Terms like "bailout" and "corporate welfare" continue to flood the airwaves with respect to banks. Is that truly what is going on? Are we giving money to failing institutions?
It would seem so, based on the information generally reported in the news.
The problem is that the issue is more complex than can fit in a three-minute spot on the 11 o'clock news or in a blog —- the bite-size pieces of information that we generally absorb.
Money from the Troubled Asset Relief Program is generally not going to weak financial institutions.
I say generally because there are two pretty big exceptions —- AIG and Citicorp. Fortunately, one of these, Citicorp, continues to demonstrate the capacity to turn around.
The application for TARP funds is short and contains very general information. The U.S. Treasury is not relying on this application for its decisions. Instead, it looks at the regulatory reports issued as the result of exams, and conducts interviews with senior bank regulators.
Based on this combined information it makes decisions on which banks should be permitted to receive TARP funds. The reality is, only the strongest applicants are chosen to participate. Why? Because it is not a handout; it is an investment. And like you, the Treasury does not want to invest in a failing financial institution.
An investment? Yes, an investment. When banks receive TARP money, they issue preferred stock to the Treasury. This stock has liquidation preferences in front of the common shareholder, meaning that it gets paid back first.
If it was really a "bailout," wouldn't the program protect the owners? Common shareholders of banks participating in the TARP continue to be in a first-loss position, further strengthening the position of the Treasury.
Is this a good investment for the Treasury? There are two parts to the investment. The first is the preferred stock, which has a quarterly dividend of 5 percent.
In order to fund these investments, the Treasury issued debt, which is currently paying 2 percent for five-year maturities. Based on $200 billion in outstanding stock purchased by the Treasury, this will generate positive cash flow of $6 billion per year.
That positive cash flow by itself may make the average investor happy with this decision.
But the Treasury wanted a "kicker" —- it shares in the upside in the increase in the value of the common shares. In addition to holding the preferred stock, the Treasury receives the right to purchase the common stock of the company for the next 10 years, equal to the depressed price of the stock on the day the preferred stock was purchased.
Unless you believe our current stock market reflects the long-term value of the market, this looks like a great deal for the Treasury. How much is that worth?
For its investment in Goldman Sachs and Morgan Stanley, the Treasury is sitting on unrealized profits of $934 million.
If these companies return to their 52-week high in the next five years, the unrealized profit will be $3.5 billion. When combined with the net positive cash flow of the dividends, the total gains to the Treasury will be $6.5 billion on a $20 billion investment. Not too shabby.
The Treasury went into these investments with its eyes wide open.
If you are a bank starving for capital, sorry, they cannot help you. If the TARP plan was really welfare, the 21 banks that have failed to date would have been first in line to get checks.
And as a closing point, the real name of the program is the Capital Purchase (not bailout) Program.
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