Felix Salmon

Alan Blinder and Glenn Hubbard make a good point today:

Memo to Washington: Take a deep breath and ask, "What is the problem that unlimited deposit insurance is meant to solve?"

It is not people lining up to take their money out of banks. There appears to be little banking panic among retail customers. It’s true that banks are not lending, but not because they lack deposits.

I’m not nearly as worried about the FDIC as Blinder and Hubbard are. And Blinder has a massive conflict: he’s the vice-chairman of the company which runs CDARS, a financial instrument designed solely to get around FDIC deposit limits.

It’s also a good idea to implement massive deposit insurance before there are any bank runs — ie, now — rather than after the horse has bolted.

But there aren’t very many places for the horse to bolt to. The only place safer than a bank is probably Treasury bills: the last issue of 6-month bills came with an interest rate of 1.12%, compared to the 3% to 4% that banks are offering on FDIC-insured 6-month CDs, which are essentially the same credit as T-bills.

Are there so many people with deposits over the new FDIC limit that they can cause a run on the bank? Under the old FDIC limits, Wachovia had quite a lot. And Treasury knows something we don’t: after all, they have real-time information on deposit outflows.

Barry Ritholtz is already including the full amount of government guarantees in his cost of the bailout; it does seem that Treasury is piling on the government guarantees with rather too much in the way of zeal and reckless abandon. If Paulson still had credibility, I’d trust that the deposit guarantee was necessary. But as it is, I worry that it might have some nasty unintended consequeces: it could act, for instance, as a message to banks that other banks really are in trouble and shouldn’t be lent to.

Credit markets are all about having faith in your counterparty; when there’s a government guarantee, you don’t need that faith, and it disappears, as Douglas Adams might say, in a puff of legislative action. If credit markets are to get moving again, we need to encourage banks to start trusting each other. Government guarantees make that less, not more, likely.

The NYT’s lead headline this afternoon is unambiguous: "Treasury Chief Says Banks Must Deploy New Capital". But in 2,300 words of reporting, reaching as far as a run on the Hungarian currency, this is the only mention of any requirement for US banks to start lending:

“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Mr. Paulson said.

That’s it. Paulson’s expressing a preference here — and he’s got a strong bully pulpit. But he’s not taking a voting stake in the banks, he’s not taking any board seats, and ultimately, if the banks’ shareholders will be better off hoarding money rather than lending it, that’s what the banks’ executives are going to do.

I was at a lunch today with Chris Wallace of Vaughan Nelson, a fund manager who’s been following the credit markets closely. So far, neither he nor any buy-side investors he knows in the fixed-income markets are buying credit: "we’re in a secular bear market for all risk assets," he said, and that means that any loans banks extend today have a good chance of being marked down tomorrow. They have huge exposures already, and are in the process of deleveraging: the new capital will help them bring their capital ratios up if they don’t go ahead and lend it out.

Lending Treasury’s funds, on the other hand, is a risky thing to do heading into what might well be the worst recession of the post-war era. Wallace anticipates real consumer spending falling by 10%, and homeownership rates falling by 4 percentage points; those kind of changes could devastate companies’ abilities to repay their loans.

Remember too that even a generous tier-1 capital ratio of 10% implies 10x leverage: a bank which receives $25 billion of new capital can use it to make $250 billion of new loans. You don’t need very many of those loans to go bad before you start eroding your capital base even further.

America’s banks — and the world’s, for that matter — have had de facto unlimited access to very cheap Fed liquidity for many months now. That hasn’t induced them to lend. Will this latest recapitalization do the trick? I’m far from convinced. And what’s more, the demand for loans is drying up fast: do you really feel like buying a bigger house right now, or taking out a car loan? Well, businesses are in the same boat. In a recession, their ROI falls, so they borrow less.

With less demand for money, and no real desire on the part of the banks to lend it out, I think it’ll take more than hand-waving statements from the Treasury secretary to get the credit markets moving again. I do hope that Paulson is looking one step ahead here, and coming up with ways to compel the banks to lend — even if they don’t particularly want to.

The details of Treasury’s recapitalization plan are out, and it’s more or less what I expected, but with a lower coupon. In fact it looks very much like Warren Buffett’s investment in Goldman Sachs, or MUFG’s investment in Morgan Stanley, only without the profit motive:

Under the program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms…

The senior preferred shares will pay a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The senior preferred shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years… In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution’s common stock at the time of issuance, calculated on a 20-trading day trailing average.

