Dear Charles, this isn’t the best answer, it was the easiest.
Here is Senator Charles Schumer’s WSJ Op-Ed today.
Here is the key point in it:
The administration’s initial approach to the crisis was to propose buying troubled assets from banks. But direct capital injections into financial institutions — modeled on the Depression-era agency, the Reconstruction Finance Corporation (RFC) — always offered a far better prospect of success. The RFC provided fresh capital to banks and restored confidence (and lending) to the U.S. banking system, while making a small profit.
I pointed this out on the Senate floor a few days before Mr. Paulson came to Congress to ask for authority to spend as much as $700 billion to buy up troubled assets. Later, Democratic leaders Sen. Chris Dodd, Rep. Barney Frank and I made explicit our desire to make direct infusions of capital a part of the approach to solving the crisis during our negotiations with the Treasury.
The benefits of this approach are clear, which is why so many economists, both liberal and conservative, have embraced it. More than a liquidity problem, today we face a solvency problem. History has shown that under such conditions, the most effective means to restore health to the financial system is large injections of capital — which only the government has the wherewithal to make.
Capital infusions are also far more efficient than purchasing assets. Banks can lend much more if their capital bases are restored, and when they dispose of their troubled assets, private markets, not the government, will fix the price.
There is little question that making the government a major investor in American banks raises thorny questions, especially about the role of the public sector in private markets. So let me be clear — this is a temporary solution to an unprecedented crisis, and the government’s role must be limited.
However, that does not mean the government should simply make investments with no or minimal restrictions. We must operate in the same way any significant investor operates in these situations — when Warren Buffett invested in Goldman Sachs and General Electric in recent weeks, he demanded strict, but not onerous terms. The government must be similarly protective of taxpayer interests, without involving itself in daily operational decision making. I believe there are a series of steps and principles, both carrots and sticks, that must be applied if Treasury embraces this approach.
The government should encourage widespread acceptance of capital injections, and mandate it where there are clear systemic risks.
Direct injections of capital will encourage all institutions to lend again. But because depositors and creditors may interpret an injection of government capital as a sign of weakness, we need to start by persuading a substantial cross section of major banks, even those in relatively good health, to accept capital. Widespread bank participation will reduce the risk that depositors may flee or that other institutions will refuse to do business with banks that accept or request public capital.
So, what about the ratio he talks about….
Here is a good definition of the “Tier 1 Ratio:
The Tier 1 capital ratio is the ratio of a bank’s core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country’s Central Bank). Most central banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.
A good definition of Tier I capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can’t be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are, as they are held by the bank, by their nature not an amount of money on which anybody but the bank can have an influence on.
Tier 1 capital is also seen as a metric of a bank’s ability to sustain future losses.
In short, there are two ways to look at it. You either increase the equity portion of the ratio, or reduce the debt. Either improves the ratio. Now, I would argue that just raising the equity portion will not do the trick. Why? Many banks already have capital ratio’s far about the legal limit yet still are not lending. Why? The bad debts they have that still cannot be fully valued are causing the debt portion of the ratio to rise and remain unacceptably unstable.
Adding capital to the banks now does NOT “encourage them to lend”. It does assure they will not fail and does let management know it has ample capital to cover future expected losses. Neither of those “encourages lending”. Rather they encourage management to “sit pat” until they have a handle on losses and things “work themselves out”. This is opposed to them running around searching for capital injections like they are now. Removing the debt would have stabilized (even diminished) loan losses AND freed up currently reserved capital being held to cover anticipated losses. Bank management then assured of its situation, would then have begun lending.
In short, removing the bad debt would have encourage lending.
While Schumer does opportunistically mention he terms Bekshire’s (BRK.A) Warren Buffett got from Goldman Sachs (GS). He also does, I think dishonestly omit Buffett enthusiastically not only supported the original plan (buying of debt), but offered to take 1% of the assets ($7 billion dollars worth). Why? It kept the gov’t out of private business and Warren was more than confident the transaction would be profitable for the tax payers and by default, Berkshire’s shareholders.
Schumer also omits this “capital infusion plan” is essentially what the Japanese did during the 1990’s. What happened? A decade of economic malaise as banks simply sat on the money. Having the gov’t as a partner only encourages the most benign of business practices. These are not conducive to economic growth.
Why wasn’t the debt purchase plan done? Timing. It would have been very difficult and time was a factor. The setting up of auctions and the implementation of it would have been a bureaucratic nightmare. Paulson and Bernanke took the capital infusion option not because it was “the best idea”, but because it was the “best idea we can do today”.
If you read the Treasury’s term sheet and watch the Paulson video here, it is clear that Paulson does not think this idea is the best one, just the one we can do this minute.
Had the market not cratered last week, this plan would not have been unveiled.
The following bank have already agred to the program: Goldman Sachs Group Inc. (GS), Morgan Stanley (MS), J.P. Morgan Chase & Co. (JPM), Bank of America Corp. (BAC), Merrill Lynch (MER), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Bank of New York Mellon (BK), and State Street Corp. (STT).
None of these banks were in danger of being below required capital ratios…
All have uncertain loan losses coming up….they still do…
What this plan did as diminish irrational fear in the market banks were going to fail. You saw that relief in yesterday’s rally. What it will not do is lead them to increase lending dramatically and that will hamper any economic recovery. That is where we sit now
I hope Schumer is as willing in the future to step up and take credit for the economic flaccidity this plan will induce just as eagerly as he was today in standing up to take credit for its implementation.
Disclosure (“none” means no position):Long WFC, C, GS, none
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