and large/corporate depositors will inevitably see the Paulson banks as a lot more solid should/when things start to go south again....

This is especially important in terms of corporate decision-making; their officers/directors are compelled to do what is in the best interest of their stockholders, and given the "house of card" nature of the financial system, that translates into an imperative to switch banks to the one that the US is "backing". The flight of capital from the resistant bank will result in it becoming insolvent...
10.14.2008 1:06am
Oren:

Third they could let Schumer publish a letter in the paper saying "Bank X is insolvent."

I wasn't aware anyone (Senator or otherwise) had to petition the government for the right to publish letters is the paper. Someone must have overruled that pesky Pentagon-Paper thing . . .
10.14.2008 1:10am
Guest12345:
I wasn't aware anyone (Senator or otherwise) had to petition the government for the right to publish letters is the paper. Someone must have overruled that pesky Pentagon-Paper thing . . .


Who said anything about petitioning? I said "let." There are lots of ways to bring pressure and the vast majority of them are entirely legal.
10.14.2008 1:29am
Commenterlein (mail):
David,

Paulson is trying to avoid the obvious adverse selection / signaling problem. If he lets banks self-select into participation, then participation becomes a potentially devastating signal of weakness, ensuring that all other sources of funding immediately shut down for banks that take the treasury investment. As a result, no bank with a fighting chance of survival would participate, and the program would fail.

Forcing all banks to participate ensures that no negative signal is created, at a fairly small cost for any bank that doesn't actually need the money.
10.14.2008 1:42am
DangerMouse:
Inflation City, here we come.
10.14.2008 2:00am
Gene Hoffman (mail) (www):
1. If the US Government launched a tender offer, Delaware law would allow them to take control of the shares tendered and force minority shareholders to accept cash. Dissenters rights are pretty limited.

2. This is involuntary only to the extent that well capitalized banks are likely able to simple redeem the preferred in a number of months by returning the capital plus a nominal return. I'm speculating, but that's what I expect is occurring. It is theater, but important theater. In a legal sense, I'm sure JP Morgan Chase (who really doesn't need the capital) could say no, but they too understand that its in their best interest to stack that on top of the other $700B they have laying around for 6 months or so before wiring it back to treasury with a small coupon on it. If they take it, they lower the stigma on the banks that need it and reduce the TED spread and counter party loan risk.

-Gene
10.14.2008 2:09am
Skyler (mail) (www):

Forcing all banks to participate ensures that no negative signal is created, at a fairly small cost for any bank that doesn't actually need the money.


Yeah, nothing negative about using force.

Shhh. Nobody tell Ilya that we've become a socialist nation.
10.14.2008 2:55am
Ted Frank (www):
Elsewhere, the Times reports that these are three-year securities can be "repaid at any time." So any truly solvent bank can choose to extract itself from the involuntary investment -- and I suspect many will once the TED spread and LIBOR rate calm down.

NB that this plan is a slightly more modest version of what Alex Pollock called for Friday.
10.14.2008 3:32am
Tom Hanna (www):
The New York Times and other major media have all edited out the "The capital injections are not voluntary" language. I can't find it in a major paper anywhere online. Was this a mistake in a wire service report or should I put my tinfoil hat on?
10.14.2008 6:44am
r.friedman (mail):
Banks are created to receive deposits and make loans based upon them, thereby "creating money". There have always been limits on the maximum amount of money banks can create, since the Depression by regulation of minimum reserve requirements. The current loans are in effect maximum reserve requirements -- we don't want to open the Fed's bank loan window to recapitalize the banks only to see those loans piddled away on conferences at resort hotels, executive salaries, stock buybacks, takeovers of other banks and stockholder dividends. We need them to finance business activity to combat a deepening recession.

