Everything Finance

Paola Sapienza

After threatening a financial meltdown in case his plan was not approved, and announcing that “the right way was not to going around using guarantees or injecting capital in the system (that is the Japanese solution),”  the Secretary of Treasury Hank Paulson has made a 180 degree turn and opted for plan B.

So, what is plan B? Plan B is an equity infusion into the banking system and a system of guarantees. This infusion amounts to $250 billion, effectively leaving very little money left for plan A to be implemented, at least in the short run.

Plan B is essentially the solution adopted by European governments and it coincides with an investment in equity in U.S. banks. The difference between plan A and plan B is quite dramatic. Advocates of plan A suggested that our crisis was merely a liquidity crisis: the assets of many financial institutions were difficult to evaluate and thus the government would take over them, get a closer look and wait till the market rebounded. Advocates of plan B fundamentally believed that the problem of the financial system was a problem of undercapitalization. According to this camp, the problem is much bigger than originally acknowledged. They argued that, while there was a liquidity problem in the market, the fundamental weakness was due to the lack of enough capital in financial institutions. When the value of their assets declined due to the real estate market collapse, they became technically insolvent. Hence, solving the problem by buying toxic assets would be possible only by buying those assets (many of them if not or all) at extremely inflated prices. A cheaper alternative was recapitalization. According to this argument, if you buy bank assets at inflated prices with 700 billion dollars, on a leverage of 10 to 1, this is like injecting equity of 70 billion. But, if you inject 700 billion of equity, then on a leverage of 10 to 1, this is adding additional balance sheet capacity of 7 trillion. So, dollar for dollar, you get more bang for the buck with the recapitalization. While there is some truth in this latter argument, the devil is in the details—if we want to ask whether plan B addresses the crisis appropriately, we should look at its details.

Well, on Tuesday the Treasury revealed some of the details. Let’s look at them.

It involves nine banks: each one of them “voluntarily” agreed to participate in the injection of money from the government. The government will effectively buy preferred stock in these institutions. The preferred stock will pay special dividends at a 5 percent interest rate for the first five years. After five years, the interest rate will be increased to 9 percent. The government also will receive warrants worth 15 percent of the face value of the stock.

At first sight, the terms of the contract are quite generous compared to a similar plan designed for United Kingdom banks (indeed, after hearing the U.S. details, U.K. banks tried to negotiate an improvement of their terms with the British government pointing out that their competitors oversee received much better terms). Unlike U.K. banks, participating institutions will be able to pay dividends to the original shareholders. This is surprising because allowing these institutions to pay dividends not only limits the ability and the incentive of the U.S. banks to raise more capital, but also potentially raises the cost for the taxpayer. After accounting for the value of the warrants, the U.S. government (i.e., the taxpayers) receives a lower return from this investment than the U.K. government. However, it is very difficult to understand what the effective cost for the taxpayer is and what the benefit is given that the market value of the assets of the participating institutions is not known to anybody.

To attempt an evaluation of the effectiveness of this plan, I will keep things really simple and assume that the benefit for taxpayers should be measured by better economic conditions. The short term measure of the latter is that the financial system will start lending again. In other words, I will assume that the taxpayer is happy if the banking industry starts lending again, no matter how dearly he has to pay for this.

The taxpayer’s cost of this operation depends on how much money the taxpayer will be able to recover. It is a risky investment and the amount the U.S. government will recover depends on the quality of the assets of the institutions that participated. To better understand how it works, consider the following hypothetical balance sheet of one participating institution.

Balance sheet (book values)

I have written the “book value” of the assets and liabilities of this hypothetical institution. Unfortunately, the market value of the loans and other assets is lower than 100, and for this reason, this institution is not lending to businesses and other banks. Nobody apparently knows how much the loans and other assets are really worth. This is why some economists had originally proposed some auditing process to look into this (as did my colleague Debbie Lucas in a blog entry).

Let’s consider three possible scenarios to evaluate the plan.

CASE1: Best case scenario

Let’s suppose the market value of the loans and other assets is $90. This is an easy case. In this situation, the balance sheet can be re-written at market value in the following way.

