Is the Treasury Impotent?

The U.S. Treasury now proposes to spend some of its $700 billion authority – $250 billion to start – to purchase equity in struggling banks. This proposal echoed the proposals of a number of academics. However, in the haste of developing this plan, few have considered the fact that Treasury capitalization will reduce private capitalization, with little net effect on the overall capitalization of the industry.

PRIVATE CAPITAL EXISTS

It is a known fact that the private sector has itself been looking seriously at recapitalizing banks, with some investors already committing cash. Within the past year, the Abu Dhabi group purchased a large stake in Citigroup. Bank of America announced early this month that it would issue more shares in the amount of $10 billion. Mitsubishi is acquiring a stake in Morgan Stanley. Most of us would guess that JP Morgan Chase would raise capital even without the Treasury’s help if it found additional lucrative opportunities to expand. One calculation found that banks have already raised over $400 billion.

Even if existing banks could not attract capital on their own, their inaction creates opportunities for other institutions to commit capital to funding investment projects in our economy. Walmart would like to get into the banking business. Pension funds, university endowments, venture capitalists and corporations all bring money to new investment projects. For example, a profitable corporation (there are many of them these days), could cut their dividend in order to fund projects that would have otherwise been funded by a bank.

PRIVATE CAPITAL IS READILY CROWDED OUT BY TREASURY CAPITAL

Do not assume that the private sector funds are invariant to Treasury actions. Rather, the private sector has both the means and the motive to neutralize Treasury purchases. If, say, Bank of America gets $10 billion from the Treasury, they can change their minds about their plan to issue $10 billion in the private sector (or maybe they anticipated this purchase, and without it would have planed to raise $20 billion). Even if it were true that there were some banks that were not raising private funds because their shareholders want their money out rather than throwing good money after bad, Treasury investments could still be readily neutralized by the private sector. For example, banks could use their new-found Treasury cash to buy back shares! Or they could use that cash to raise the dividend, or to put off a dividend cut that they had planned. The Washington Post called the dividend-hike possibility “the biggest hole in Treasury's financial plan,” although basic economics suggests that there are many large holes of this character.

Yet another hole of this type is for one bank receiving Treasury cash to buy the shares of another bank on the open market. Two see how this is equivalent to dividend payments and share buybacks, consider two scenarios. In scenario A, the Treasury buys stock in Bank ABC, after which bank ABC takes the Treasury cash to buy its own shares in the open market. Scenario A ends with bank XYZ's buying bank ABC in exchange for XYZ shares. In scenario B, the Treasury buys stock in Bank XYZ, after which bank XYZ purchases bank ABC for cash. In both scenarios, the Treasury ends up with XYZ shares. In both scenarios, bank ABC shareholders end up with Treasury cash. In both scenarios, there is no impact on the capitalization rate or the loan portfolio of either bank. The only difference between scenarios A and B is that the latter makes it slightly less obvious that the Treasury cash is going straight to bank shareholders.

Is it mere coincidence that I have been writing about this ever since the bailout was announced, and the AP reported today?!:

Treasury Secretary Henry Paulson has said the money was aimed at rebuilding banks' reserves so that they would resume more normal lending practices. But reports then surfaced that bankers might instead use the money to buy other banks. Indeed, the government approved PNC Financial Services Group Inc. to receive $7.7 billion in return for company stock and, at the same time, PNC said it was acquiring National City Corp. for $5.58 billion.

MICROMANAGEMENT IS THE NEXT ACT IN THIS CIRCUS

Remember that it is unclear whether the Treasury will vote along with the other shareholders, let alone micro-manage bank operations. If bank shareholders want cash in their pocket rather than loaning it out, there are strong market forces (not to mention fiduciary responsibility) pushing bank executives to pay out the cash.

Even if by luck or judicious micro-management the Treasury were to prevent these payouts, the flow of private sector funds toward funding new projects would still be reduced, thereby offsetting the Treasury investment. In this case, the banks receiving the Treasury investments would cede less business to new entrants to the banking industry and to alternative institutions that fund investment projects. For example, profitable non-financial corporations would no longer have to cut their dividend to finance their projects, because they could obtain the funds from one of the Treasury-partnered banks. The total amount of funds available for investment projects is just the same.

Bush, Paulson, most economists, and I agree that a nationalized banking sector is by itself undesirable. But the Treasury purchase plan is going forward because the purported benefits – a more capitalized banking industry – outweigh that cost. The purported benefits will never materialize because private capital is pulling out -- and will continue to pull out -- of the banking sector to make way for Treasury capital.

[This article is apparently not very interesting: it was turned down by the Wall Street Journal, the Washington Post, the LA Times, and Forbes.]