Authorization to Recapitalize Banks

For a number of weeks professional economists and experts of banking crises have been arguing that the proper way to resolve a banking crisis is not to buy toxic assets but rather to recapitalize banks directly via injections of public capital (in the form of preferred shares) into distressed but solvent financial institutions. We criticized the TARP legislation just passed by Congress for not allowing for such a recapitalization of banks via public capital (an approach that has been instead now taken by the UK with its $87 bn bank rescue package and even Belgium/Netherlands in the case of the rescue of Fortis).

So how come that "to inject capital into financial institutions" was the first item that Hank Paulson listed as his priority in his press conference yesterday, thus suggesting that now the US, like the UK, will undertake a partial nationalization of its distressed banks?

The reality is that the TARP legislation passed by Congress (formally the Emergency Economic Stabilization Act) does not in any explicit way allow for such recapitalization of banks via injection of public capital. The US Treasury has initially resisted including explicitly such authority in the Act for several reasons: the banking industry that helped drafting the legislation was against it; there was ideological resistance to the idea of the government taking equity – however preferred – in financial institutions; there was concern that being explicit about public recap of banks would lead to banks’ resistance to participate in the toxic asset purchase program. That is why the Treasury formally resisted putting any explicit wording of public recapitalization of banks into the legislation.

So how come Treasury now says that its first priority is to inject public capital in banks? And where is Paulson getting such authority since there is nothing formally explicit in the Act to allow such recapitalization?

This is a fascinating story that is worth telling in full detail. Here below are those details…

The 180 degree turn in the Treasury position is driven by the disastrous market reaction to the passage of this legislation and to the realization that US banks are in such a deep trouble that, absent a direct partial public takeover of the banks this severe financial crisis will get much worse. After the Senate passed the Act on Wednesday there was no relief rally in the stock market: the next day Thursday the stock market tumbled by 5%; and then on Friday when the House finally reversed itself and passed the Act the Dow fell by about another 400 points between the time the legislation passed and the close of market.

Things got worse this week when on Monday and Tuesday and Wednesday stock prices tumbled even more in spite of new and aggressive actions by the Fed (interest payment on reserves and doubling of TAF on Monday; plan to purchase commercial paper on Tuesday; coordinated policy rates cuts on Wednesday). By yesterday Wednesday it was clear that we are close to a market crash that could – at this point – occur any time. When major policy actions for three days in a row fail to revive the stock market when such market is obviously oversold it is clear that there are no bottom buyers left and the risk of a 1987 like market crash is now at its highest level.

So by yesterday, Wednesday, it was clear that we were on the verge of a systemic financial meltdown and that that flawed TARP has been effectively Tarp-edoed by the market that realized that this approach to a systemic financial crisis was flawed. Thus Treasury and Paulson had to reverse themselves 180 degree and start supporting a direct partial takeover of US banks by the US government: you may not want to call is partial nationalization of the banks as the term is politically incorrect; but this is effectively what will happen as the US will directly inject capital – in the form of preferred shares (and possibly even common shares and sub debt) into financial institutions.

So where did Paulson get the authority to do such capital injection when there was no such authority in the wording of the legislation? Several of us had been explicitly and feverishly talking to Congress and the Fed and other senior officials (last week before the passage of the legislation) to include such explicit wording in the legislation; such campaign included the October 1^st column by George Soros in the FT where he strongly argued – as many of us had recommended – to design legislation that explicitly allowed for public capital injection in banks.

At first, Congressional aides we contacted were confused on whether the wording in the legislation did allow such public recapitalization was permitted or not. They pointed out to us that several sections of the legislation could be interpreted as allowing such public capital injection. Specifically such senior Congressional aides argued that several sections of the bill could be used to argue that the purchased “assets” as used in these provision would include not only securities accounted for as assets on the balance sheet of the financial institution but would also include common and preferred share, warrants on common and preferred shares, as well as secured and unsecured and convertible debt in the financial institution itself, which would be accounted for as assets on the balance sheet of the US Treasury. Specifically, the bill generally permitted TARP to purchase only distressed assets but opened the door wider in Sec 3(9)(B) where it included "any other financial instrument". Also, Section 111, subsection C of the bill (that stated “the Secretary shall pursue additional measures to ensure that prices paid for assets are reasonable and reflect the underlying value of the asset”) could also be used to argue that the purchased “assets” as used in this provision would include not only securities accounted for as assets on the balance sheet of the financial institution but would also include common and preferred share, warrants on common and preferred shares, as well as secured and unsecured and convertible debt in the financial institution itself, which would be accounted for as assets on the balance sheet of the US Treasury.

