I’ve posted here previously about the historic times we are living in.  Well, Tuesday, October 14th, 2008 will be no exception.  The US Treasury has decided to buy preferred shares in the major US banks… and it’s not really optional.  From the New York Times piece:

The Treasury Department, in its boldest move yet, is expected to announce a plan on Tuesday to invest up to $250 billion in banks, according to officials. The United States is also expected to guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers, officials said.

Here is some more detail on the banks affected:

Treasury Secretary Henry M. Paulson Jr. outlined the plan to nine of the nation’s leading bankers at an afternoon meeting, officials said. He essentially told the participants that they would have to accept government investment for the good of the American financial system.

Of the $250 billion, which will come from the $700 billion bailout approved by Congress, half is to be injected into nine big banks, including Citigroup, Bank of America, Wells Fargo, Goldman Sachs and JPMorgan Chase, officials said. The other half is to go to smaller banks and thrifts. The investments will be structured so that the government can benefit from a rebound in the banks’ fortunes.

And lastly, for those curious, the terms of the new preferred paper:

Bringing together all nine executives and directing them to participate was a way to avoid stigmatizing any one bank that chose to accept the government investment.

The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock. For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.

Some of the more egregious issues, however, will be addressed with executive compensation and corporate finances:

But officials said the banks would not be required to eliminate dividends, nor would the chief executives be asked to resign. They will, however, be held to strict restrictions on compensation, including a prohibition on golden parachutes and requirements to return any improper bonuses. Those rules were also part of the $700 billion bailout law passed by Congress.

This plan has some negatives to it – primarily the forced capitalization and potential costs to banks that might not have needed these terms to be successful.  However, given the collective risk of a failing bank system, that cost is likely worth bearing.

Long term, I hope that if we do decide to make executive compensation a regulated affair, that we apply it consistently across industries.  It does no one any good to have executives biased away from finance as a career option.

Overall, there is a lot to like in the current plan, as it eliminates the stigma of government help, and should effectively recapitalize banks in the short term.  More importantly, it puts some detail around how the government could continue to help capitalize the system without socializing it.

That is not intended as a snarky title.  We are seeing the full power of the Fed come to bear in this financial crisis.  There is a reason why they have said for decades, “Don’t fight the Fed”.

The Fed’s power comes from the ability to almost limitessly create assets and money supply, with a charter to do so.  As long as the Treasury cooperates, the Federal Reserve effectively has the full balance sheet of the United States to work with.  And that’s a big balance sheet.

A lot of noise was made in the past months about the “limited” firepower of the Fed.  After all, they technically had assets of only $800B in Treasuries as of August 2007, and we’re dealing with a problem measured in trillions.

The Econoblog has a great post today on how the Federal Reserve balance sheet has shifted, particularly in the past 30 days.  It’s fairly wonky, but if you are into how modern money supplies are managed, I haven’t seen a better article:

Econobrowser: Balance Sheet of the Federal Reserve

You can read it for yourself if you are interested, but the short story is that the Federal Reserve has inflated its balance sheet to over $1.5 Trillion, with a lot of that growth happening in the past few weeks.

Check out this graph, from MacroBlog:

At this point, Bernanke and Paulson are basically calling in all the King’s horses, and all the King’s men.  Let’s hope they can put Humpty Dumpty back together again.

One fun fact – the amount of reserves that banks are now sitting on – not lending, not converting to cash, but just sitting on is approximately 2.5x the amount that got locked up post-9/11.   Unprecedented.