Thursday, October 9, 2008

US Considering Nationalizing Banks

From the NY Times:

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.

The proposal resembles one announced on Wednesday in Britain. Under that plan, the British government would offer banks like the Royal Bank of Scotland, Barclays and HSBC Holdings up to $87 billion to shore up their capital in exchange for preference shares. It also would provide a guarantee of about $430 billion to help banks refinance debt.

The American recapitalization plan, officials say, has emerged as one of the most favored new options being discussed in Washington and on Wall Street. The appeal is that it would directly address the worries that banks have about lending to one another and to other customers.

Let's look at this plan. The US government essentially injects capital (money) directly into banking institutions. The US government gets some kind of ownership interest in the bank (usually preferred shares). The idea behind this is in giving the banks money the banks will turn around and make loans.

The primary benefit of this program is taxpayers will get an ownership interest in the banks. Therefore, when the banks become more profitable the taxpayers various interests will increase in value and therefore provide a return on the investment.

There are serious drawbacks to this plan:

1.) The US government becomes an owner of banks. How many owners are hands off? Not many. Is this a good idea?

2.) There is no reason to think this will be cheap. We've already seen over $500 billion in writedowns. With 1 in 6 US homeowners now underwater there is no reason to think the trend in writedowns will diminish anytime soon. In other words, if someone says this will be cheaper they're not seeing reality clearly. Any option is going to cost serious money.

3.) Why will banks magically start to lend? We're seeing increased problems according to the latest Quarterly Banking Profile from the FDIC:

The continued downturn in the credit cycle, combined with lingering weakness in financial markets and falling asset values, had a pronounced negative effect on banking industry performance in the second quarter. Insured commercial banks and savings institutions reported net income of $5.0 billion for the second quarter of 2008. This is the second-lowest quarterly total since 1991 and is $31.8 billion (86.5 percent) less than the industry earned in the second quarter of 2007. Higher loan-loss provisions were the most significant factor in the earnings decline. Loss provisions totaled $50.2 billion, more than four times the $11.4 billion quarterly total of a year ago. Second-quarter provisions absorbed almost one-third (31.9 percent) of the industry's net operating revenue (net interest income plus total noninterest income), the highest proportion since the third quarter of 1989. A year ago, provisions absorbed only 7.3 percent of industry revenue. The average return on assets (ROA) in the second quarter was 0.15 percent, compared to 1.21 percent a year earlier. Large institutions as a group had more substantial earnings erosion than smaller institutions, but downward earnings pressure was widely evident across the industry. At institutions with assets greater than $1 billion, the average ROA in the second quarter was 0.10 percent, down from 1.23 percent a year ago. At institutions with less than $1 billion in assets, the average second-quarter ROA was 0.57 percent, compared to 1.10 percent in the second quarter of 2007. More than half of all insured institutions (56.4 percent) reported year-over-year declines in quarterly net income, and almost two out of every three institutions (62.1 percent) reported lower ROAs. Almost 18 percent of all insured institutions were unprofitable in the second quarter, compared to only 9.8 percent in the second quarter of 2007.

In other words, this is not an environment where banks will start to make loans -- it's the natural time when banks start to slow down anyway. My guess is banks will use the cash to shore up their balance sheets.

Here's the real bottom line. There are no good answers to this problem. There are no magic bullets. The financial system is in serious trouble. The Feds are one step ahead of the latest domino falling. But the dominoes will continue to fall for awhile.