A 5% cost of tier-1 capital is incredibly low, especially when there’s an embedded call option. And the common-equity kicker, at 15%, is small: that makes it a maximum of $3.75 billion, for firms getting the full $25 billion. (Citi, JPM, BofA, Wells Fargo.) There’s not much dilution for equityholders here, and their companies are getting lots of cheap money: no wonder shares in Citi and Bank of America are up again today, even as the broader market is down.

But here’s the thing: JP Morgan and Wells Fargo, who don’t need the money, have seen their stocks fall. The government has given them $50 billion to play with, and presumably there’s some hope that they’ll leverage that $50 billion and lend it out in the real economy — as opposed to simply using it to shore up their capital ratios. But in this market, shareholders don’t want to see lending nearly as much as they want to see as much cash as possible on the balance sheet. So don’t hold your breath waiting for large new loan commitments from any of these banks — especially since Treasury has no voting rights, and hasn’t told the banks that they need to start lending again.

There’s no doubt that TARP II, in its present incarnation, is a vast improvement on TARP I. But it’s still not nearly as good as the UK scheme, which was put together to inject money exactly where it would do the most good, rather than trying to set up "standardized terms" which treat each bank equally. That seems like a waste of government money to me.

The scorpion, it seems, is staying as true as he can to his nature. And although I’m the first to admit that this is no time to worry overmuch about moral hazard concerns, the slowly-emerging shape of Treasury’s plan to recapitalize the banking system worries me.

The idea seems to be, in the first instance, that Treasury will buy nonvoting preferred stock in America’s nine largest banks. They surely include the ones whose CEOs met with Hank Paulson in Washington today: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, and Bank of New York Mellon. Wells Fargo will be on the list too, and a couple of others.

In the case of the most solvent banks, this is a necessary annoyance. They might not like raising equity at these levels, but they need a working banking system as much as anybody else, and if that involves destigmatizing Treasury capital, then so be it. Note that in the UK, the two biggest recipients of government capital, RBS and HBOS, both saw substantial falls in their share price today, while Barclays, which said thanks-but-no-thanks to the government, rallied impressively.

It’s not entirely clear what Treasury’s capital injections are for, however. On the face of it, since they’re aimed at all banks, not just those in trouble, they’re not an attempt to restore solvency. But that might change when we see the numbers: if Morgan Stanley ends up getting much more cash than Wells Fargo, the impression will change.

There’s a symbolic element to the recapitalization: with the government buying preferred shares, it’s essentially saying that it has no interest in supporting the stock price, but that there’s no way it will allow sub debt or any other bondholders to suffer. And that symbolism is backed up by explicit intent:

The FDIC is expected to temporarily extend its backstop from bank deposits to new funds raised by banks and thrifts for three years. That would be an aid to companies that have had a hard time raising capital without government assistance.

This bit of the plan, incidentally, I like. With Frannie buying up toxic assets and the FDIC insuring bonds, that frees up most of the TARP funds to be used for recapitalizations.

But the broad-brush approach of the proposed plan, with no voting rights and seemingly very little due diligence, worries me. Pricing the Treasury’s preferred stock will be a bugger; I have a feeling they might just make all the banks pay them a nice round 10% and leave it at that, with the banks having a call option after say three years.

But that one-size-fits-all approach, especially when it’s combined with the present bank management which got us all into this mess to begin with, is a recipe for hail-mary passes and other forms of counterproductive risk taking.

If you’re running an insolvent bank, and you get a slug of equity from Treasury, your shareholders will thank you if you use that equity to take some very large risks. If they pay off and you make lots of money, then their shares are really worth something; if they fail and you lose even more money, well, there was never really any money for them to begin with anyway.

Brad Setser has it right, I think:

A world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

I asked Brad to clarify, and he wrote back:

If the guarantee is credible then an institution with little or no equity has the capacity to raise wholesale funds to gamble for redemption.

And those bets are a potential source of instability.

Regulation theoretically can limit this risk, and right now there is enough fear that I am not sure that it is most immediate risk — but conceptually, the incentive to make big bets with the government’s guaranteed money is there.

This is a real risk, I think, especially when you’re talking about banks like Morgan Stanley whose books are very opaque and which can lever up substantially within minutes should they feel like it.

There’s no sure way to prevent such risk-taking altogether. But if you go the UK route and insist on board seats and the ouster of failed executives, it helps. That’s what Treasury did with AIG, and they should do the same with the banks they’re rescuing. If they don’t, they’re basically getting all of the downside of nationalization with none of the upside.

I’m quite sure that Paulson hates the fact that he’s semi-nationalizing the banking system. But he needs to get real and accept it, rather than trying to brush it under the carpet. Otherwise he’s putting hundreds of billions of taxpayer dollars at unnecessary risk.

Update: The Big Four banks get $25 billion each. That’s $100 billion gone right there; I hope it’s worth it.