Paulson Backs Up the Truck

It's official. The bazooka Hank Paulson referred to earlier this summer has been fired, and as far as global markets are concerned, it was the shot heard 'round the world.

Just three weeks ago, Paulson said, "Some said we should just stick capital in the banks, take preferred stock in the banks. That's what you do when you have failure … This is about success."

Apparently, we've had failure.

The Treasury will use $250 billion of the $700 billion bailout plan to purchase colossal stakes in U.S. banks by way of senior preferred shares that will pay a 5% dividend for the first five years and 9% thereafter (the banks can buy back the shares at face value after three years). In addition, the Treasury will get warrants to buy common shares equal to 15% of the value of the preferred shares. All in all, a reasonable price given what Goldman Sachs (NYSE: GS  ) had to pay Warren Buffett and Morgan Stanley (NYSE: MS  ) had to pay Mitsubishi UFJ Financial Group.

Meanwhile, the amount the Treasury plans on initially injecting into these banks is just staggering. Have a look:

Bank

Amount

Percentage of Market Cap

Citigroup (NYSE: C  )

$25 billion

            29%

JPMorgan Chase (NYSE: JPM  )

$25 billion

17%

Bank of America (NYSE: BAC  ) *

$25 billion

22%

Wells Fargo (NYSE: WFC  )

$20-$25 billion

22%

Goldman Sachs

$10 billion

            22%

Morgan Stanley

$10 billion

52%

Bank of New York Mellon  (NYSE: BK  )

$3 billion

9%

State Street

$2 billion

10%

*Includes capital for pending transaction with Merrill Lynch.

That's right: Banks used to make headlines and move markets when they raised a billion or two; now they're raising $250 billion in one fell swoop.

On top of the capital injections, the Federal Deposit Insurance Corp. is expected to start guaranteeing most new debt issued by banks and offer to insure all non-interest-bearing bank accounts, regardless of how big they are, which removes a huge burden of fear from small businesses and corporations scared that vital accounts such as payroll might come up empty should their bank go belly up. The idea here is to inject a little trust into the system to get banks lending again and help prevent bank runs that have cast the deciding blow to banks like Washington Mutual and Wachovia over the past several weeks.

Why this will help
Many of us here at the Fool have been rooting for the bailout out of fear that anything less would invite a visit by the Four Horsemen, but that's not to say we were doing cartwheels over it. The originally announced plan was designed to prevent a catastrophic collapse -- which it did -- but it still didn't address how banks would dig themselves out after that. Without being recapitalized, the saved banks wouldn't be able to begin lending again, which is really the heart of the problem right now. Add to it the fact that credit markets just got progressively worse and worse over the past several weeks, and it became clear that something heavier than just buying up bad assets at steep discounts was needed to right the financial system.

Now that the largest banks are getting capital shoved down their throats, huge slugs of deposits are guaranteed, and some new bank debt is backed by the full faith and credit of the U.S. of A., the fear demons that have been gumming up the gears of the financial sector for several weeks could start running out of things to fret about.

That's not to say we're out of the woods -- like the original plan, this is no panacea -- but there comes a point when the government readies so much heavy artillery in defense of banks that it gets harder for markets to remain in bunker mode. Now that new debt is insured and banks are being handed mountains of cash, the freeze in interbank lending should begin to thaw and the plug that threatened to choke off lending to even the most creditworthy borrowers should begin to ease … at least in theory. Cross your fingers.

What this means for taxpayers
If there's one thing you, the taxpayer, should be happy about, it's that direct capital injections into banks stand a much better chance of ending up in the green than buying soured assets at steep discounts. Taxpayers now hold a direct claim on all of the banks' assets -- asset management, brokerage, investment banking -- many of which are still rather profitable and should do well in the coming years. Make no mistake about it, the credit crunch is far from over, and it could take many, many years to recover from it, but once all is said and done, there's a good chance that purchasing mammoth stakes in the country's largest banks won't look like a such a bad idea, and the final cost to taxpayers should be far, far less than the $700 billion figure being thrown around.

What do you think about the recent moves? Take a moment to share your thoughts in the comment section below, or take a look at our bailout discussion board to see what others are saying.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2008, at 3:16 PM, OnyongJun wrote:

    I for one think it's a good investment in the future of Planet Earth.....No Apocalyse no problem.....make that less problems....A much better outlook than allowing all weak businesses to fail and hope the planet is still inhabitable after that.

  • Report this Comment On October 14, 2008, at 4:21 PM, knighttof3 wrote:

    So now the Fed and Treasury are fully in the investment game. How do they decide where to invest? If I am a banker, whom do I have to bribe for them to take a stake in my bank? It's ironic that socialist countries are moving towards freer markets and El Presidente Boosh and the Dems in congress have us moving towards communism. Long live DSRA - the Democratic Socialist Republic of America!

