Investors Should Still Avoid Banking Stocks Despite Bailout

By: Money_Morning

Martin Hutchinson writes: The $250 billion bank bailout announced Monday is a great improvement on the $700 billion Troubled Asset Relief Program (TARP). However, for those thinking of buying bank stocks on the back of it I would point out one thing: Once the government's plan to take equity stakes in troubled financial institutions is implemented, each of the 117 million U.S. taxpayers will have an average of $2,136.76 already invested.

You haven't received Uncle Sam's credit card bill yet.

Under the new bailout plan , the government will invest as much as $250 billion into special preferred stock of the participating banks, and will receive additional warrants for shares equal to 15% of the amount of each investment. The minimum amount invested will be 1% of a bank's total assets, while the maximum will be $25 billion, or 3% of the bank's total assets, whichever is smaller. The preferred stock will be redeemable after three years and will carry a dividend of 5% for the first five years and 9% thereafter.

In addition, participating banks will have fairly mild restrictions on top-management compensation and, in particular, on “golden parachutes.” Thus, it will be attractive for banks to redeem the government preferred stock early – for example, through a share issue of common stock.

The rescue plan contains two provisions that represent improvements on the original TARP (the provisions of which have been fudged to accommodate it):

• First, the money is going directly into banks, recapitalizing worthwhile entities to allow them to rebuild their businesses and lend to productive industry. The TARP, on the other hand, would have invested in troubled mortgage loans, relics of a home mortgage bubble that should never have occurred in a well-managed economy.  In a period of tighter money such as we have entered, every dollar borrowed from the markets and invested in junk assets is a dollar that is not available to finance real businesses.

• Second, the rescue plan will invest in banks via a “ preferred ” stock, which is easy to value, and in most cases can be redeemed fairly quickly. Thus, there is no need for the vast and expensive paraphernalia of 10 investment managers selected by the U.S. Treasury Department to purchase distressed debt. Further, while a few of the recapitalized banks will prove to have really severe problems – and will fail – in the majority of cases, where the bank survives, the taxpayer will not suffer any loss from the investment, and may even see a profit from the warrants. That is in complete contrast to purchasing questionable debt assets, where the Treasury will have no easy way to value them, will be tempted to overpay for them and will have great difficulty collecting value on them, since they will mostly represent tiny parts of innumerable mortgages and other debts. Indeed, having devoted $250 billion to recapitalizing banks, half of which has already been spent, the Treasury would do better to abandon the debt-purchase operation, rescind the second half of the $700 billion TARP- funding request, and simply keep the other $100 billion available for emergencies.

So, should we buy common stock of the banks that the U.S. taxpayer has so kindly rescued for us?  In a word – no. They still have all those lousy assets on their books, and will continue to record losses from those assets. And while the new capital will provide a cushion for creditors against those losses, it won't do anything for existing shareholders. The preferred shares themselves represent fairly expensive funding, especially when short-term rates are below their cost of 5%. Moreover, the attached warrants – doubtless exercisable at a low share price – will further dilute existing shareholders when they are exercised. Finally, bank management's attention will be devoted to figuring out ways of repaying the preferred shares through new capital issues, which are bound to dilute existing shareholders.

In any case, the business of banking itself is likely to be pretty unattractive over the next few years. There is huge overcapacity in the financial-services arena, which needs to shrink substantially from the 40% of Standard and Poor's 500 Index profits that it represented in 2007. The business has actually doubled its percentage of U.S. gross domestic product (GDP) in the last 30 years, and will probably have to shrink most of the way back to its original size, since many of the new innovations represented “rent-seeking” on the part of the financial system – providing no added value to the economy.

At the same time, for a given volume of business, banking organizations of the future will need to carry much more capital. Thus, with revenue depressed and capitalization increased, the operating profitability of the banking business will be low – even once the current troubles have passed.

News and Related Story Links :

• Wikipedia : Preferred Stock .
• Money Morning News : Paulson Announces New Plans to Buy Equity Stakes in Banks and Revive Credit Markets .
• Money Morning News Analysis : While Lawmakers Reach Credit Crisis Compromise, Money Morning Bailout Plan Expert Displays Doubt .

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