Treasury plan to buy bank stakes carries risks

John W. Schoen Senior producer • Profile • E-mail

Faced with the continued unwinding of the global financial system, the Treasury is opening a new front in its battle to right the banking system. By buying stakes directly, the government would immediately bolster banks’ capital foundations. But such a move — as the details of how it will be done are still sketchy — carries its own set of risks.

Treasury Secretary Henry Paulson said Wednesday that the financial bailout bill approved by Congress gives him wide authority to inject capital into the banking system. The White House confirmed Thursday that could include having the government take a direct ownership stake in banks.

The move follows action by the British government Wednesday to spend hundreds of billions of pounds to rescue its banking system.

In just the past few weeks, the contraction of lending has accelerated. Banks are unwilling to lend to each other out of fears that the borrower may be the next institution to fail. As the global lending machinery slows, the economy slows with it. The longer it takes to get money flowing again, the greater the risk of a deep and prolonged recession.

The plan would have little immediate impact on the safety of individual deposits. The Federal Deposit Insurance Corp. recently raised insurance limits individual accounts. But that may not be enough to calm nervous depositors — who may decided to move money to countries with unlimited guarantees on bank deposits.

“Internationally several countries — Germany, Ireland, and so forth — have guaranteed all deposits,” said William Seidman, “We'll have to see if that drains money out of the United States.”

The Treasury’s investment of billions of dollars indirect ownership of banks would constitute a stunning reversal of the government’s policy of minimal intervention in free markets. Much of the opposition to the $700 billion financial bailout came from Republicans who opposed using tax dollars to backstop failing financial institutions

Supporters of the idea, including Sen. Charles Schumer (D-NY), who chairs the Joint Economic Committee, said having the Treasury buy stakes in banks could insure that taxpayers benefit later.

"When the market recovers, the federal government would profit," Schumer said.

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The idea is not without risks. If banks turn over stock to the government, it dilutes the value of shares already held by investors. Lowering value of already-battered bank stocks could put greater pressure on lending.

“If they're going to go in with an injection of capital into banks where the taxpayer is going to profit from that, that drives down equity capital in banks,” said David Malpass, a senior Treasury official in the Reagan administration. “It's a giant sucking sound away from bank equity and away from bank equity capital and from lending. Banks won't lend.”

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