News Analysis - A Winner for Treasury? Time Will Tell - NYTimes.

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October 15, 2008

NEWS ANALYSIS

A Winner for Treasury? Time Will Tell

By FLOYD NORRIS

The Treasury Department will make substantial profits on its investments in banks under the
bailout program announced Tuesday — if the banks return to health within a few years. If not, the
government could end up breaking even, or perhaps even lose money.

In a number of ways, Washington’s proposal comes with fewer strings attached than the rescue
plans in European countries. That would seem to place the American government at a
disadvantage, but Washington could benefit if that relative leniency helps banks recover quickly
and provides a big profit on the equity stake it is receiving.

Whereas some European plans barred banks from paying dividends on common stock until the
government got its money back and demanded promises that the banks would keep loans flowing
to businesses and individuals, Washington allowed the banks that it invests in to continue paying
dividends on existing common and preferred shares.

In addition, while European banks are being required in some cases to put government
representatives on their boards, the American government will not receive board seats or have
voting power.

Those differences were reflected in stock market reactions on Tuesday. Shares in the British banks
that are being partially nationalized fell, as investors adjusted to the fact that it could be years
before dividend payments are resumed. Share prices in American banks generally continued to
rise as details of the Treasury’s plan became known.

Under the American plan, the government is guaranteeing new loans to banks — and planning to
collect a fee for doing so — and it is planning to invest $250 billion by buying preferred stock from
banks. That stock will come with warrants that give the government a chance to earn big profits if
share prices recover.

The American plan provides both a carrot and a stick to encourage banks to repay the government
as soon as possible with money they raised by selling shares to private investors.

The carrot allows banks to cut in half the number of common shares the government will
eventually be able to purchase. That can be done if a bank sells stock by the end of 2009, and
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News Analysis - A Winner for Treasury? Time Will Tell - NYTimes.com 10/15/08 1:40 AM

eventually be able to purchase. That can be done if a bank sells stock by the end of 2009, and
raises at least as much cash as the government is investing.

“If they can replace government capital with private capital, there will be much less dilution to
existing shareholders,” said Robert Barbera, the chief economist of ITG. “That is important to
current shareholders.”

Meeting that 2009 deadline may be a challenge. Economies in the United States, Europe and
Japan appear to be in recession, and many economists think the declines will continue well into
2009. The extent to which banks will be able to regain investor confidence before the economy
recovers — reducing the number of loans that are not being paid — is open to question.

The stick comes from the terms of the preferred stock. For the first five years, the Treasury will
receive 5 percent interest, a rate not too far above what the government itself was paying to
borrow a few months ago before financial panic caused investors to gobble up Treasuries as a way
to avoid risk.

After five years, if a bank has not been able to repay the government, that interest rate will leap to
9 percent, and stay there until the money is paid back. There is no deadline for the repayment, but
the government may sell its stake to private investors, assuming there are any who wish to buy it.

One important determinant of how well the American government does financially will be whether
it makes wise choices regarding which banks to invest in. It has not promised to let all banks into
the program, and it has not announced the criteria it will use.

Should banks fail despite the capital injection, the Treasury would be likely to lose most, if not all,
of its investment. The government would be treated the same as other preferred stockholders, who
generally suffer major losses in bank failures.

Another possible break for the banks is that the exercise price for the warrants will be the average
common share price for the 20 days before the government makes its investment. That means
that the price will reflect investor knowledge of the plan. If it continues to be favorably received by
investors, that could mean the banks get higher prices for their shares than they would if the price
were fixed today.

One index of regional bank stocks has risen 10 percent this week, with some banks that had been
deemed among the most vulnerable doing even better.

The government will receive warrants equal to 15 percent of its investment. For a bank that gets a
capital infusion of $10 billion, that would mean the government could buy $1.5 billion of common
stock. If that bank had an average share price of $20 a share during the period before the deal was
concluded, that would give the government the right to buy 75 million shares at that price.
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News Analysis - A Winner for Treasury? Time Will Tell - NYTimes.com 10/15/08 1:40 AM

concluded, that would give the government the right to buy 75 million shares at that price.

If the stock was trading at $30 a share when the warrant was exercised, that would give the
government a profit of $750 million.

However, if the bank managed to raise $10 billion in a stock offering before the end of next year,
the government would only be able to exercise warrants for half the shares, or 37.5 million in this
example. That would cut the government’s possible profit in half.

In some cases, smaller banks will get a sweeter deal. If the preferred shares are issued by a bank
holding company, they must be cumulative, meaning that if the company misses a dividend it
must eventually make it up. But individual banks not in holding companies, generally smaller
institutions, will be allowed to issue noncumulative preferred stock. Such companies could halt
dividends for one or more quarters, and then resume them without having to make up the missed
dividends.

Only if a bank has missed dividends for one and a half years would the government be able to
claim spots on the board.

By forcing nine major banks to “volunteer” for the program, and by making it possible for them to
suffer relatively little dilution if they can reassure investors by the end of next year, the Treasury
Department hoped to remove any stigma that would be attached to participating in the program.

How well it succeeded will become clear as more banks announce that they have signed up and
receive capital infusions. If markets react by bidding up the share prices of those banks, the
Treasury will have scored an early victory.

But the final verdict will not be rendered until all the money has been repaid, or lost. At best, that
number will not be known for several years.

Copyright 2008 The New York Times Company

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