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U.S. Treasury Funds: Hidden Intentions or Seat-of-the-Pants Management?

October 31st, 2008 by John Eastman

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It is widely known that the U.S. Treasury is funneling money to commercial banks through what some economists and analysts call a bank nationalization effort. The Treasury has, in some instances, taken an equity stake in an outright takeover and, in other instances, offered an availability of funds in exchange for preferred shares and restrictions. In addition to its objective of stabilizing banks and building confidence in the minds of depositors, the Treasury’s goal has been to loosen up credit and liquidity for inter-bank lending, subsequently making available funds to loan to customers. With the nation’s businesses so dependent on credit, a stranglehold on it can literally stop business activity in its tracks. It is important to acknowledge that these actions were not on the list of publicized objectives of the Federal Reserve when it sought $700 billion in funds from the U.S. Congress for the plan. The majority of discussion was focused on the government’s measure to purchase the toxic securities in the banking system, hold them until the market’s recovery, and then resell them, hopefully, at profit or in the worst case, breaking even. The idea was to remove the toxic securities from the system in order to free up credit and liquidly in the banking system, for the banks to ultimately begin lending again. When the economic situation across the world begin to collapse at a much faster and alarming rate, the Federal Reserve then decided it would use the $700 billion in other ways as well: directly becoming a shareholder of some banks, again designed to provide liquidly for lending to customers. This aspect of the strategy was a European one, adopted by the U.S. and led by actions of the UK.

At the bequest of Treasury Department, the banks began to accept funds. The Treasury has reportedly bought $25 billion in preferred stock from Bank of America, J.P. Morgan, Citigroup, and Wells Fargo & Co.; $10 billion from Goldman Sachs Group Inc. and Morgan Stanley; $3 billion from Bank of New York Mellon; and approximately $2 billion from State Street Bank.

At that time, banks were, in fact, not willing to lend to each other or to businesses and consumers, for fear of not recovering their funds. The early indications and efforts of injecting funds into banks has had no sudden impact on lending.

Then along came the PNC Financial Services and National City Bank transaction. National City had been long rumored to be in trouble with real estate related loans. They were reportedly talking to the Treasury about acquiring $5.5 billion in funds to use to stay afloat. PNC was in a better position– it was financially healthy and its exposure to real estate loans and securities was minimal. In an unprecedented move, PNC took $7.7 billion in federal funds and used roughly $5.5 billion to acquire National City Bank. The Treasury Department announced that it supported the deal and declared it an acceptable use of funds as PNC was rescuing a financial institution that had the potential to fail and have to be bailed out by the government.

The use of funds– originally intended for purchasing toxic securities, freeing up liquidity, and then being channeled to directly take a position in banks– is now being used by banks to acquire competing banks. There are no objectives for increasing lending, and spurring economic activity, the lifeblood of the economy. In fact, in the mix of the bailout plan legislation is a benefit that enables banks acquiring other institutions to benefit significantly by being able to deduct the acquired bank’s losses immediately against the transaction– an enticing concept that encourages acquisitions. Tax expert Robert Willens notes “It couldn’t be clearer if they had taken out an ad.”

One has to question whether these intentions were on minds of the Bush Administration and Hank Paulson, and simply could not be sold to Congress, so they were omitted, or whether they did they not see the new use of funds by commercial banks to acquire competitors as likely. Either way, it is a disturbing situation. One implies that they mislead Congress and sold a bill of goods with other intentions. The other is that they were inept and are simply managing by the seat of their pants.

So the question naturally is: do banks that take federal funds to stay afloat have any intention of using the money to make new loans? We hear every day that banks are actually tightening credit policy, demanding more collateral, wanting more leverage from their customers, and in some cases, even pulling in credit lines altogether. While the idea of taking a position and injecting capital directly came from the UK, the U.S. version does not mandate that accepting institutions actually lend the money that they have accepted. So for now, they simply are not.
Even more concerning is that Paulson came from Wall Street himself; he is the former CEO of Goldman Sachs. Is this not unlike what happens when you put the prisoners in charge of the prison?

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