the visible hand

it is the theory which decides what can be observed – einstein

recapitalization and partial nationalization

Posted by ecoshift on October 9, 2008

Noriel Roubini’s latest blog post should be read by everyone following the current financial crisis. It appears that our political system is so ideologically constrained and dominated by financial institutions that the only way to get legislation enacted that would allow recapitalization of banks through the purchase of preferred shares by the Treasury was to interpret non-explicit language in the bill as allowing the Treasury to buy stock in distressed institutions — as per the “Swedish Plan”…

I’d rather see sausage made…

Ironically it was the market that rejected Paulson’s plan and trumped the political process.

From Roubini’s blog:

The 180 degree turn in the Treasury position is driven by the disastrous market reaction to the passage of this legislation and to the realization that US banks are in such a deep trouble that, absent a direct partial public takeover of the banks this severe financial crisis will get much worse. After the Senate passed the Act on Wednesday there was no relief rally in the stock market: the next day Thursday the stock market tumbled by 5%; and then on Friday when the House finally reversed itself and passed the Act the Dow fell by about another 400 points between the time the legislation passed and the close of market.

Things got worse this week when on Monday and Tuesday and Wednesday stock prices tumbled even more in spite of new and aggressive actions by the Fed (interest payment on reserves and doubling of TAF on Monday; plan to purchase commercial paper on Tuesday; coordinated policy rates cuts on Wednesday). By yesterday Wednesday it was clear that we are close to a market crash that could – at this point – occur any time. When major policy actions for three days in a row fail to revive the stock market when such market is obviously oversold it is clear that there are no bottom buyers left and the risk of a 1987 like market crash is now at its highest level.

So by yesterday Wednesday it was clear that we were on the verge of a systemic financial meltdown and that that flawed TARP has been effectively Tarp-edoed by the market that realized that this approach to a systemic financial crisis was flawed. Thus Treasury and Paulson had to reverse themselves 180 degree and start supporting a direct partial takeover of US banks by the US government: you may not want to call is partial nationalization of the banks as the term is politically incorrect; but this is effectively what will happen as the US will directly inject capital – in the form of preferred shares (and possibly even common shares and sub debt) into financial institutions.

So where did Paulson get the authority to do such capital injection when there was no such authority in the wording of the legislation?

Here’s the story…

At first, Congressional aides we contacted were confused on whether the wording in the legislation did allow such public recapitalization was permitted or not. They pointed out to us that several sections of the legislation could be interpreted as allowing such public capital injection…

But we pointed out that this interpretation of “assets” as including preferred shares, left to itself, was a real stretch of the meaning of the legislation as preferred shares and common shares and sub debt are liabilities – rather than assets – of the bank. Thus, it was important to clarify that “any other financial instrument” was not limited to assets but also included institution’s liabilities such as stock, preferred stock, subordinated debt, senior debt…

Since it was too late – by Wednesday last week – to explicitly modify the legislation to allow for explicit wording on this matter and since Treasury was resisting such late explicit changes (that would have jolted the banking industry) the tool that was used (in full agreement with the House and Senate leadership) to allow for such interpretation was to have Representative Jim Moran use the October 3rd House floor debate right before the final vote to put on the legislative record such interpretation. See the following important exchange between Jim Moran and Barney Frank that is now on the legislative record of the House:

Mr. MORAN of Virginia. Thank you, Madam Speaker. I won’t take that much time. I do want to thank the chairman for his masterful leadership on this bill, and I do want to clarify that the intent of this legislation is to authorize the Treasury Department to strengthen credit markets by infusing capital into weak institutions in two ways: By buying their stock, debt, or other capital instruments; and, two, by purchasing bad assets from the institutions, in coordination with existing regulatory agencies and their responsibilities under this legislation, as well as under already existing authorization for prompt, corrective action and least cost resolution.

Mr. FRANK of Massachusetts. Will the gentleman yield?

Mr. MORAN of Virginia. I’d be happy to yield.

Mr. FRANK of Massachusetts. I can affirm that. As the gentleman knows, the Treasury Department is in agreement with this, and we should be clear, this is one of the things that this House and the Senate added to the bill, the authority to buy equity. It is not simply buying up the assets, it is to buy equity, and to buy equity in a way that the Federal Government will able to benefit if there is an appreciation.

So Moran asks Frank to clarify that the explicit intent of the legislation is to allow the purchase of bank liabilities (stock, debt, or other capital instruments) not just assets; and Frank replies firmly that this is the case and that Treasury agrees with such interpretation. Done!

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5 Responses to “recapitalization and partial nationalization”

  1. SomeDude said

    Snapback tomorrow, massive weekend action, descent continues next week….

  2. ecoshift said

    Capitulation Monday?

  3. ecoshift said

    8pm PST
    DJIA futures: -259.00
    Snapback looks like it will start off down.

  4. SomeDude said

    Can I have a do-over?

    Seriously, we’re gonna bounce off the top of the channel and then wander back south slowly. ‘evil speculator’ had the charts a few weeks ago. This is about an orderly descent into darkness, they don’t want this thing to go exponential growth curve down.

    I think we keep setting new lows and keep having facilities or rebates when that happens, to keep the slide orderly.

  5. ecoshift said

    Yes, well. A controlled slide does have some benefits over panic inducing freefall — if we can keep the cost of the new facilities and bailout measures down to a trillion or two.

    Still it’s a shame. Several trillion is still a big number. Imagine the impact of investing several trillion in real assets and capacity: clean green tech, rebuilding an aging infrastructure, educating the next generation of american workers to increase the competitiveness of our work force, etc., etc…

    Wonder where the bottom will really be. Quite a bounce yesterday…

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