Treasury bids to free up lending with cash infusion to banks

WASHINGTON -- The Treasury Department's extraordinary announcement Tuesday that it will buy as much as $250 billion in stock to shore up the nation's banking system is designed not to undermine free-market capitalism — but to save it. But will it work?

Government officials, including President Bush and Treasury Secretary Henry Paulson, expressed hope that the historic move will free up bank lending, quell a spreading financial panic and send a message to vital foreign investors that the USA remains one of the most attractive places to put their money.

And yet the proposal is perhaps the most exceptional federal intervention in the banking sector since the Great Depression. Still, it stops well short of outright nationalization of banks and thrifts. The Treasury Department will not be involved in day-to-day bank management and will not exercise stock voting rights except in special cases. Participation will be voluntary, though the nine major banks that agreed to participate did so under pressure.

"It's an uncomfortable feeling for Americans to consider taking gigantic stakes in the banking industry … but it's a better way to get the system working again," says David C. Smith, associate professor at the University of Virginia. "We are in territory that we have not been in, in modern times — since the 1930s."

Economists and lawmakers, while acknowledging risks, generally applauded the plan, noting that every $1 in bank capitalization frees up as much as $10 in new lending. Martin Bailey, a fellow at the non-profit Brookings Institution, questioned whether the government demanded a big enough return on its investment. Mega-investor Warren Buffett, for example, got preferred stock paying a 10% dividend for a recent investment in General Electric. The Treasury will get half that much, initially.

Money manager Ken Winans of Winans International notes that the market for the kind of stock Treasury is buying from banks is very small, which could make it tougher for the government to sell shares later. Some economists fretted that the government would exercise too much control over banks, pointing to the first-ever limits on executive compensation for lenders that participate. Others said Treasury didn't demand sufficient management changes in return for aid.

Treasury is financing the program with $250 billion from the $700 billion financial rescue law enacted Oct. 3. The money was initially to be used to buy mortgage-backed securities and other assets from financial firms, helping set a floor under prices. Paulson, who initially balked at buying stock in banks, still plans to proceed with an asset plan.

The new bank-stock plan is one in a series of increasingly radical government efforts during the past year to keep the economy afloat, and it backs up Federal Reserve Chairman Ben Bernanke's Tuesday pledge that the government "will not stand down" until financial markets are repaired and reformed. It follows, among other things, the brokering by the Fed of the sale of investment bank Bear Stearns last March and the government takeovers in September of insurer American International Group and mortgage giants Freddie Mac and Fannie Mae.

Credit markets had become so tight that some businesses have been unable to secure financing for more than a few days. Fully 117 U.S. banks are in danger of failure, according to the government.

Banks on Tuesday began stepping up to use the new program, though some stressed that they were acting not because they needed capital, but because they wanted to stabilize the financial system. Bank of America said in a statement that it is a "healthy bank," having recently raised $10 billion in capital on its own. "However, we recognize what is going on in the financial system and that we need to be part of the solution."

Fear of stigma

Camden Fine, CEO of the nearly 5,000-member Independent Community Bankers of America, said more than 97% of community banks are "well capitalized and stable and doing relatively well." The minority experiencing financial difficulty will be wary of accepting federal government help because of "the stigma of it," Fine aid.

Citigroup analyst Keith Horowitz on Tuesday upgraded 12 bank stocks, including Bank of America, to a buy, saying the government plan is a "game changer" because it addresses a trifecta of banks' issues: capital, liquidity and the ability to issue debt.

Under the Treasury plan, the government will buy $125 billion of preferred stock, which gives it first claim on dividend payments, in the nation's nine largest lenders, including Bank of America bac, Wells Fargo wfc and State Street stt. Another $125 billion will be made available to purchase preferred stock in thousands of other banks and thrifts across the country, on a voluntary basis. The effort is aimed at institutions that are under stress but not failing. The government will receive warrants allowing Treasury to buy $15 in common stock for every $100 preferred stock investment.

Treasury officials designed the plan to give the banks an incentive to buy stock back from the government as soon as practical. Dividend payouts on preferred stock, for example, increase over time. The plan calls forlimits on the pay of executives at participating banks and bars golden parachutes for departing executives. It also limits tax deductions for executive pay above $500,000 annually.

The Federal Deposit Insurance Corp., through 2009, will also insure 100% of non-interest-bearing accounts, mainly used by small businesses to process payroll. The move is aimed at shoring up confidence in small and regional banks, which have lost business accounts to larger competitors, said FDIC Chairman Sheila Bair.

The recently enacted financial rescue bill expanded federal deposit insurance to $250,000, but small-business accounts often exceed that, says John Hall, spokesman for the American Bankers Association. Some businesses may have up to $1 million in a payroll account, if only for a day, he says.

The FDIC's move was a big relief to Jeremy Shepherd, CEO of jewelry website In the past month, Shepherd had limited all the company's accounts to under $100,000 and spread it across several banks. "Anything over $100,000 was a big risk last week," says Shepherd. "Now I will be able to sleep at night a little easier every time a large deposit comes in."

Initial resistance

The idea of buying stock in banks has gained momentum since Paulson, in September congressional testimony, resisted the idea. Buying bank stock is a faster, more certain and more transparent way to inject capital into the banking system than buying bad assets, Treasury's initial focus. Because there is no market for the tainted assets, they are difficult to price correctly, putting taxpayers at risk if the government paid too much and not helping banks if it paid too little, says University of Virginia's Smith.

Still, Smith and others say they don't see the present situation as an either-or proposition. "The combination is better than just doing one or the other," Smith says.

Stepped-up government efforts were especially welcome in South Florida, where Phil Scruton, a certified business analyst at the Small Business Development Center at Florida Atlantic University in Boca Raton, has been finding it increasingly difficult to help his small-business clients find lenders.

Still, Ken Gaebler, who owns a small-business advisory firm in Chicago, and his clients aren't sure the moves will solve their problems. "If money starts flowing again and businesses no longer have to worry about access to credit, you'll see things start to mend," says Gaebler. "If the banks hoard the cash they are getting access to, then it's going to require an escalation in intervention."

Even if the plan works, consumers and businesses will likely face a rough economic climate for some months, with Bernanke saying pointedly Tuesday that the way ahead will not be easy.

Jonathan Carmel, finance professor at University of Michigan's business school, says the government's action may make an economic downturn shorter or more shallow than it would be otherwise. But the nation is likely still destined for a recession similar to the early 1980s, when a credit crunch exacerbated an already weak economy.

The 1981-82 recession lasted 16 months, twice the length of the two most recent U.S. downturns. Unemployment peaked at 10.8% at the end of 1982 vs. 6.1% today.

Contributing: Kevin McCoy, Kathy Chu, Sandra Block, Matt Krantz and Jayne O'Donnell