  • Report this Comment On October 14, 2008, at 4:45 PM, XMFWildjohn999 wrote:
  • Report this Comment On October 14, 2008, at 5:16 PM, dogtag2000 wrote:

    The way I see this whole picture is that it

    was a way for "THE GOOD OLD BOYS"

    to interfer with this 'ELECTION 2008" and get everyone upset and the whole world going topsy turvey in all directions.

    B.Obama is in the heart of their "Big Plans" using all his people to pull all kinds of tactics while he sits back and looks like the long awaited "Savior" of the World.. Every program he is on is the Same O, Same O talk..changes his mind every time he speaks on a issue.

    McCain & Palin are not getting FAIR coverage and treatment. So Obvious!!!

  • Report this Comment On October 14, 2008, at 5:34 PM, FOOLBEFREE wrote:

    The government investment in banks should lower the LIBOR 3 month rate. It is a bit lower to 4.64%. It should be close to 1.5%, the Fed rate. This has been choking the banks and credit.

    No matter what, after a finacial crisis, an economy always enters recession.

  • Report this Comment On October 14, 2008, at 6:34 PM, Tinka82 wrote:

    Now that triage is starting to show signs of stabilizing the patient, the real surgery needs to begin.

    We need to re-build our economy on producing real goods. We've lost much of our manufacturing and exports. Without real goods being built and sold here within our borders, the intangibles (credit, service, etc. ) mean nothing. Don't tell me about supply side economics or a 'service based economy' as a means out! It's failed and it's no one party's fault over the other. The short sighted, corrupt, think-only-of-their-own-bank-account fools need to move aside. Where is a Milton Freidman student? We need one or similar, STAT!!

  • Report this Comment On October 14, 2008, at 10:32 PM, bearbitten wrote:

    The main problem is that there was to much money at very low interest rates looking for ways to make money. This cheap money is what caused the problem. Flooding the market with more money I hope will help in the short term, but in the longer term we will have to pay for our excesses.

  • Report this Comment On October 14, 2008, at 10:37 PM, bearbitten wrote:

    Off the subject but has anyone mentioned that the manipulators that drove up oil/gas prices just happened to make it possible to have off-shore and federal lands drilling, etc, how coincidental is that?

  • Report this Comment On October 15, 2008, at 12:20 AM, cfolounge wrote:

    Ha - Does anyone know if Paulson has friends at Morgan Stanley?

  • Report this Comment On October 15, 2008, at 9:57 AM, JRMtwo wrote:

    We all hope for the sucess of this bailout. However, the stock market still does not like the bailout. Problem is the saveguards like the Up-Tick Rule and the Naked Shorts are still allowing unchecked runs on the Market.

    The fundementals of most firms are good, but the stock prices are being depressed by unchecked short selling. As long as the Mark-To-Market, no Up-Tick-Rule, and Naked Shorts issues are not addressed the economy will sink.

  • Report this Comment On October 15, 2008, at 1:55 PM, USAeconomist wrote:

    We sit on the sidelines in shock as the financial system unravels in front of us. Housing is falling, retirement are shrinking, and our homes are listed on sites like this; http://www.BuyMyHouseBeforeTheBankTakesIt.com . America is being fleeced and the biggest crime of the century has been committed and there is no one is being held accountable.

    In 2004, Bankers came up with a plan to target subprime market. Historically, lending to the subprime market was at 9%. This data was used to create a formula and Banks projected a 6% default rate and thought it was acceptable as long as they could pass a new bankruptcy law. Washington Mutual, Bank of America Corp., JPMorgan Chase & Co. and Citigroup Inc. spent $25 million in 2004 and 2005 lobbying for a legislative agenda that included changes in bankruptcy laws to protect profits.

    Their investments paid off, banks finally got their chance for bankruptcy reform. In 2004 the bankruptcy reform was pushed by the Republican majorities in the Senate and House after the 2004 elections breathed new life into the bill. The bill was introduced in its current form by Republican Senator Chuck Grassley of Iowa. The bill was supported by President Bush. Tom DeLay also championed the controversial legislation and was signed into law by President Bush 4/25/2005.

    Republicans played right in to the hands of banking industry and sacrificed the average hard working American. This new bankruptcy law created a monster; predatory lenders saturated the market place and the new law bankruptcy law made it difficult and too expensive to file bankruptcy. Banks finally had the tool they needed to meet their projections.

    Banks created a short term affordable product that required customers to continuously refinance. They have created the perfect repeat customer, these low teaser rates created high fees. Between 2004 to 2006, 40% of all mortgages were subprime mortgages. Previously, predator lending practices only accounted for 9% of the market.

    Beginning in late 2006, the U.S. subprime mortgage market started to meltdown. Subprime mortgage defaults and foreclosures increased and caused more than 100 subprime mortgage lenders to fail. Portfolios of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. They sold this worthless c paper as guaranteed AAA paper and infected the banking system with a “subprime virus”.

