By Martin Hutchinson
Contributing Editor
Money Morning
The $250 billion bank bailout announced Monday is a great improvement on the $700 billion Troubled Asset Relief Program (TARP). However, for those thinking of buying bank stocks on the back of it I would point out one thing: Once the government’s plan to take equity stakes in troubled financial institutions is implemented, each of the 117 million U.S. taxpayers will have an average of $2,136.76 already invested.
You haven’t received Uncle Sam’s credit card bill yet.
Under the new bailout plan, the government will invest as much as $250 billion into special preferred stock of the participating banks, and will receive additional warrants for shares equal to 15% of the amount of each investment. The minimum amount invested will be 1% of a bank’s total assets, while the maximum will be $25 billion, or 3% of the bank’s total assets, whichever is smaller. The preferred stock will be redeemable after three years and will carry a dividend of 5% for the first five years and 9% thereafter.
In addition, participating banks will have fairly mild restrictions on top-management compensation and, in particular, on “golden parachutes.” Thus, it will be attractive for banks to redeem the government preferred stock early – for example, through a share issue of common stock.
The rescue plan contains two provisions that represent improvements on the original TARP (the provisions of which have been fudged to accommodate it):
- First, the money is going directly into banks, recapitalizing worthwhile entities to allow them to rebuild their businesses and lend to productive industry. The TARP, on the other hand, would have invested in troubled mortgage loans, relics of a home mortgage bubble that should never have occurred in a well-managed economy. In a period of tighter money such as we have entered, every dollar borrowed from the markets and invested in junk assets is a dollar that is not available to finance real businesses.
- Second, the rescue plan will invest in banks via a “preferred” stock, which is easy to value, and in most cases can be redeemed fairly quickly. Thus, there is no need for the vast and expensive paraphernalia of 10 investment managers selected by the U.S. Treasury Department to purchase distressed debt. Further, while a few of the recapitalized banks will prove to have really severe problems – and will fail – in the majority of cases, where the bank survives, the taxpayer will not suffer any loss from the investment, and may even see a profit from the warrants. That is in complete contrast to purchasing questionable debt assets, where the Treasury will have no easy way to value them, will be tempted to overpay for them and will have great difficulty collecting value on them, since they will mostly represent tiny parts of innumerable mortgages and other debts. Indeed, having devoted $250 billion to recapitalizing banks, half of which has already been spent, the Treasury would do better to abandon the debt-purchase operation, rescind the second half of the $700 billion TARP- funding request, and simply keep the other $100 billion available for emergencies.
So, should we buy common stock of the banks that the U.S. taxpayer has so kindly rescued for us? In a word – no. They still have all those lousy assets on their books, and will continue to record losses from those assets. And while the new capital will provide a cushion for creditors against those losses, it won’t do anything for existing shareholders. The preferred shares themselves represent fairly expensive funding, especially when short-term rates are below their cost of 5%. Moreover, the attached warrants – doubtless exercisable at a low share price – will further dilute existing shareholders when they are exercised. Finally, bank management’s attention will be devoted to figuring out ways of repaying the preferred shares through new capital issues, which are bound to dilute existing shareholders.
In any case, the business of banking itself is likely to be pretty unattractive over the next few years. There is huge overcapacity in the financial-services arena, which needs to shrink substantially from the 40% of Standard and Poor’s 500 Index profits that it represented in 2007. The business has actually doubled its percentage of U.S. gross domestic product (GDP) in the last 30 years, and will probably have to shrink most of the way back to its original size, since many of the new innovations represented “rent-seeking” on the part of the financial system – providing no added value to the economy.
At the same time, for a given volume of business, banking organizations of the future will need to carry much more capital. Thus, with revenue depressed and capitalization increased, the operating profitability of the banking business will be low – even once the current troubles have passed.
News and Related Story Links:
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Wikipedia:
Preferred Stock. -
Money Morning News:
Paulson Announces New Plans to Buy Equity Stakes in Banks and Revive Credit Markets. -
Money Morning News Analysis:
While Lawmakers Reach Credit Crisis Compromise, Money Morning Bailout Plan Expert Displays Doubt.
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Before the bail out bill was passed I said that what congress should do was keep Fanni &Freddi ; use the income to pay donw the national debt ; lower insterest rates to 4.5 % fixed
on all loans , for realestate ( 1st , 2nd , 3rd , equity lines )..
Along with a few other coments ob this page .. I also sent the same info ( copies to a lot of senators & reps )… Also
that all the lenders should writwe down the loan amounts
based on how far the value has droped in the market where
the loans was made… It would make more sense than
foreclosing then reselling at a loss of 50 to 70% of the inittial
value placed on the property when the loan was made…
If you take in the cost of sale , fixing , maintaining the item
, the loss on the loan , the cost of foreclosure it is at least
50 of the original loan amount they are lossing … It would just
be eaiser to refi to a lower rate & write down the note….
Instead the lenders dsidn't think any farther than they could
dee at their feet…By letting the homes go to foreclosure &
lossing then they have driven down the value of other
properties in the surounding areas…..So this is a double edged
swoard …… Most of the people who bought these homes
would still be in them if the lenders had taken a min to think…
Instead they do as all bankers do when times are good they give money to any warm body ; when they are bad they want you to pay for their mistakes…..