But we pointed out that this interpretation of “assets” as including preferred shares, left to itself, was a real stretch of the meaning of the legislation as preferred shares and common shares and sub debt are liabilities – rather than assets – of the bank. Thus, it was important to clarify that "any other financial instrument" was not limited to assets but also included institution’s liabilities such as stock, preferred stock, subordinated debt, senior debt.

In other terms it was necessary to explicitly clarify that the definition of “assets” or “any other financial instrument” in the legislation did allow for such public injection of capital so as to ensure that the regulations following the legislation would allow for such interpretation and actual practice. Since it was too late – by Wednesday last week – to explicitly modify the legislation to allow for explicit wording on this matter and since Treasury was resisting such late explicit changes (that would have jolted the banking industry) the tool that was used (in full agreement with the House and Senate leadership) to allow for such interpretation was to have Representative Jim Moran use the October 3^rd House floor debate right before the final vote to put on the legislative record such interpretation. See the following important exchange between Jim Moran and Barney Frank that is now on the legislative record of the House:

Mr. MORAN of Virginia. Thank you, Madam Speaker. I won’t take that much time. I do want to thank the chairman for his masterful leadership on this bill, and I do want to clarify that the intent of this legislation is to authorize the Treasury Department to strengthen credit markets by infusing capital into weak institutions in two ways: By buying their stock, debt, or other capital instruments; and, two, by purchasing bad assets from the institutions, in coordination with existing regulatory agencies and their responsibilities under this legislation, as well as under already existing authorization for prompt, corrective action and leastcost resolution.

Mr. FRANK of Massachusetts. Will the gentleman yield?

Mr. MORAN of Virginia. I’d be happy to yield. 

Mr. FRANK of Massachusetts. I can affirm that. As the gentleman knows, the Treasury Department is in agreement with this, and we should be clear, this is one of the things that this House and the Senate added to the bill, the authority to buy equity. It is not simply buying up the assets, it is to buy equity, and to buy equity in a way that the Federal Government will able to benefit if there is an appreciation.

So Moran asks Frank to clarify that the explicit intent of the legislation is to allow the purchase of bank liabilities (stock, debt, or other capital instruments) not just assets; and Frank replies firmly that this is the case and that Treasury agrees with such interpretation. Done!

So, all is well that ends well. A totally flawed and ineffective legislation that did not explicitly allow to do the right thing – recapitalize banks with public capital injections – and was rather aimed to do the wrong thing (wasting $700 bn of taxpayers’ money to buy only toxic assets at an inflated price) was rescued at the last moment right before the House vote via an interpretation of the wording of the legislation in the record of the House that allowed such recapitalization. It is a sorry reflection of the state of the US democracy that hundreds of Senators and Congressfolks did vote for the biggest bailout ever in US history ($700 bn) without even knowing exactly what they were voting for. They effectively and rightly allowed for a partial nationalization of the US financial system (the only solution that will prevent a systemic financial meltdown) without even exactly knowing that they were voting for this. So a huge plan that was sold as spending $700 bn to buy toxic waste of banks – and where the public discussion was all and only about this purchase of toxic assets – was finally and luckily rectified (with the hard and explicit efforts of many of us) to allow for a partial government takeover of such financial institutions.

Paulson should be lucky that his early opposition to such public capital injection in the financial system did not prevent Congress – via the back door – to do what was right. And he is now lucky that the first thing he could mention and did mention in his press conference yesterday was a plan to “inject capital into financial institutions” rather than the half-baked idea of spending most of the $700 bn to buy toxic assets.

Hat tip to Justin Fox who was the first journalist that picked up the importance of what Paulson said yesterday.

Adam Davidson of NPR tells me that he was the first one to scoop this "stock injection plan" story last Friday (even before Justin Fox) having been tipped by someone that had been tipped by me.

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