Treasury Throws Good Money After Bad

This post first appeared on Minyanville.

In recent testimony before the Senate Banking Committee, Treasury Secretary Hank Paulson rejected the idea of the US government injecting capital into banks and taking preferred stock, suggesting that such an extreme measure would imply that the US banking system had failed.

"Some [say] we should just stick capital in the banks, take preferred stock in the banks. That's what you do when you have failure," Paulson said.

Houston, we have failure: Yesterday, after the markets closed, Paulson announced plans to just stick capital -- $250 billion, to be exact -- into the banks and take preferred stock.

According to the Wall Street Journal, 9 of our biggest banks will receive around half the total injection.

• Citigroup (C): $25 billion
• JPMorgan (JPM): $25 billion
• Bank of America (BAC) and Merrill Lynch (MER): $25 billion
• Wells Fargo (WFC): $20 - 25 billion
• Goldman Sachs (GS): $10 billion
• Morgan Stanley (MS): $10 billion
• State Street Bank (SST): $3 billion
• Bank of New York Mellon (BK): $3 billion
  

The rest of the $250 billion will be divvied up among smaller, healthier institutions around the country.

Reports indicate that some of the banks balked at the injections, which include restrictions on executive pay and requirements to help struggling homeowners.

Careful not to dilute existing shareholders by buying common equity, Treasury will purchase preferred stock carrying a 5% dividend, that jumps to 9% after five years. This represents a significant discount, however, to the 10% return Mitsubishi Finance (MTU) is earning on its recent $9 billion investment in Morgan Stanley, and Warren Buffett is picking up from his stake in Goldman Sachs.

In conjunction with Treasury's plan, the FDIC announced it will guarantee senior unsecured debt issued by banks, making it easier for them to raise capital in private markets. The FDIC will also insure all non-interest bearing deposits, which are typically held by businesses.

Over the weekend, after Europe announced a quasi-unified front to tackle the financial crisis which has spilled over into markets around the world, Washington said it planned to release details of a “comprehensive” plan to shore up America’s financial system - and by extension the economy as a whole.

Many scoffed at the idea that the government's actions to date -- hundreds of billions in liquidity injections, rescuing AIG (AIG) and Bear Stearns, the bailout package itself, and countless other measures -- didn't constitute a “comprehensive” approach. Today, as financial commentators huff and puff through reams of press releases and sift through details of the myriad new programs, we're coming to understand what a truly “comprehensive” plan entails.

Still, amazingly, bureaucrats don’t get it.

Even this morning, FDIC chairman Sheila Bair -- who by many accounts has performed admirably throughout this crisis -- described our situation as “a liquidity problem.”

Liquidity is just the external manifestation of the true issue: Too much debt. A liquidity crisis is easier to explain (and more politically palatable), because admitting the true problems facing this economy and their implications for our long-term prosperity are a bit too scary to trumpet around on national television.

Professor Depew laid out the details of why this is a debt crisis, not a liquidity crisis, last week:

"Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little real income. As a result, global time preferences are retreating, risk aversion is growing, and access to credit is diminishing."

Until that debt load shrinks -- until American consumers and businesses alike save, repay debt, save again and repay some more -- the merry-go-round of bailouts, capital injections and more bailouts will continue its revolutions.

Unless they’re interrupted by a revolution of another kind.

Morgan Stanley, Mitsubishi Say "I Do"

This post first appeared on Minyanville.

A collective sigh of relief just went up in the narrow boulevards of lower Manhattan - and it’s not just because the Federal Reserve said it will lend out unlimited amounts of dollars to help prop up the global financial system: Morgan Stanley (MS) managed to secure its capital infusion from Japan’s largest bank, Mitsubishi UFJ Financial Group (MTU).

Just weeks ago, when the transaction was first announced, Mistubishi’s agreed to hand over $9 billion for a 20% stake in the storied Wall Street firm. But during the market’s train wreck last week, shares of Morgan Stanley sunk below $7 on concerns the deal would be derailed.

At those levels, the Japanese bank could have picked up the entire firm for less than the proposed injection.

Nevertheless, after a weekend of what must have been intense negotiations, the 2 sides agreed on a deal.

