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The Troubled Asset Relief Program (TARP) has been called both "socialist" and "insufficient" by critics. Some worry it goes too far, virtually nationalizing the banking industry, while others worry it doesn't go far enough and can't possibly cover the mounting losses at banks. With both extremes upset, I'm inclined to think the federal government may have got this one just right.

If viewed objectively, I would argue the TARP Capital Purchase Program (CPP) has the potential to replenish the capital of the banking system while also earning a decent return for the government.

What the TARP Covers
The TARP CPP, which was announced by the U.S Treasury on Oct. 14, 2008, allows the government to invest up to $250 billion in preferred stock in banking institutions that qualify. The banks must apply by November 15, 2008, and the capital investment is limited to a minimum of 1% of total risk based assets, and a maximum of either 3% of risk based assets or $25 billion, whichever is lower.

The preferred stock pays a 5% dividend for the first five years then 9% after that. The government also gets warrants to purchase stock in the participating banks equal to 15% of the preferred investment.

Who's Buying In
The government invested $125 billion in the nation's nine largest banks when the program was first announced, although many media reports said that the nine were strong-armed into accepting the capital. The balance of the Capital Purchase Program was reserved for regional and smaller players, but it seemed at first that some banks were reluctant to participate in the program, fearing that it would make them look weak. However, over the last week there was a rush to participate with several large regional banks jumping in.

Some approval to sell preferred shares include:

Financial Institution Amount
Fifth Third Bancorp
$3.4 billion
City National
$395 million
First Horizon
$866 million
UCBH Holdings
$298 million
Regions Financial
$3.5 billion

The most immediate consequence of the CPP will be to boost the capital levels of the participating financial institutions since the preferred shares will count as Tier 1 capital when calculating regulatory ratios. City National will see its Tier 1 capital ratio increase to 12% from 9.1%. First Horizon will see its Tier 1 capital ratio go to 14.1% from 10.9%. (Find out how financial institutions calculate risk in How Do Banks Determine Risk?)

The warrants have the potential of providing huge upside for the government once a recovery occurs. The treasury will receive warrants to buy whatever amount of shares equals 15% of the preferred investment. If we use Regions Financial as an example, the treasury will receive warrants to purchase 52.5 million shares at a strike price of approximately $10.50. However, according to the term sheet released by the treasury, these warrants can be reduced by 50% if the bank can raise more Tier 1 capital by the end of 2009.

The banks have plenty of incentive to pay the government back quickly because after five years, the dividend jumps to 9%.

The Downside ... For Executives
There is one downside to the CPP for a participating institution. They must abide by executive compensation and corporate governance standards that were included in the Emergency Economic Stabilization Act of 2008. These standards are:

  • Ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution.
  • Required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate.
  • Prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision.
  • Agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.
Bottom Line
Critics have argued that the TARP CPP is "socialism" and amounts to a takeover of the U.S. banking system. Others have said that it is insufficient to cover the black hole that represents the mounting credit losses of the banks. Both arguments are flawed. The progam is about confidence and restoring faith in our financial system. It also has the potential to help revitalize the capital of the U.S. banking system and be a good investment for the federal government.

For related reading, check out The Industry Handbook: The Banking Industry.

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