Bailout part 2

The U.S. Treasury has changed course and is investing directly in banks. Retail banks are typically levered 10 to 1, meaning $10 of debt per dollar of equity, equity being retained earnings or direct investments. The government is purchasing preferred stock in all the major US banks, which goes directly to equity. In theory, this will enable each bank to lend out up to 10 times the amount invested.

Preferred shares pay dividends to the owners, which in this case are US taxpayers. The terms are not punitive to existing shareholders, but they do protect the taxpayer. Additionally, there are some executive compensation restrictions for banks who participate (and the large banks like Bank of America, Citigroup and JP Morgan don't have a choice but to). The restrictions look fairly reasonable. Other banks may apply to participate. The Treasury decided to force this on the largest banks so as not to give the impression that any one of them is weak and spark a crisis of confidence.

The government will be using $250 billion to do this. Presumably, purchasing dodgy assets is still an option on the table. It turns out that it was the right thing for Congress to decide to give the Treasury the option to do this; Paulson initially requested authority only to purchase dodgy assets. Even if Congress had immediately signed off on Paulson's original request, it doesn't look like the Treasury would have been able to move fast enough so that Paulson's less invasive original plan would have sufficed. It was unclear what assets the Treasury was going to buy and what it might pay. It could have taken too much time to decide that. Investing directly in the banks was a lot quicker; it looks like Paulson just called everyone in and got them to agree.

At present, I think the plan looks reasonable. It remains to see what the effects will be. The Dow may have been up 900 points yesterday, but over short periods the markets can react in unpredictable ways.

Edit: The preferred shares yield 5% for the first 3 years and 9% thereafter. This encourages companies to redeem the shares. The government also gets warrants to purchase a certain number of shares at current market prices. This essentially means taxpayers get the opportunity to profit some time down the road - assuming nothing goes horribly wrong.

5% is below the rates that banks were able to borrow at before the crisis. The US government is able to borrow lower than that, though, so this part of the program is generating a small return. The US Treasury's website shows that the US government would be paying around 2% if it issued new 3 year Treasury bonds.