To TARP or Not to TARP - This is the Question

CEOs of large and small banks alike are wrestling with the question: should they avail themselves of a piece of the government's $125 billion of capital offered to them? Unlike the nation's largest 9 banks, they have a choice in the matter.

Answering this question isn't easy, particularly given the countless uncertainties associated with the plan. A recent conference call with 35+ SuperCommunity bank CEOs confirmed that the vast majority of executives are deeply concerned about the unknown elements of the program.

Below is an attempt to outline some of the pluses, minuses and unknowns we are all facing. I hope the laundry list will help you determine whether TARP is for you.

Positives

  • TARP will strengthen the banking system, which is a good thing for all of us. Customer jitters have exceeded expectations, as evidenced by the tapping out of Treasury issues (and their price) as well as customers' flight to quality (or interest-free DDAs, now temporarily fully insured).
  • The recession is upon us, but none of us knows how deep or long it will go. Excess capital will help everyone weather the storm better.
  • Banks can't get capital on better terms today, and some can't get it at all. The financial aspects of the plan are very attractive (5% for 5 years, then 9%, callable in 3 years etc.), notwithstanding the $64 billion dollar question: what will the government do next, once its nose is inside our collective tents?
  • TARP will provide stronger banks (it's only available to banks with CAMEL ratings of 1 and 2, and, on a case-by-case basis for 3 rated banks), with excess capital that will facilitate their buying weaker banks and thereby further rationalizing the system.
  • Capital availability overall is questionable. Even if one is willing to accept draconian terms, such as double digit dividend rates, generous board seats and huge ownership dilution, capital might still not be available.
  • The temporary capital glut can be EPS neutral through a securities purchase program in the short term, until better uses for the capital emerge.
  • Your first loss is your best loss. TARP money can help some banks truly come to grips with their asset quality and securities market valuations and further write down their assets to a more realistic level.
  • It is unclear whether not taking the capital will result in negative stigma to the bank.
  • The financial system is getting re-intermediated, with $2.5 trillion of loans that were in SIVs, CDOs etc. coming back on banks' balance sheet. You need the capital to absorb your fair share of the credits.

Other Considerations

  • It'll take growing the securities portfolio 3-4 times to make the excess capital neutral/cover the cost. It's a significant medium-term commitment.
  • Availability to sub S banks is unclear. My expectation is that they will be able to access the capital.
  • It this a fair deal to those banks who have run a strong balance sheet thus far? Isn't this supporting weaker banks unfairly? What about free market and Darwinistic capitalism?
  • Are you delaying the failure of any bank whose deposits are worth buying 4-5 years hence?
  • Do you want to be the CEO who missed the opportunity?
  • You may become acquisition bait if you didn't take TARP funds and another bank with capital did.
  • Unintended consequences...

Negatives

  • The money is callable only after 3 years; who knows what will happen between now and then?
  • Rating agency treatment is uncertain, despite their demise, their opinion still counts
  • Known activity limits include:
    • no share repurchase;
    • no golden parachutes;
    • no 280G treatment to senior executives' compensation during change of control;
    • no dividend increase without approval of Treasury for three years;
    • no tax deductibility of executive compensation above $500K;
    • no golden parachutes
  • Equity markets might be very inefficient in 3-5 years when it's time to replace the capital. There will be a flood of capital issued which will impact pricing and market capacity to absorb, pricing etc.
  • This might be only the beginning, a harbinger of more government intervention.
  • Timing of unwinding the leverage position might also create temporary but critical pricing aberrations.
  • The government retains the ability to transfer its warrants at any time, flexibility that might imply lack of control over your own destiny.
  • The government can always change the rules.

To summarize, the pluses are:

  • Cheap capital
  • Strengthen regulatory capital ratios
  • Peer pressure
  • Cushion in uncertain economic times
  • Enhances strategic flexibility

The minuses are:

  • Limitations on business
  • Limitations on CEO compensation
  • Some banks don't need it
  • Uncertainty as to final terms and future changes

Obviously, every bank has its own unique issues and opportunities to consider. Only you know how deep is the hole within your assets, and whether you have enough capital to fully handle it. Some banks, most notably recent IPOs, have more capital than they can currently deploy, and have no use for additional cushion.

At the same time, we should recognize that we live in unprecedented times. What we are seeing these days are phenomena that have never occurred before, and therefore we can't predict how they will get resolved. This is true not only regarding the precipitous rise and fall of the residential real estate market, the melt-down of the secondary market for mortgage instruments within hours and the evaporation of robust, deep markets such as the Trust Preferred market literally overnight. This is also true for other key financial instruments that reflect the extraordinary unpredictability we've had to deal with in recent months, such as the swap curve, which so many banks use as a central indicator in their asset/liability management. The 5 year swap to Treasuries is at an all time high, while the 30 year is at an all time low, and has, for the first time, reflected a negative spread to Treasuries. We are seeing behavior in the financial and derivative markets that was professed to be impossible, both by market forces and by mathematical calculations.

This level of uncertainty requires extraordinary protective measures from all of us. It might be time to say, there is no such thing as too much capital... at least not in the short term!