The Treasury Department will make substantial profits on its investments in banks under the bailout program announced yesterday – if the banks return to health within a few years. If not, the government could end up breaking even, or perhaps even lose money.
The government is guaranteeing new loans to banks – and planning to collect a fee for doing so – and it is planning to invest $250 billion by buying preferred stock from banks. That stock will come with warrants that give the government a chance to earn big profits if share prices recover.
The plan provides both a carrot and a stick to encourage banks to repay the government as soon as possible with money they raise by selling shares to private investors.
The carrot allows banks to cut in half the number of common shares the government will eventually be able to purchase. That can be done if a bank sells stock by the end of 2009, and raises at least as much cash as the government is investing.
“If they can replace government capital with private capital, there will be much less dilution to existing shareholders,” said Robert Barbera, chief economist at ITG Inc. “That is important to current shareholders.”
Meeting that 2009 deadline may be a challenge. Economies in the United States, Europe and Japan appear to be in recession, and many economists say the declines will continue well into 2009. The extent to which banks will be able to regain investor confidence before the economy recovers – reducing the number of loans that are not being paid – is open to question.
The stick comes from the terms of the preferred stock. For the first five years, the Treasury will receive 5 percent interest, a rate not too far above what the government itself was paying to borrow a few months ago before financial panic caused investors to gobble up Treasuries as a way to avoid risk.
After five years, if a bank has not been able to repay the government, that interest rate will leap to 9 percent, and stay there until the money is paid back. There is no deadline for the repayment, but the government may sell its stake to private investors, assuming there are any who wish to buy it.
One important determinant of how well the American government does financially will be whether it makes wise choices regarding which banks to invest in. It has not promised to let all banks into the program, and it has not announced the criteria it will use.
Should banks fail despite the capital injection, the Treasury would be likely to lose most, if not all, of its investment. The government would be treated the same as other preferred stockholders, who generally suffer major losses in bank failures.
Another possible break for the banks is that the exercise price for the warrants will be the average common share price for the 20 days before the government makes its investment. That means that the price will reflect investor knowledge of the plan. If it continues to be favorably received by investors, that could mean the banks get higher prices for their shares than they would if the price were fixed today.
One index of regional bank stocks has risen 10 percent this week, with some banks that had been deemed among the most vulnerable doing even better.
The government will receive warrants equal to 15 percent of its investment. For a bank that gets a capital infusion of $10 billion, that would mean the government could buy $1.5 billion of common stock.
If that bank had an average share price of $20 a share during the period before the deal was concluded, that would give the government the right to buy 75 million shares at that price.
If the stock was trading at $30 a share when the warrant was exercised, that would give the government a profit of $750 million.
However, if the bank managed to raise $10 billion in a stock offering before the end of next year, the government would be able to exercise warrants for only half the shares, or 37.5 million in this example. That would cut the government's possible profit in half.
By forcing nine major banks to “volunteer” for the program, and by making it possible for them to suffer relatively little dilution if they can reassure investors by the end of next year, the Treasury Department hopes to remove any stigma that would be attached to participating in the program.
How well it succeeded will become clear as more banks announce that they have signed up and receive capital infusions. If markets react by bidding up the share prices of those banks, the Treasury will have scored an early victory.
But the final verdict will not be rendered until all the money has been repaid, or lost. At best, that number will not be known for several years.