Balance sheet before the government intervention (market values)

Equity value is now equal to zero. This is what we mean when we say that equity holders are the residual claimants. What does the government equity injection do in this case? It will modify the balance sheet in the following way:

Balance sheet after the government intervention (market values)

Note that I have left the equity (old equity) at zero because in a government recapitalization the equity is generally wiped out. Not so in Paulson’s plan B. In this particular plan, the government surprisingly left some dividends out for the old equity holders. Hence, accounting for this characteristic, the balance sheet should look like:

Balance sheet after the government intervention

The government has subsidized the old equity holders with taxpayer’s money, what somebody has called the ‘Reverse Robin Hood system’ (taxing the poor to give to the rich).

However, the important point is not redistribution, but credit crunch here. Has the government accomplished what the original goal was? Will the banking system start to lend again? Even in this best case scenario, it is hard to say. It depends on how the banks decide to use the additional cash. The current plan does not require the banks to use the cash to lend again. In principle, a profit maximizing institution could reason in the following way: It is currently paying much higher rates on its debt than it is paying the Treasury for the preferred equity. It is entirely possible that these institutions would use the cash to buy back the debt rather than lending money. If this is the case, the Treasury would have not accomplished its goal: it would have only accomplished the goal of subsidizing the investors of this institution and avoiding the default of the institution (which per se could be a legitimate goal). This is the reason for the criticism, expressed by some, of the cheap terms that the Treasury gave to the banks and to the lack of strings attached to the cash injection. I am not persuaded that is recommendable for the Treasury to tell the participating institutions how to use the money. However, the key to the success of the plan is whether these institutions will indeed lend again.

CASE2: Debt overhang case

Now, let’s assume that the value of the loans and other assets of this bank is $85 and that the government still injects $10 into the bank. What would happen? Before the injection, the balance sheet looks like:

Balance sheet before the government intervention (market values)

Not only equity would be worth zero, but debt is worth less than its face value. Indeed, this scenario seems plausible in light of the prices of the credit default swaps for the institutions involved in the Treasury plan (see the charts in Bob McDonald’s blog entry. The government steps in with its injection of capital. What happens?

Balance sheet after the government intervention (market values)

The government still pays $10, but only has $4 in equity value (preferred equity). Where did the remaining $6 go? $1 went to the equity holders who still receive dividends on the old shares, and $5 went to the debt holders who see the value of their debt rise. This is what economists call “debt overhang.” Part of the taxpayer money goes to the investors of these banks. Some economists have calculated that for each dollar spent by the taxpayer in this plan about 33cents go to the debt holders of these banks.  One indirect measure of the subsidy from taxpayers to debt holders is how the credit default swap prices adjust after the injection of money by the Treasury. Note, however, that if the goal is to make this bank to lend again, and we plan to accomplish it with this scheme, the subsidy from taxpayers to debt holders is a necessary evil. Once again, we are no longer worried about redistribution, we are worried about the credit crunch. What would be the effect of the injection of money? As before, it depends on how these institutions use the cash. It also depends on whether the institution has enough capital to lend. To keep banks safe the regulator requires that banks have sufficient equity to finance their lending. Even if the government injected $10, the level of equity in this institution is now much lower. To understand the effectiveness of the plan it is important, however, to estimate which fraction of the infusion of money effectively goes to recapitalize equity.

Would the amount injected ($10) be enough to allow this institution to lend again? This is a $700 billion question.

CASE 3. The pessimistic scenario

Now, let’s consider the worst case scenario. Suppose that the value of the loans and assets is $75 (or less).

Balance sheet before the government intervention (market values)

After the government intervention the balance sheet of our hypothetical institution would look like:

Balance sheet after the government intervention (market values)

While this institution has some cash in the balance sheet, it is technically bankrupt: this is why it does not lend to the system. Many analysts believe that this is the status of some US and European banks. The government spent $10, but has not achieved its goal. Now, it has to decide whether to inject more money or let the institution go through a restructuring procedure.  This would be now plan C.

What is the most likely scenario? It is very difficult to say. We can safely exclude case 1 by looking at the credit default swap prices of the participating institutions (see the charts in Bob McDonald’s blog entry). If we trust these market prices, we should conclude that the debt of these institutions was worth less than the face value and there was a serious risk of default. Thus, we are either in case 2 or 3. The quality of the assets of the participating institution is dictating which one of the two cases we are facing right now.

One thing we can be sure of: If we are in case 3, the consequences could be dramatic. Since the Treasury has chosen this approach, it is probably in the best interest of everybody to calibrate the intervention in such a way that the quantity of capital injected is high enough to take us closer to case 2 rather than leave us in case 3. It will cost the taxpayers a lot of money, but, at least, it is more likely to accomplish the goal of making financial institutions resume lending.