Wednesday, February 11, 2009

The Treasury's Bank Plan, Part I

The markets tanked yesterday after Geitner announced the Treasury's plan to clean up the banks. The general complaint was a lack of specificity in the plan. So, let's go through it to see what it really says. I'm going to take this in small chunks to get an idea for everything that's involved.

The Stress Test:

* Financial Stability Trust: A key aspect of the Financial Stability Plan is an effort to strengthen our financial institutions so that they have the ability to support recovery. This Financial Stability Trust includes:

+ A Comprehensive Stress Test: A Forward Looking Assessment of What Banks Need to Keep Lending Even Through a Severe Economic Downturn: Today, uncertainty about the real value of distressed assets and the ability of borrowers to repay loans as well as uncertainty as to whether some financial institutions have the capital required to weather a continued decline in the economy have caused both a dramatic slowdown in lending and a decline in the confidence required for the private sector to make much needed equity investments in our major financial institutions. The Financial Stability Plan will seek to respond to these challenges with:

# Increased Transparency and Disclosure: Increased transparency will facilitate a more effective use of market discipline in financial markets. The Treasury Department will work with bank supervisors and the Securities and Exchange Commission and accounting standard setters in their efforts to improve public disclosure by banks. This effort will include measures to improve the disclosure of the exposures on bank balance sheets. In conducting these exercises, supervisors recognize the need not to adopt an overly conservative posture or take steps that could inappropriately constrain lending.

# Coordinated, Accurate, and Realistic Assessment: All relevant financial regulators -- the Federal Reserve, FDIC, OCC, and OTS -- will work together in a coordinated way to bring more consistent, realistic and forward looking assessment of exposures on the balance sheet of financial institutions..
# Forward Looking Assessment – Stress Test: A key component of the Capital Assistance Program is a forward looking comprehensive "stress test" that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.

# Requirement for $100 Billion-Plus Banks: All banking institutions with assets in excess of $100 billion will be required to participate in the coordinated supervisory review process and comprehensive stress test.

+ Capital Assistance Program: While banks will be encouraged to access private markets to raise any additional capital needed to establish this buffer, a financial institution that has undergone a comprehensive "stress test" will have access to a Treasury provided "capital buffer" to help absorb losses and serve as a bridge to receiving increased private capital. While most banks have strong capital positions, the Financial Stability Trust will provide a capital buffer that will: Operate as a form of "contingent equity" to ensure firms the capital strength to preserve or increase lending in a worse than expected economic downturn. Firms will receive a preferred security investment from Treasury in convertible securities that they can convert into common equity if needed to preserve lending in a worse-than-expected economic environment. This convertible preferred security will carry a dividend to be specified later and a conversion price set at a modest discount from the prevailing level of the institution's stock price as of February 9, 2009. Banking institutions with consolidated assets below $100 billion will also be eligible to obtain capital from the CAP after a supervisory review.

+ Financial Stability Trust: Any capital investments made by Treasury under the CAP will be placed in a separate entity – the Financial Stability Trust – set up to manage the government's investments in US financial institutions.

Here's what this looks like to me. Before any money gets lent, the government gets to look under the hood in detail to see what is actually on the balance sheet. My guess is they are doing this for several reasons.

-- Will this bank survive? I think this is the key issue. If a bank is on life-support, I don't think (at least I hope) the Treasury will invest any money. Instead they will look for a forced bankruptcy or shotgun merger. Again, that's my read.

-- No one knows who owns what. This way we'll know who owns what particular asset.

-- This gives them a better idea of which company's are best suited for a forced Treasury shot gun marriage. If the Treasury doesn't like what they see, then they can use this evaluation to start quietly shopping sock banks to one healthier banks. The Treasury and the Fed have forced several marriages over the last year and a half or so. My hope (and perhaps it's a faint hope) is they will continue this trend. Remember -- Geitner is one of the main players behind the Bear Stearns sale -- that is, the behind the scenes movement.