Going Through The Front Door

The major news this morning affecting financial markets is that the Treasury is making a drastic change in its approach to the current crisis.

You know about the $700 billion Troubled Assets Relief Program (TARP). As originally conceived, the idea here was to contrive ways of purchasing assets like mortgage-backed securities from banks and Wall Street firms.

The purchases were to have been done at an overvaluation. This would have effectively recapitalized the financial system, through the back door as it were.

This morning, however, the Treasury has announced a far more aggressive, and invasive, plan. They’ll be going through the front door.

This morning at 8:30 Eastern time, Secretary Paulson is expected to announce that some amount of the TARP’s monies, perhaps $125 billion, will be used to purchase preferred-stock in nine large banks.

The winners will now each receive a hefty slug of additional capital directly from the government. This comes at a time when the solvency of the banking system has been the biggest long-term problem facing the economy.

Bank balance sheets have been shredded by heavy losses from mortgage lending. And their attempts to raise new capital have been rendered impossible by plummeting stock prices. (If you were a typical sovereign wealth fund that has invested in equity placements by such firms as Citigroup and Bear Stearns over the past twelve months, you’ve probably been resisting further entreaties by saying “fool me twice, shame on me.”)

As I said, the original TARP approach contemplated the artificial creation of a secondary market for mortgage assets so that banks could gradually clean up their balance sheets, restore some semblance of profitability, and attract new capital from private sources.

But events rapidly overtook that plan, which was radical in itself, so radical that it threw Congress into a two-week paroxysm of indecision and partisan finger-pointing. That delay gave the simmering crisis of mid-September the opportunity to explode into a raging fire that essentially halted global capital markets, making it questionable whether companies in many industries could even continue with normal business.

There would have been no time for the original TARP plan to work, given the sudden emergence of a threat to the global economy that, in its dynamics, was not unreasonably compared to the early years of the Great Depression.

One imagines that people at the Treasury and the Fed had another come-to-Jesus moment this week, similar to the money-market crackup four weeks ago that precipitated those scary closed-door sessions in Congress.

So they decided to mainline capital directly into nine of the largest banks. According to published reports, the winners include Citigroup, JP Morgan Chase, Morgan Stanley, Goldman Sachs, the Bank of America, Wells Fargo, State Street Corporation (of Boston), and the Bank of New York/Mellon.

This is a breathtaking step. To call it radical is hardly adequate. And financial markets will be thrilled by it. There are already some early signs that overseas credit markets are responding with reduced interbank lending rates.

It’s too early for an analysis because we have no details yet.

What we think we know so far is that Treasury (meaning you, Mr and Mrs Taxpayer) will be buying blocks of preferred stock in America’s new National Champions.

Preferred stock is non-voting stock, but has a prior claim on the earnings and assets of a company than common stock does. Neel Kashkari, the Goldman whiz-kid that Paulson tapped to run the TARP, hinted yesterday that there would be some sort of arrangement that the new Treasury capital would be supplemented with private capital.

An extravagant amount of danger is being created here, which we’ll need to analyze as details emerge.

The proximate danger is, of course, moral hazard. You could make an excellent free-market case that one, more than one, or even all of the nine big banks should have been allowed to fail, to atone for the sin of losing money.

One assumes that this problem will be addressed by cramming down the existing shareholders, whose position in the capital structure will be taken by the new preferred issues, and also by firing senior executives and capping compensation for those who are left.

The much larger danger is moral hazard from Congress and the coming Administration.

Our august representatives in Washington may decide they enjoy being the stewards of a fully-nationalized banking system. You may have thought corruption was bad with Congresspeople and Senators directing earmarks to people and companies that fund their campaigns.

You ain’t seen nothing yet. The potential for corruption and resource-misallocation with Congress in direct control of the banking system matches anything since, well, Fannie Mae and Freddie Mac.

But that’s not Treasury’s problem now. They’re doing what they can to keep what will certainly be a tough, sharp recession from becoming much worse.

Three cheers, no holding back, for what they’ve done here.

But keep in mind that they’ve handed us a very large and difficult task. By “us,” I mean you and me, the people who decide who gets to sit in Congress and the White House.

It’s going to be up to us to demand, in every way and at every turn, that the nationalization of America’s big banks be unwound as quickly as possible after the crisis abates.

-Francis Cianfrocca