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:

*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.

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