By Binyamin Appelbaum
Washington Post Staff Writer
Tuesday, October 14, 2008
The federal government is renewing its attempt to persuade people to give money to banks, and banks to give money to people.
In its most sweeping gesture, yet, the government compelled the chief executives of nine major banks to sell taxpayers an ownership stake in their companies. The investment is heavily symbolic. It is meant to assure the world that the American financial system is open for business. It is also intensely practical. It is intended to encourage many of the nation's 8,500 smaller banks to ask for the money they need, but cannot get anywhere else, to rebuild their reserves and increase their lending to people and businesses.
The government will spend $250 billion on this program, but that's not nearly enough money to restart the banking system. So officials also are introducing two new programs to persuade others to give money to the banking system as well.
The Federal Deposit Insurance Corp. plans to announce that it is expanding its guarantee of deposits to include essentially all the bank accounts of the nation's small businesses. The agency also will create a parallel insurance program to guarantee investments in debt issued by banks.
Because the financial system depends heavily on confidence, the government's response is aimed at repairing perceptions as well as problems. For that reason, the government ordered the chief executives of nine prominent banks to attend a meeting yesterday at the imposing offices of the Treasury Department, next-door to the White House.
The participants included: Bank of America, J.P. Morgan Chase and Wells Fargo, retail banking giants that together control 30 percent of the nation's deposits; Wall Street titans Goldman Sachs, Morgan Stanley and Merrill Lynch, which has agreed to be bought by Bank of America; and Citigroup, the most international of the American banks. Also invited were the Bank of New York Mellon and State Street, lesser-known banks that play a crucial role as the back offices for the financial system.
Treasury Secretary Henry M. Paulson Jr. told the executives that for the good of the nation -- patriotism was specifically invoked, according to a person briefed on the discussions -- they would each have to sell the government a stake in their companies.
Representatives of several banks underscored after the meeting that they did not need the government's money but said they cooperated out of obligation and to help heal the financial system.
The government will invest $125 billion in the nine banks, and then it will make another $125 billion available to the 8,500 smaller banks, which can choose whether to participate. Banks that accept the investments -- as the big nine must -- will issue to the government preferred shares of stock, meaning that the shares will pay annual interest. That has the effect of immediately reducing the value of existing shares and of limiting the companies' future profits, by directing some of their revenues to the government.
The preferred shares also are designed to encourage companies to repay the government within three years. During the first three years, companies will pay 5 percent interest on the government's investment. After that, if the companies do not repurchase the preferred shares, the annual interest rate climbs to 10 percent.
The government will not run the companies. Its investment varies case by case: Citigroup and J.P. Morgan Chase will receive $25 billion each; Bank of America and Wells Fargo, $20 billion; Goldman Sachs and Morgan Stanley, $10 billion, Bank of New York and State Street $2 billion to 3 billion. Wells Fargo will get an additional $5 billion, for its purchase of Wachovia, and Bank of America gets the same for Merrill Lynch.
Instead the analogy is with recent investments by Warren E. Buffett in General Electric and Goldman Sachs. In both cases, the investment was primarily symbolic. The companies needed Buffett's testimonial to their health more than they needed the money. Buffett is a director of The Washington Post Co.
This time, it is the government that wants to convince the world that the American financial system is open for business. By investing in these nine banks, the Treasury told executives it wants to send the message that "you can do business with these big companies and feel safe about it," said one person briefed on the meeting who spoke on condition of anonymity because he was not authorized to make public statements.
The goal of the program also is intensely practical, however. Massive losses on mortgage-related investments have depleted the reserves of many American banks, and fears of further losses have led many banks to hoard money and restrict lending.
The government, along with a nearly unanimous chorus of economists, thinks the best way to restart lending is to give the banks more money. In England, the government accomplished this last week by requiring banks to accept its money. But the Bush administration thought it was politically impossible to impose such a solution on thousands of smaller banks. So it sought to create a program that would persuade banks to participate by overcoming the fear that accepting government funding would send a signal to investors that the bank's financial condition was desperate.
Still, is not clear how many banks will participate. Larger banks that are publicly traded need the confidence of their shareholders and may be forced to seek government investments as an endorsement of their financial health. But there are roughly 8,500 banks in the United States, almost all of them small institutions owned by a handful of businesspeople. The American Bankers Association estimates that 95 percent of the nation's banks are well-capitalized, and many of them are not likely to see any reason to give the government a share of their profits.
To further encourage participation, the Treasury created a program with minimum strings attached.
Participating banks cannot increase their dividends unless the Treasury gives its permission. But the nine banks getting the initial infusion already pay out about $7 billion in quarterly dividends, raising questions about whether money invested by the government will simply flow through to shareholders, as through a hole in the bottom of a fire bucket, rather than staying to fund new lending.
In fact, the plan does not require banks to increase their lending, although that is its stated purpose. Banking regulators say they will watch with increased vigilance to make sure that banks do not simply hoard the money, as banks like to do during economic downturns.
It appears that participating banks will be subject to some limits on executive pay, but here, too, it is not yet clear that an actual bank executive will see a pay reduction.
The government also is expanding its efforts to reassure depositors and to encourage new investment.
The FDIC will extend its guarantee of bank deposits to include all money, without limit, in any account that doesn't pay interest. Since banks are not allowed to pay interest on business accounts, the government is effectively guaranteeing the deposits of the nation's small businesses, which keep the largest balances in bank accounts, and therefore are the most prone to destabilize a bank by pulling their money at the first sign of trouble.
The guarantee matches similar moves by European countries, easing a concern that businesses would move money to overseas accounts.
It also offers an elegant solution to some other potential pitfalls. It avoids the moral hazard of allowing banks to chase unlimited deposits by offering high interest rates, because there is no additional guarantee on accounts that pay interest. For the same reason, it could help preserve the politically important status quo in the relationship between banks and money-market mutual funds.
The new guarantee runs until the end of 2009, and it will be backstopped by the FDIC's existing insurance fund, increasing concerns about the sufficiency of that fund to cover the government's growing responsibilities as banks continue to fail.
The FDIC also is creating a new insurance fund, to guarantee investors that they will be repaid if they purchase debt issued by banks. The insurance program will be funded by premiums paid by the banks. It will cover debt issued until the end of June 2009, with terms lasting no more than another three years.
At the core of the current crisis is a breakdown in confidence that has made banks unwilling to lend money to each other, the lifeblood of a capitalist economy. But unlike European governments, the United States is not directly guaranteeing that lending between banks. The government officials who engineered the plan think that by guaranteeing banks' debts, banks will be more willing to lend to each other, confident they will get paid back.
Staff writers Neil Irwin and Zachary A. Goldfarb contributed to this report.