    Now the world’s money supply was now infected with subprime mortgages, backed by homes like: http://www.BuyMyHouseBeforeTheBankTakesIt.com . The sub-prime formula was wrong and now we are faced with a collapse of the world banking system. The cost is now being factored into the economy and stock prices will reflect its cost.

  • Report this Comment On October 15, 2008, at 6:17 PM, Tiingall wrote:

    Thank you USAeconomist for putting together the elements that have plunged us all into this termoil. I've always has a sense of caution about banks and about 12 months ago - after reading about the sub-prime scam and it's unfolding consequences - sold 90% of my stocks when I noticed the banks pulling stunts like long delays in TT transactions, and deliberately routeing foreign currency payments through related banks so they could pull out more fees. Clearly, if the banks needed to hold my few thousand $ in TT transactions for more days to prop up their loan accounts, or create convoluted excuses for extracting another $50 fees, they were in very serious trouble. Each time it happened and I warned I'd lodge a Police report about missing funds, the money materialised in minutes or hours. The banks apparently did not like the idea of Police wandering around their premises looking for my money.

    As USAeconomist writes "the biggest crime of the century has been committed and there is no one is being held accountable."

    We all know that the same parasitic, self serving, greedy, unprofessional individuals in banks and financial institutions who created this scam and happpily plunged us all into the catastrophic consequences are still sitting in the same - or more elevated - jobs, with fat salaries, bloated bank accounts, and investments around the world. Confidence will only return to the markets when these criminals are stripped of all their assets - to help repay the taxpayers money needed to fix their debacle - and they are locked up in gaol (jail); so they can't possibly do it again. The scale of human suffering and injustice they have hapily created in order to rip off everyone's money to satisfy their personal greed is way in excess of a bank robber who steals even a few million $. They need to be dealt with by the law on a scale that suits this premeditated crime.

    The French President in his Monday announcement made a comment suggesting the bankers who perpetrated this crime will be made to pay for their actions. More countries need to follow his lead.

    These are very smart people who are prepared to abandon all business ethics, sense of humanity, ignore the trust we placed in them by giving them our savings to manage, and manipulate the system in a grossly unprofessional manner, in order to satisfy an immense personal greed. In a conference yesterday about doing business in a world economy affected by climate change, I was told that the world's top illicit money making activity is arms trading, followed by trading in endangered wildlife. I believe the bankers have moved themselves to the top of this list, ahead of the arms dealers, because of the international injustice, catastrophic consequences and human suffering they are willing to create for their personal financial benefit. They should be similarly pursued, publicly humiliated through the arrest and court process, and locked away; so the world is no longer at risk from these corrupt and sick minds.

  • Report this Comment On October 15, 2008, at 8:22 PM, Tiingall wrote:

    Come on you guys in the great USA, get into action. You have a presidential election soon; make sure they know how much you hate what the bankers and financial parasites have done to your savings and what you want done to them. You have a lot more votes than the corrupt bankers.

    And if your answer is that those bankers have a lot more money to invest in Presidential campaigns to make sure they get their way, think about this. A recent TMF article stated that 50% of USA households now have money in the stock market. Time you mobilised that people power. Imagine the turmoil in government email systems if just one member of each of those families sent ten emails of complaint each day for a week? What about closing down the businesses than make the bankers and financiers rich? One member of each family sitting in hundreds of Wall Street lift lobbies and building sidewalks for a week. That should get them where it hurts. The media coverage would ensure the world knows you - ordinary USA citizens - don't like what your financial institutions have done, and that the vast majority of USA citizens are responsible and honest people who care.

    A few quotes from Irish statesman, philosopher and politician, Edmund Burke (1729 - 1797) to help your mental fortitude:

    "Never despair; but if you do, work on in despair"

    "No passion so effectively robs the mind of all its powers of acting and reasoning as fear"

    "He who wrestles with us strengthens our nerves and sharpens our skills. Our antagonist is our helper"

    "The wise determine from the gravity of the case; the irritable, from sensibility to oppression; the high minded, from disdain and indignation at abusive power in unworthy hands."

    "All that is necessary for the triumph of evil is that good men do nothing."

    The bankers and financiers who perpetrated this collapse parade themselves as responsible businesses men and women, but they live and work in an ethical vacuum. They don't care what happens to the people they exploit to satisfy their personal greed. They are evil. But they are now benefiting from your taxpayer money because of their evil deeds. They must be laughing!

    Passive, non-violent, civil disobedience at this time will make sure your political representatives know that you good men and women have had enough of their deceitful abuse, manipulation and exploitation. You want these evil doers removed.

    The rest of the world might then be happy to invest in USA stocks again. If you good men and women do nothing, you'll reap the results of continued international no-confidence. And of course the evil bankers and financiers you allowed to continue in their jobs because of your inaction, will continue to rip you off.

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