In another article in the Times, it is announced that Simpson Thacher has been selected as counsel to the bailout fund. Dedicated as its lawyers have been to the causes of deregulation, private wealth, corporate greed and Federalist Society anti-governmentalism, what advice can we expect them to give to the Treasury about its obligations to the oligarchs of capital? Bernstein, do you think you could give the Troubled Assets Fund the legal advice most favorable to it, given the adversion you express? Would you be willing to do to property rights what John Yoo did to civil rights? In such uncharted waters, what are the duties of lawyers to recognize their predelictions, report them to their clients, and try to overcome them if it be in the clients' interest?
10.14.2008 8:59am
wm13:
Contra some of the commentators, I think three of the New York banks are indeed unhappy about being forced to take the Treasury's money: one that says "we already got all the money we need from Warren Buffet," one that says, "we already sold our subprime assets for 22 cents on the dollar, and sold our whole bank to BofA," and one that says, "We got out of subprime in the spring of 2007." The other three New York banks are probably happy, although I don't actually know that much about BNY Mellon. I don't have any good contacts at the non-New York banks, so I don't know what they think.

As to how Paulson can force banks to participate, that's pretty easy: he could take away their primary dealer status, pull all federal deposits, exclude them from new FDIC programs, etc. The list is endless. The chances of a bank resisting are about the same as the chance of a heroic university faculty saying, "Keep all your money, Uncle Sam, it's a matter of principle with us not to allow military recruiters." Ha ha.
10.14.2008 9:25am
Prof. S. (mail):
jccamp - That was a brilliant observation.
10.14.2008 10:08am
Aaron Meyer (mail):

Maybe someone can explain how dividends are not paid from earnings.


Dividends are set at a fixed amount per share. Yes they are paid out of earnings, but unlike payouts that are set at a portion of earnings, dividends must be paid even if there are no "earnings" over the dividend period. If payments are set at, say, 5% of earnings and the earnings for the period are $0.00, then there are no payouts. Dividends, however are set at fixed dollar amounts and must still be paid.
10.14.2008 10:15am
krs:

The capital injections are not voluntary

Glancing briefly at this post... at first I thought it was about the death penalty.
10.14.2008 11:44am
Bob from Ohio (mail):
The "not voluntary" language is not a quote. It is allegedly what was said at the meeting.

Maybe the source or the reporter is simply wrong.
10.14.2008 11:59am
gab:
The reason some of the banks don't want the money is that there is a significant tie-in to executive salaries. Accepting the money means that salaries over a certain amount become non-deductible.

Never forget on Wall Street, it's all about the benjamins.
10.14.2008 1:00pm
LarryA (mail) (www):
Duck, apparently Paulson has decided that the issue is not banks that "need" the money, but that the feds need to inflate the money supply, and pronto, and the mechanism to do so is by giving money to major banks.
I'd guess it's embarrassment. It will be damn hard for Paulson and Congress to explain why banks don't need The Super Emergency Funding That Must Immediately Be Passed With All The Earmarks Representatives Added Or The World Will End Tomorrow.
That sentence doesn't compute. If he wants everyone to accept, then it is voluntary. If it is not voluntary, then there is no acceptance.
See: Income Tax.
What's he going to do if they say NO?
See: IRS.
10.14.2008 1:22pm
byomtov (mail):
Dividends are set at a fixed amount per share. Yes they are paid out of earnings, but unlike payouts that are set at a portion of earnings, dividends must be paid even if there are no "earnings" over the dividend period. If payments are set at, say, 5% of earnings and the earnings for the period are $0.00, then there are no payouts. Dividends, however are set at fixed dollar amounts and must still be paid.

I assume you're trying to distinguish between common dvds and preferred dvds. Even so, this is not quite right. Preferred dvds are indeed usually set at a certain amount per share, but their payment, unlike interest on debt, is not mandatory. What happens is that no common dvds can be paid if the preferred dvd is skipped. Generally this is cumulative - all unpaid preferred dvds must be caught up before common dvds can be paid, though there are exceptions.

And of course it is true that paying the preferred dividend reduces the amount available to pay dividends to the holders of common stock.
10.14.2008 1:23pm
davod (mail):
Paulson maybe in the Bush administration but he is a Democrat.

I suppose this means the likes of Acorn are out of the bank executive and family intimidation business. The next Socialist Republic of the United States will direct its partner banks to issue worthless mortgages in the spirit of fairness.
10.14.2008 2:06pm
DiverDan (mail):

The shares will not be dilutive to current shareholders, a concern to banking executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings.


