Wednesday, May 13, 2009

Why Markets, Not the Treasury, Determine Bank Capital

Bailout mania began with the Bush administration’s attempts to boost bank capitalization rates. The Obama administration’s reaction to bank stress-test results marks an important change by asking failing banks to raise their own capital rather than injecting another round of taxpayer funds. Yet neither administration has admitted to the public how difficult it is for the Treasury to have an impact on bank capitalization, because the market works to offset Treasury transactions in bank capital.

Bank capital refers to the excess value of banks’ assets over liabilities. Bank capital belongs to the bank shareholders, but provides a degree of insurance to the bank’s creditors –- its depositors and bond holders –- because their claims on bank assets (in the case of bankruptcy, for example) are senior to those of bank shareholders. Some economists also think that adequate bank capital is also essential for lending.

As the housing market crashed, so did the value of some of banks’ important assets: residential mortgages and mortgage-backed securities. This not only reduced the value of bank stocks, but heightened the risk that bank creditors might not be paid in full, because bank capitalization rates (the amount of bank capital per dollar of bank assets) were falling. Some thought that bank lending would suffer, too.

The Federal Reserve and the Bush administration let some banks fail, but ultimately desired to do something to replenish bank capital. They convinced Congress that they could do so, and had $700 billion (almost $7,000 for every United States household) earmarked for that purpose. Almost $300 billion of that amount had been awarded to banks between late October 2008 and Inauguration Day, in the form of Treasury purchases of newly issued bank stock.

Although the Federal Reserve and the Bush administration included quite a number of officials who once admired the power of free markets, none of them admitted to the taxpayers (whose money they requested) that the marketplace would largely, if not entirely, thwart their recapitalization efforts. The market would react to Treasury share purchases by reducing private holdings of bank capital, and react to Treasury share sales by increasing private holdings.

As noted above, bank capital belongs to the shareholders. Moreover, a variety of market mechanisms permit shareholders to increase or decrease bank capital. New shares can be issued in the private sector, or old shares bought back. Dividends can be increased, or decreased. Banks can merge with each other in cash deals, which decrease the combined capital of the merging banks and increase cash paid to shareholders.

Thus, bank capitalization rates are expected to suit shareholder interests, not the United States Treasury’s. Markets will neutralize Treasury transactions regardless of whether the Treasury reasonably desires banks to be more capitalized, because the bank capital belongs to the shareholders, even if the shareholders’ desired capitalization is “unreasonable” or “panicked.”

In other words, bank shareholders will have whatever capitalization level they want to have, and if they don’t like the level foisted upon them by the Treasury, they can easily grind it back down to their preferred level. And they have done just this, again and again.

Although lawmakers acted surprised, it is more than coincidence that payouts to bank industry shareholders occurred at the end of 2008 as the United States Treasury was “injecting capital.” Banks paid dividends that were far greater than what was commensurate with their profitability.

Joe Nocera reported in The New York Times that JPMorgan Chase’s chief executive, Jamie Dimon, told his employees that the $25 billion they obtained from selling equity to the Treasury would help them acquire competitors.

These are all ways how Treasury bailout funds ended up with bank shareholders rather than adding to bank capital, as bailout advocates led taxpayers to believe.

Several banks are now trying to give back their taxpayer capital injections — i.e., they are asking Treasury to sell back their bank shares. (Perhaps they find the Treasury to be an extraordinarily meddlesome shareholder.)

If the Bush administration had been right that Treasury purchases of bank stock raise bank capital, shouldn’t Treasury sales reduce bank capital? Recent events suggest not. Bank cash going back to the Treasury will be largely offset by cash coming in from the private sector: an offset mirroring what we saw in the fall, when cash coming in from the “capital” injections was spent on dividends, cash mergers and the like.

That’s what’s happening at banks such as BB&T, which plans to pay back $3.1 billion to the Treasury. At the same time, BB&T will issue $1.5 billion in common stock and cut their dividend by $0.725 billion per year. In two years’ time, the combination of those two actions alone will raise $2.95 billion, almost entirely offsetting the cash going to Treasury as it sells back BB&T shares.

The Obama administration’s reactions to bank stress-test results are refreshingly cognizant that the marketplace, and not Treasury injections, will determine bank capitalization. When the latest stress tests find that a bank has too little capital, the Obama Treasury (unlike the Bush Treasury) is asking that bank to raise its own capital, rather than arranging for a Treasury “injection.”

The moral: Bank capital is determined by the market, not the amount spent by taxpayers on bank bailouts.

CORRECTION: A previous version said that National City shareholders got cash from the merger -- they did not receive much, but as PNC shareholders they continued to get a historically high dividend ($0.66 per share) through January 2009.

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