Global markets are rising fast in the wake of yesterday's 11.1% Dow rally in the U.S. And they may be in for more upside depending on how investors react to the latest plan to invest capital in nine big banks -- a plan that sounds similar to the one in the U.K. The true test of this plan will be whether it causes inter-bank lending rates to plunge. But it also runs the risk of causing capital flight from banks that don't get enough of the government's money to ensure their soundness.
Global markets are sending positive signals this morning. Tokyo's Nikkei has a record one-day gain of 14%; Australia's key index rose 3.7%; South Korea's Kospi added 6.1%; Hong Kong's Hang Seng Index increased 3.2%; and all major European indexes climbed at least 4% in early trading. This all feels good but yesterday's 936 point gain on the Dow was not the largest percentage gain. During the Great Depression, the Dow rose more on a percentage basis in 1929, 1931, 1932, and 1933. This suggests that these rallies could be bear traps.
I am pleased that the U.S. has gone ahead with a plan to inject equity into some of the 8,494 U.S. banks that the FDIC insures. But it only does part of the cull and capitalize that I think is needed. The U.S. plans to buy $250 billion in perpetual preferred stock in an undetermined number of banks with $125 billion going to nine top banks. Here's how much these banks will get and their stock price rise in pre-market:
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Bank of America (NYSE: BAC) ($25 billion) +9.7%
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JPMorgan Chase (NYSE: JPM) ($25 billion) +5%
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Wells Fargo (NYSE: WFC) ($25 billion) +6%
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The Goldman Sachs Group (NYSE: GS) ($10 billion) +10%
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Morgan Stanley (NYSE: MS) ($10 billion) +18.5%
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Bank of New York (NYSE: BK) ($2 billion) +6.5%
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State Street (NYSE: STT) ($2 billion) +5.5%
What does the government get in return for this capital? It gets perpetual preferred stock that receives dividends plus warrants to buy some stock. Specifically, the perpetual preferred earns a 5% interest rate that will rise to 9% after five years. The warrants will be worth 15% of the face value of the preferred -- e.g., a $25 billion investment, will grant the government $3.75 billion in warrants (although it's not clear at what price those warrants would be exercised). If the stock goes up, taxpayers can profit.
This plan is much better than the toxic waste reverse auctions that the Administration is now pretending it never sold as the only way to avoid financial catastrophe. But it could be even better. My cull and capitalize plan would create a handful of very strong banks and merge or close the rest. Such a plan would create banks that would not be afraid to lend to each other since the survivors would be so well-capitalized.
I am concerned that the government's latest plan will leave too many zombie banks which will lose deposits to the better capitalized banks and eventually be forced to merge or close -- at a higher cost to taxpayers because they are allowed to linger for so long accumulating losses. While the U.S. government plan solves a problem with the UK plan -- dilution of existing common shareholders -- the 15% warrants also leave taxpayers with a minimum of upside potential to recoup their losses.
The government plan also guarantees non-interest bearing bank deposits -- most of which are held by small businesses. This should help stop the outflow of those deposits from weaker banks. The true test will be whether business lending rates drop today when the credit markets reopen -- they are still near record levels.
Overall, I think this plan is headed in the right direction and it could be even better.
Update. Since my initial post, I have learned that the warrants will be priced at the market price of the banks' common shares at the time of the transaction. And those banks will be able to buy back their equity "at par" after three years, according to Bloomberg News.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citi and Wells Fargo stock and has no financial interest in the other securities mentioned
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Reader Comments (Page 1 of 1)
10-14-2008 @ 11:09AM
steve cheung said...
Where is my share of this bail out. 2 years from now when the banks are making money again, the execs are going to take large bonuses and we'll never see this money again.. Our kids will suffer ..
10-14-2008 @ 11:55AM
KEN said...
THE CEO'S OF ALL OF THESE FAILED FINANCIAL INSTITUTIONS AND THE POLITICIANS THAT AIDED THEM NEED TO BE CHARGED WITH TREASON. THE DEMS IN CONTROL FAUGHT AGAINST REGULATION AND CLAIMED THERE WAS NO PROBLEM COMING. BU ISNT A COINCIDENT HOW THIS FAILURE HAPPENED 30 DAYS BEFORE THE ELECTION. THE DEMS DONT WANT ANYONE TO LOOK TO CLOSE BECAUSE THEY ARE GUILTY OF MANIPULATING THE ECOMY FOR FINANCIAL AND POLITICAL GAINS. FRY ALL THE CROOKED POLITICIANS. FOLLOW THE MONEY PEOPLE
10-14-2008 @ 11:55AM
Frederick H Lamitte said...
How about the credit unions? Are they FDIC covered? Are they under the 250k umbrella as well?
10-14-2008 @ 12:32PM
jesusjammer26 said...
How about the credit unions? Are they FDIC covered? Are they under the 250k umbrella as well?
2 stars
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Yes they are insured to the 250 limit but not by the FDIC but by the NCUA which is almost the same as the FDIC but for credit unions
10-14-2008 @ 5:57PM
Frankie said...
Why give the money infusion to the large banks when the smaller community banks are the ones that should have been 1st on the list so the money could have been lent out to deserving familys in the community! It sounds like the big banks might have a few friends in high places that can influence the politicians. Oh yes, the big bank executives can now give themselves a raise or get more golden parachutes!