Aggressive recapitalization of world's banking system:
US follows European lead
By Jon Fernquest |
Recapitalization of banks is now the centerpiece of the new US strategy for stemming the current global financial crisis.
This change in strategy follows aggressive steps taken by European states last week to stem the growing financial crisis.
Acting in unison is necessary to prevent any one state from lagging behind and losing funds to other states with more promising rescue plans (beggar thy neighbor policy).
The US government plans to take equity stakes in US banks. Up to $250 billion in preferred stock will be purchased, half in the nine largest banks and the other half in thousands of smaller banks (See list of the nine large banks below on right).
The plan is aimed at unfreezing credit markets and getting banks lending to each other again as well as to households and businesses. None of the banks really had a choice about their participation in the plan. Limitations on executive pay will also be part of the plan.
There are incentives in the plan for these banks to raise their own capital and to leave the plan as soon as possible:
The government will purchase preferred stock, an equity investment designed to avoid hurting existing shareholders and deterring new ones. Such shares typically don't come with voting rights. They will carry a 5% annual dividend that rises to 9% after five years...The government will also receive warrants worth 15 percent of the face value of the preferred stock. For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.
Senior debt issued by banks over the next three years will have the option of a government guarantee:
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Among the other key components of the plan: The FDIC is expected to offer to temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts. This would apply to debt issued by June 30 with maturities up to three years. One problem plaguing credit markets has been a fear among financial institutions that it is unsafe to lend to each other even for periods of a few days. U.S. officials hope this guarantee removes that fear, which could bring down short-term lending rates, such as the London interbank offered rate, or Libor, a benchmark for consumer and business loans.
New deposit insurance
The US government is also increasing deposit insurance much like many European states did last week.
The US Federal Deposit Insurance Corporation (FDIC) will "offer an unlimited guarantee on bank deposits in accounts that do not bear interest."
This measure is to stem small businesses with deposits over the deposit insurance limits shifting funds from smaller banks that they consider risky to larger banks they consider more stable (bank run). The FDIC's raising of the deposit insurance limit earlier this month to $250,000 extended insurance coverage to 68% of all small business deposits. The new rules will cover the remaining 32%.
Vocabulary:
deposit insurance - if the bank fails you will still get some or all of your money back
Federal Deposit Insurance Corporation (FDIC) - the US government that insures bank deposits up to $100,000 (See Wikipedia)
bear interest, accounts that bear interest, interest bearing accounts - if you keep you money in these bank accounts you get paid a percentage of the money in your account every year (interest)
a bank run - when many bank depositors suddenly take fright and try to withdraw their money from a bank (See Wikipedia)
Not the first bank nationalization in US history
The US government programme to rescue banks during the Great Depression was roughly the same size:
The nearest precedent for the Treasury plan...are the investments made by the Reconstruction Finance Corporation in the 1930s. The agency, established in 1932, not only made loans to distressed banks, but also bought stock in 6,000 banks, at a cost of $1.3 billion, said Mr. Sylla, the N.Y.U. economist. A similar effort these days, in proportion to today’s economy, would be about $200 billion [today]. When the economy stabilized eventually, the government sold the stock to private investors or the banks themselves — and about broke even...(Source: New York Times, link)
Vocabulary:
nationalization - when the government becomes owner or part owner of private companies
the Great Depression - a worldwide economic downturn that originated in the United States in the stock market crash on October 29, 1929, known as Black Tuesday. The end of the depression in the U.S. is associated with the onset of the war economy of World War II, beginning around 1939 (See Wikipedia)
Reconstruction Finance Corporation - an asset management company owned by the US government that sold off real estate loans of banks (actually "Savings & Loan Associations) that failed during the US Savings and Loan Crisis of the 1980s (See Wikipedia)
a precedent - a case when it happened before
broke even - didn't lose money or gain money
(Source: New York Times, business, 14-10-08, link)
Vocabulary:
recapitalization of banks - adding equity to a bank (banking laws require banks to have a minimum amount of equity or capital backing the money they loan out, so if new loans are to be made bank recapitalization is needed)
equity, owner's equity, capital - the value of the owners' investment in a company, assets - liabilities = equity (the difference between the market value of a company (assets) and the claims (liabilities) held against it)
a stake - owning part of something
an equity stake - being one owner of a company (perhaps several owners)
take an equity stake - buy part of a company
the centerpiece of Y - the main and most important part of Y
stemming - stopping or reducing
aggressive - acting quickly and forcefully as if determined to succeed
aggressive steps taken - quick and forceful actions were taken to solve the problem
acting in unison - acting together at the same time
lagging - behind, not at the same level
a beggar thy neighbor policy - a policy that solves economic problems in one country but makes problems in other countries worse (See Wikipedia)
incentives - rewards to encourage people to behave in a certain way
common stock - stock shares that receive a share of the profits (dividend rights) and can vote to select the board of directors to govern the corporation (voting rights)
preferred stock - stock shares with dividend rights that are higher priority than common stock but no voting rights
warrants - an option to buy securities (the right to purchase shares or bonds issued by a company at a specific price within a specified time)
senior unsecured debt - debt that has the right to be paid back first (senior) and has no assets to be taken if money cannot be paid back (security)
Libor, the Libor rate - the most important inter-bank lending rate that drives other interest rates (See Wikipedia)
a benchmark - a value used to measure other values against (an additional amount is added to the "benchmark" Libor interest rate for borrowers who are riskier than banks)