Is the guy who wrote this a complete moron!! And what about the writer and editor at NYT who failed to notice that this statement is ridiculous on its face?? of COURSE any investment in preferred shares is dilutive to current shareholders, unless the government signs up for preferred with a stated dividend rate of 0% [which would be really silly, but I'm beginning to doubt that even this is beyond the capacity of our government]. By definition, if the new government owned preferred shares will demand a dividend, that will reduce the amount of earnings available to existing equity, and, by definition, dilute their ownership share in the corporation. Now, as a practical matter this might be either good or bad for existing shareholders, depending upon whether or not the management can invest the cash paid for the new capital at a rate greater than the dividend requirements of the new shares (i.e., if Bank of America could take its new $25 Billion in paid in capital and obtain a yield of 8%, while only paying the government a dividend yield of 6%, that would result in an annual net gain to existing shareholders of $500 Million). But if that were the case, it wold be beneficial to the existing shareholders, presumably the Board would readily approve of the issuance of new capital, and the purchase of capital would not have to be involuntary.

There are only three possible outcomes here, and two are bad; only the third, and least likely, is a wash. If the dividend claim by the government is more than the earnings that can be obtained by the banks on the new funds, then the involuntary investment by the government essentially takes a portion of the value of existing shares, raising a 5th Amendment problem. If the dividend claim by the government on the capital investment is less than the earnings that the banks can obtain by investing the new capital, then the investment is an unwarranted gift to existing bank shareholders. Only if the dividend claim made by the government on its new capital is exactly equal to the earnings the banks can make on the investment of the capital is this plan neither an unconstitutional taking nor an unwarranted gift.
10.14.2008 2:28pm
r.friedman (mail):
The Socialist Republic of the United States will not have partner banks, it will be a command economy.
10.14.2008 3:06pm
Harry Eagar (mail):
Hmmm. So, we assume the gummint gets at least as good a return on its preference stock as Mitsubishi (10%), so a bank gets $25B but has to return $2.5B to the gummint almost immediately out of income.

Why would the common shareholders want this to happen?
10.14.2008 3:24pm
byomtov (mail):
Why would the common shareholders want this to happen?

Maybe because in the case of some of the banks the common shares would be worthless without this investment.

I don't which banks, if any, that's true of, but it would certainly be a reason for common shareholders to like the deal.
10.14.2008 3:46pm
Harry Eagar (mail):
Well, that's true, but the predicate was the some of the banks were solid.

So far as I can tell, probably none of them are. But that's another story.
10.14.2008 7:30pm
blackrockmarauder (mail):
"that they would have to accept government investment for the good of the American financial system. "

Wink. Wink.
10.14.2008 10:34pm
Vinegar Hill:
A Meyer

Whoa!

You say

"dividends must be paid even if there are no "earnings" over the dividend period".

Up to a point, Lord Copper. Only attention must be paid, as Willie Loman's wife will tell you.

To expand on what byomtov said, as a practical matter, "dividends" on Preferred shares are really interest paid on money loaned &are fixed. In real life, if they are not paid out of earnings, that's "eating the seed corn", which is not a Good Thing; if they aren't paid at all, then other payments, like the rent &accounts payable, probably aren't being made either, also not a Good Thing, &it's probably Chapter XI or Chapter VII.

With Common Shares, a Board of Directors declares a dividend quarterly on such shares after reviewing the corporation's finances. An indication that there will be no earnings forthcoming will cause directors to declare no dividend forthcoming.

If for some unforseen reason, there were no earnings for XYZ Co. after a Common Share dividend had been declared, the dividend would, indeed, be due but where would the money come from? We're back to the seed corn or Chapters VII or XI. Or, wait, maybe some emergency loan or government infusion!
10.15.2008 1:47am
Samantha Joy (mail):
The third paragraph you quote, including the inflammatory "not voluntary" language, has been removed from the article.

I wonder if that is because it is not accurate, or if that is because it is more accurate than "they" would like us to know.
10.15.2008 1:27pm
Harry Eagar (mail):
byomtov, mea culpa, mea culpa, mea maxima culpa.

Although I have been calling on my blog for weeks for the firing of Paulson on the grounds of incompetence and incomprehension, even I failed to divine the depths of his failure.

After Mitsubishi and Buffett got highly publicized deals offering 10% returns on their investments in sick banks, I assumed that even Paulson would not be able, for public image reasons if nothing else, to ask for less.

I overestimated him again.
10.15.2008 2:42pm