The more likely effect of the Treasury equity infusion

It’s becoming more evident that the most useful effect of the US Treasury’s capital infusion into the banks is not to jumpstart lending, but to enable these banks to attract more private capital. Illustrating that the infusion is not likely going to result in more immediate lending, here’s a New York Times article.

On Monday, Mr. Paulson unveiled plans to provide $125 billion to nine banks on terms that were more favorable than they would have received in the marketplace. The government, however, has offered no written requirements about how or when the banks must use the money.

The banks could use the money from the government for any number of things. Some analysts say the banks may use it to acquire weaker competitors. Others say they might use it to avoid painful cost-cutting. And still others say the banks may sit on the capital.

Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts said that trend was unlikely to be reversed by the government’s money.

“I don’t think that the market wants to see that capital being put to work to leverage the business up again,” said Roger Freeman, an analyst at Barclays Capital. “My expectation is it’s quarters off, not months off, before you see that capital being put to work.”

“It’s clear that the government would like us to use the capital,” Mr. Dimon (JP Morgan) said on a conference call with analysts on Wednesday. “If you are a bank that is filling a hole, you obviously can’t do that.”

Bank of America said in a statement that the money “will add to our capital, which will increase our capacity to expand our balance sheet and make more loans.” It did not say if it was willing to increase its lending.

“We will have the opportunity to redeploy that,” Mr. Thain (Merrill Lynch) said of the new capital on a telephone call with analysts. “But at least for the next quarter, it’s just going to be a cushion."

However, given that these banks now have more cushion against further possible writedowns, it is now possible for new investors from the private sector to come into these banks without fear of being wiped out.

And as this article from Bill Poole indicates, it is in the interest of these same banks to seek new private capital, to be able to buy out the government as soon as possible.

Banks will not want to play this game. Treasury's new program provides that a bank can exit by repurchasing Treasury shares with newly raised private capital. Given the program's distasteful features and future dangers, banks may want to exit as soon as they can to escape potential federal intrusion into their lending practices.

Bill Poole argues that not using the infusion to immediately increase lending is justifiable, and prudent.

Some banks need more capital not to expand lending, but to shore up the existing balance sheet. It would be a terrible mistake for Treasury to direct banks participating in its capital-infusion program to expand credit in particular directions, or in the aggregate. Exhibit A: Fannie Mae and Freddie Mac, both now wards of the state. Do we need further exhibits? Federal credit allocation will be an unmitigated disaster.

Treasury Secretary Hank Paulson was quoted by Bloomberg on Tuesday as saying that "leaving businesses and consumers without access to financing is totally unacceptable." Actually, it is perfectly acceptable to leave certain businesses and consumers without access to credit. Everyone understands that we would be a lot better off today if the market had denied mortgage credit to many subprime borrowers.

Treasury chose to infuse healthy banks first because unhealthy banks were not likely to volunteer themselves as participants in the plan, given that the move itself is a red flag to its own depositors and investors.

Because participation carries terms objectionable to banks, such as limits on executive compensation, only weak banks will want to participate willingly. If some banks participated and others did not, those who did would be in effect declaring they were weak and scaring away depositors and investors.

The stigma argument does carry some weight. But the way to deal with it is for participating banks to raise private capital as well as Treasury capital -- so that they can demonstrate that they are unquestionably solvent and strong. One way to demonstrate strength would be to hold capital clearly in excess of the regulatory minimum.

You can be sure that the first banks to raise private capital and get out of the Treasury plan will be the ones most likely to thrive when the crisis has been contained. Just don’t expect them to start a massive lending program anytime soon, and never at the same licentious levels as before.

More likely, The Fed's decision to pay interest on reserves will be more effective in stimulating lending, albeit among banks. By paying interest on all bank reserves placed with the Fed, the Fed is now using the reserve as a way to mop up excess liquidity from the financial system. In today’s credit contraction environment, this allows the Fed to collect the excess liquidity that is otherwise not being lent out by banks, and use it to lend to those banks needing Fed loans. By using the liquidity that is already out there, but trapped within each bank, it minimizes the Fed’s need to increase money supply every time a bank uses the discount window. Voila, the Fed is now the conduit bringing back inter-bank lending.