Big Bucks Not Just for Big Banks

publication date: Oct 18, 2008

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author/source: John Fredericks / STAFF

How the $700B Bailout is Designed to Trickle Down to Local Businesses

By John Fredericks / STAFF

Editor’s Note: This is the first part in a two-part cover series exploring the impact of the national economic downturn on the North Fulton economy. Next week we will look at how local banks plan to take advantage of the bailout and how other local businesses are dealing with the crunch.

HOW IS THE BAILOUT SUPPOSED TO WORK?
The much maligned $700 billion economic bailout package passed earlier this month by Congress was sold by the Bush administration and their Treasury Department to a reluctant Congress as a necessary antidote – a poison pill of sorts – to stem the looming economic crisis and provide critical capital to banks to increase their ability to loan money in the marketplace. 

Treasury Secretary Henry Paulson maintained that failure to pass the legislation would extend the crisis to mammoth proportions and cause Draconian economic measures down the road. He even went so far as to predict another “Great Depression.” While we may never know whether such claims were anything more than hyperbole, we do know that the bailout bill was designed to have far-reaching effects that should eventually hit home for North Fultonites.

Below is a summary of how the bailout is supposed to work – both nationally and locally.

THE BIG PICTURE
Essentially $450 billion of the $700 billion bailout is earmarked for the largest banks and financial institutions in the country. These taxpayer funds are to be used for “buying up bad paper.”

In simple terms, when financial institutions regulated by the Federal Government have to “write down” bad loans that no longer have sufficient collateral to back them up, the discrepancy hits their bottom line and available capital has to be moved from their bad loan reserve fund to cover the difference.

For example, if a Florida condo home buyer has an outstanding loan of $500,000 and defaults, or falls way behind on making payments, then the property securing the loan can be foreclosed on by the bank carrying the note. This is no problem if the property is worth $500,000 or above. But when the market declines and the value of the home is now only $250,000, then the note-holder, in this instance the bank, is hit with a $250,000 loss on its books.

This reversal of fortune impacts their bottom line, their balance sheet and finally their liquidity. U.S. banks have to maintain at least 8 percent of available capital to assets (loans). As losses on bad paper mounts, they have to use their available capital to cover the deficit. The result is that they have less money available to loan out, as their available capital –normally set aside for making loans- has to be used to cover existing deficits instead.

This is where the U.S Treasury Department steps in. The Feds use the bailout money to buy these bad loans from banks so they are removed from their balance sheets and the institutions effected do not have to allocate their available capital to cover them.

That means more money is available for these banks to continue to grow their asset base and loan money to qualified borrowers. The U.S. Treasury Department then owns the property or other collateral originaly used to secure the loan.

The whole plan works for taxpayers if the property they now own appreciates in value.  Staying with the Florida example, if the condo property the government bought for $500,000 that is now worth $250,000 appreciates to say, $550,000 over time, taxpayers actually would make a profit on the transaction. If, on the other hand, it stays the same or declines further, then taxpayers take a loss and foot the bill. The immediate benefit to the economy is the bad loan is off the bank’s balance sheet and they can loan out the money in their reserves to someone else rather than use it cover their losses.

The Treasury has dubbed this the Troubled Asset Relief Program or TARP.

THE LOCAL EFFECT
The remaining $250 billion of the original $700 billion package is allocated to buying preferred stock in national, regional and local banks. This has been divided into two categories – $125 billion for the nine major banks and $125 billion for all the other banks.

THE BIG NINE
In the case of the big nine banks, Paulson strong-armed all of them to sell 3 percent of their asset base to the U.S. government in preferred stock. This means that the government now owns considerable shares of stock in each of these banks.

Paulson’s purpose was to pump $125 billion in capital into these institutions to increase their capital – which would increase their liquidity – and make more cash available to them to loan out. Over time, as their deposits grew, the $125 billion in new capital would likely mean more than 10 times that amount for new loan money, as they typically maintain equity of less than 10 percent of assets. 

REGIONAL AND COMMUNITY BANKS
The remaining $125 billion is allocated to all other banks, many of them local or community banks. The system allows for banks to apply for the program, so it is voluntary, not mandatory, and no pressure is put on them by the Fed to participate.

The stock purchase plan is not available to banks in trouble. It is not a bailout. If a bank applies and gets approved, then they can sell up to 3 percent of their asset base in preferred stock to the U.S government. Stock price for private institutions is set by the price paid for each share by the most recent private investors.

For its trouble the U.S. government becomes a potential major stockholder in that bank and picks up some perks along the way. The Feds get a guaranteed 5 percent annual dividend, their dividends must be received before those of any other shareholders in that bank, and they have an option to buy up to an additional 15 percent of their original shares purchased from each participating bank at any time for the purchase price.

So if the bank thrives and their initial share value appreciates, taxpayers get a windfall.

TRICKLE DOWN EFFECT
Finally, here is how the Paulson plan can impact businesses and consumers in North Fulton County. Take locally operated American Trust Bank, with branches in Roswell, Alpharetta and Cumming, as an example. ATB’s asset base is about $250 million. If they choose to participate in the plan and are approved, they can sell 3 percent of their asset base – or $7.5 million – to Uncle Sam at their average private investor stock price – say $10 per share.

That means the government would be an investor in ATB and own 750,000 shares of their preferred stock. ATB would then take the $7.5 million in new capital and immediately make it available for loans to qualified borrowers.

Over time, as their deposit base grew, that $7.5 million could be leveraged to $75 million in new loans. The key is that $7.5 million is available on day one.

Let’s say ATB was considering three loans for approval on the same day, all meeting their lending criteria. Before the capital infusion from the government they may only have had enough capital to approve two of the three – so one gets turned down. Now they can fund all three.

If you own a business and you need a credit line for Christmas inventory, or if you are a consumer trying to get a car or home loan, and you were number three – you would have been denied the loan. Not because you are a risk, but because ATB – or any bank – simply did not have sufficient capital available to fund it. With the stock sale to the government, now they can. So you get the funds you need.

The downward pressure on local banks is not necessarily due to bad loans or bad management. In a tight credit market with deposit rates relatively high compared to low lending rates, community banks get squeezed. Capital is not expanded – it contracts or dries up.

Now you get the loan, and you buy the car or home, which helps the local inventory supplier, the local car dealer, the local builder and so forth.

ONLY TIME WILL TELL
That is how the plan is designed to work on a local level. It’s too late for some local banks, who will be allowed to die off and be forgotten as nothing more than a casualty of a market correction or just plain bad management. But for others, the availability of fresh capital could be enough to spur a local economy that has already felt the effects of sour economic times.