According to the Wall Street Journal, Mitsubishi picked up $7.8 of convertible preferred stock with a conversion price of $25.25 per share, along with $1.2 billion of non-convertible preferred shares. Both investments carry a 10% dividend, which seems to be the going rate for equity positions in former-investment banks (Warren Buffett is earning a similar dividend on his investment in Goldman Sachs (GS)).

The deal comes without any implicit backing from the US government - though Bloomberg, citing the New York Times, reports federal officials told Mitsubishi its investment would be “protected.” It’s unclear whether there will be specific guarantee slapped on the deal, or if the government simply implied its plans to inject cash into troubled financial institutions will keep Mitsubishi’s money safe.

The 2 firms are already forging a strategic partnership, identifying several areas of cooperation: Corporate and project-related loans, investment banking and certain aspects of retail banking and asset management.

Both Morgan and Goldman are paying a high price for private capital; 10% is nothing to scoff at for what are alleged to be strong financial institutions. That also sets the bar for what taxpayers should expect to earn when the Treasury Department starts taking equity positions in American banks.

Existing shareholders, already fretful these equity investments will be highly dilutive to existing shares, now have to worry that the high cost of capital will eat into future earnings. According to Bloomberg, Morgan’s annual payout to Mitsubishi could be as much as 16% of next year’s profits.

In the coming weeks, as details emerge about Treasury's plans, taxpayers should be up in arms if they're not duly compensated for being investors of last resort.

Fed Pushes Fannie, Freddie Shareholders in Front of Train

This post first appeared on Minyanville.

The effects of this weekend’s dramatic power grab in Washington are rippling through the financial markets - and the pundits are arguing about who was right and who was wrong about the Fannie Mae (FNM) and Freddie Mac (FRE) bailout. In the meantime, federal regulators are quietly doing damage control.

Small banks will see large chunks of capital wiped out from equity losses in Fannie and Freddie - but they can now get in line for the government dole.

In seizing the embattled mortgage giants, the Treasury Department shoved common shareholders in front of the train, reaffirming they’d bear the brunt of future losses. As with the Bear Stearns takeover, the Federal Reserve and the Treasury dealt with the moral hazards of risky investments by simply punishing common shareholders and bailing out debtholders.

The countless financial institutions holding Fannie and Freddie preferred stock must now act as the second line of defense for the money of our trading partners, allies and certain well-connected institutional bond investors.

Preferred shareholders have no voting rights, but they stand in front of common shareholders in terms of dividend payments and the right to recover their investments in the event of liquidation. There had been speculation that Washington would go easy on preferred holders and protect their dividends, and, by extension, the value of preferred shares. Since most holders of these assets were other financial institutions, the logic went, the Treasury wouldn't put undue stress on an already troubled group.

The Treasury’s bailout plan doesn't protect preferred shareholders, as evidenced by the steep drop in the value of those shares today. However, various financial regulators are prepared to step in and assist small banks with significant exposure to Fannie or Freddie via investments in preferred shares.

FDIC chairman Sheila Bair tried to diffuse the situation by claiming that “Across the industry, banks do not have significant exposure to GSE equity securities.” But since the FDIC also neglected to include collapsed mortgage thrift IndyMac on its list of potentially troubled financial institutions just weeks before it went bust, her assertion shouldn’t carry much weight.

Sovereign Bank (SOV) isn’t likely to be comforted by Bair’s soothing words either, as losses on the bank’s Fannie and Freddie preferred stock could erase almost a year’s worth of earnings, according to analysts at Credit Insights. JPMorgan (JPM) is also likely lose money on similar holdings, although even if it’s entire $1.2 billion investment is wiped out, the hit would represent less than 1% of its tangible capital.

Capitalist ideals go right out the window during times of crisis. Unprecedented financial calamities result in unprecedented government intervention.

It's anybody's guess as to how long it will be before markets are allowed to find a true bottom, to experience true price discovery and thus establish a true foundation for recovery. Until then, investors should try to relish being a part of some of the most historic financial events in the past 80 years, while preserving capital for the inevitable opportunities that lie on the ever-elusive other side of the abyss.