Let me see if I have this right. We the taxpayer are involuntarily "loaning" private banks money at a theoretical 5%. The banks will then loan the money back to the taxpayer at between12-30%. Makes sense to me. Wouldn't that make our government a pimp??? This is why you don't show up at a house fire with a can of gas.
Warren Buffet has been buying up Wells Fargo for the last year or so. It is now one of his top three holdings in Berkshire Hathaway. Wells Fargo recently increased their dividend and would be considered a gem among the stones to some.
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Homeowners have been hit hard with higher real estate & personal property taxes, energy and food costs. Their incomes have not increased and what used to be a comfortable living is now stressed. People are having a hard time purchasing basic necessities and need financial relief.
With inventories at its peak, higher interest rates and portfolios like http://www.BuyMyHouseBeforeTheBankTakesIt.com only creates a recipe for panic. What we have left to our real estate market is the necessity buyer, and if the economy does not pick up soon, corporate America will freeze and the relocation market will dry up. The best thing the Federal Government should do at this time is to offer 4% fixed rate mortgages for the refinance of the principal of their homes to people who can afford it (standard lending practices). This would free up household disposable income, create a market for the banking industry, and create jobs so people could start spending a little again.
The Washington Consensus: Bailout The Rich…
See Also: What benefits do the taxpayers get out of the bailout bill?, No investigation of those who caused fake ‘crisis’, 7 Out Of 9 Banks Agree: Bailout Is A Failout, AIG Execs Caught Wasting Even More Of Our Money After Bailout, JPMorgan Respon……
The article is interesting and well reasoned, but I think your closing conclusion that "In any case, the business of banking itself is likely to be pretty unattractive over the next few years." is probably not correct. I remember reading a lengthy analysis article in Time Magazine in the late 70's that concluded Wall Street investment banks could not possibly supply the huge amounts of capital that American companies would need in the future, and therefore the commercial banks would become dominant over Wall Street. How wrong that analysis was!
For the past thirty years, the Wall Street investment banks have been steadily taking business away from the commercial banks. The reasons for this have been lower and more favorable capital requirements, the relative freedom from regulation, the cost of deposit insurance, and a greater willingness to take risks, since a commercial bank is taking the risk itself and the investment bank is taking the risk on behalf of its investor customers.
The recent turmoil has upended almost all of these advantages. All the big investment banks are now owned by commercial banks or have been forced to convert to commercial banks, so the capital cost advantage is gone. Regulations are likely to get much stricter on Wall Street. Since the Fed is now bailing out money market funds, deposit insurance costs on those funds cannot be far behind. And excessive risk taking is not likely to be rewarded in either a commercial or an investment bank. The playing field has leveled so that commercial bank products such as loans and deposits are going to be much more attractive to both borrowers and investors than the commercial paper, structured investment products, and money market funds Wall Street offered.
Another advantage to the commercial banks is the relative gap between prime and LIBOR. LIBOR loans are been very cheap for the customer. If the recent rise in LIBOR is sustained for any length of time, this will represent a significant profit increase for commercial banks, who have a substantial portion of their comercial loans tied to LIBOR.
The coming years may be the commercial banks' time in the sun. That being said, I agree with your conclusion that this is not the time to invest in bank stocks. Purely aside from problems arising from sub-prime loans, credit default swaps, and all the other toxic waste banks may have on their balance sheets, the political environment is likely to be toxic as well; Congress is likely to pass a number of ill-considered programs mandating credit allocations, additional aid to "under-served communities", etc.
Watchful waiting!
[…] Even After the Bailout, Bank Stocks are a Bad Deal for Investors Right Now By Martin Hutchinson from Money Morning […]
RATHER THAN BUYING BIG BANK COMMON STOCK, THIS IS THE PERFECT OPPORTUNITY TO BUY TRADITIONAL PREFERRED STOCK OF BIG BANKS BECAUSE THE CAPITAL FROM THE NEW US GOVERNMENT PREFERRED SHARES CAN BE REPURCHASED BY ISSUING COMMMON STOCK( OR CONTINUING TO PAY A DIVIDEND AT 5% OR 9%), CAUSING DILUTION OF THE COMMON, BUT THE TRADITIONAL (NON SPECIAL US GOVERNEMENT PREFERRED) PREFERRED WILL BE MORE STABLE DUE TO THE US GOVERNMENT CAPITAL INFUSION – CAUSING THE TRADITIONAL PREFERRED DIVIDEND TO BE EVEN MORE SECURE.
It would be better in the long run to simply let them all go broke.
I know that sounds heartless, but it happened in 1921, and within a year the country picked itself up and recovered.
That they didn't learn the lesson was evidenced by the crash of 1929, and after that the Government got involved and it lasted until world war 2.
Socialising the debt will only prolong the problems. You can't spend your way to wealth, and that is what America, and to much the same degree the rest of the West has been living for 20 years.
The people who approved 100% mortgages, Loans to unemployed people, and those who were not credit worthy deserve to go broke. And those who got the loans deserved to lose their houses.
Unfortunately today no one is allowed to fail! And that is simply unrealistic. If you stop failure the only alternative is to penalize the successful. And that will drag down the entire structure.
[…] The United States $700 billion bailout package is by far the largest, but even that might not be enough to return the domestic banking industry back to safety. […]
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