How the US government’s response to the financial crisis in the fall of 2008 created enormous value for banks and saved a few that were on the brink of bankruptcy
On Monday, October 13, 2008, the CEOs of US’ largest banks were summoned to a meeting in Washington DC. The call came just days after the worst weekly decline in US stock market history. At the meeting, the-then US Treasury Secretary Henry Paulson announced a plan that reportedly took the CEOs by surprise. The plan was to inject a massive $125 billion in preferred equity investment in the country’s top banks and provide them with various guarantees – an unprecedented move that would hopefully restore stability to a tumultuous financial market.
Much controversy followed on whether this was the right thing to do and whether the government should have stepped in at all.
A recent paper titled “Paulson’s Gift” that I co-authored with Chicago Booth professor Pietro Veronesi states how the rescue plan announced by Paulson on October 13, 2008, indeed created value. The plan affected the country’s 10 largest commercial banks, including Wachovia, which was purchased by Wells Fargo, and three former investment banks: Goldman Sachs, Morgan Stanley and Merrill Lynch. In particular, Paulson’s plan increased the value of banks’ financial claims – debt, equity, and derivative liabilities – by $130 billion. Accounting for what the government spent for the rescue plan, which was between $21 billion and $44 billion, the plan produced a net gain of $86 billion to $109 billion.
The likely reason why Paulson’s plan appeared to have created value is that it prevented a disastrous run on the banking system that, according to the paper’s estimate, would have destroyed 22% of a bank’s enterprise value. Unlike a traditional run on deposits, a bank’s short-term creditors can run on a bank by refusing to roll over loans if they fear other creditors will do the same, which can quickly make a bank insolvent. The fear of a run can be self-fulfilling. Thus, successfully stopping a run on banks can create significant value.
In spite of its success, the plan ended up being very expensive for taxpayers. The terms of the deal were very friendly to banks. Moreover, a bankruptcy procedure that allows banks to restructure their debt would have been a better strategy to repair insolvent banks. In the long run, the success of Paulson’s plan underscores how tempting it is for the government to intervene, which encourages banks to take on more risk. The results exacerbate the perception that banks are too big to fail.
The financial rescue plan that Paulson presented, had three parts.The first was a $125 billion preferred equity investment in the 10 largest US commercial banks. In exchange for this capital infusion, the government would get preferred stock with a nominal value equal to the amount invested and which would pay a dividend of 5% for the first 5 years and 9% thereafter. In addition, the government would receive a warrant equal to 15% of the value of preferred stock with a strike price equal to the average stock price 20 working days before the money is invested. The second part of the plan was a 3-year Federal Deposit Insurance Corporation (FDIC) guarantee for all new issues of unsecured bank debt until June 30, 2009. The third part provided full FDIC insurance coverage on all non-interest-bearing deposits.
The study analyses the impact of Paulson’s plan by looking at the change in the market value of banks’ equity, debt, and derivative liabilities before and after the announcement.Looking at the changes in bank Credit Default Swap (CDS) rates between October 10 and 14, 2008, and at the same time controlling for movements in the CDS rate of the largest financial firm that was not involved in the intervention (GE Capital), the study finds that bond holders of the 10 participating banks gained $120.5 billion from the announcement of the Paulson plan. Citigroup and the three former investment banks gained the most.
On Monday, October 13, 2008, the CEOs of US’ largest banks were summoned to a meeting in Washington DC. The call came just days after the worst weekly decline in US stock market history. At the meeting, the-then US Treasury Secretary Henry Paulson announced a plan that reportedly took the CEOs by surprise. The plan was to inject a massive $125 billion in preferred equity investment in the country’s top banks and provide them with various guarantees – an unprecedented move that would hopefully restore stability to a tumultuous financial market.
Much controversy followed on whether this was the right thing to do and whether the government should have stepped in at all.
A recent paper titled “Paulson’s Gift” that I co-authored with Chicago Booth professor Pietro Veronesi states how the rescue plan announced by Paulson on October 13, 2008, indeed created value. The plan affected the country’s 10 largest commercial banks, including Wachovia, which was purchased by Wells Fargo, and three former investment banks: Goldman Sachs, Morgan Stanley and Merrill Lynch. In particular, Paulson’s plan increased the value of banks’ financial claims – debt, equity, and derivative liabilities – by $130 billion. Accounting for what the government spent for the rescue plan, which was between $21 billion and $44 billion, the plan produced a net gain of $86 billion to $109 billion.
The likely reason why Paulson’s plan appeared to have created value is that it prevented a disastrous run on the banking system that, according to the paper’s estimate, would have destroyed 22% of a bank’s enterprise value. Unlike a traditional run on deposits, a bank’s short-term creditors can run on a bank by refusing to roll over loans if they fear other creditors will do the same, which can quickly make a bank insolvent. The fear of a run can be self-fulfilling. Thus, successfully stopping a run on banks can create significant value.
In spite of its success, the plan ended up being very expensive for taxpayers. The terms of the deal were very friendly to banks. Moreover, a bankruptcy procedure that allows banks to restructure their debt would have been a better strategy to repair insolvent banks. In the long run, the success of Paulson’s plan underscores how tempting it is for the government to intervene, which encourages banks to take on more risk. The results exacerbate the perception that banks are too big to fail.
The financial rescue plan that Paulson presented, had three parts.The first was a $125 billion preferred equity investment in the 10 largest US commercial banks. In exchange for this capital infusion, the government would get preferred stock with a nominal value equal to the amount invested and which would pay a dividend of 5% for the first 5 years and 9% thereafter. In addition, the government would receive a warrant equal to 15% of the value of preferred stock with a strike price equal to the average stock price 20 working days before the money is invested. The second part of the plan was a 3-year Federal Deposit Insurance Corporation (FDIC) guarantee for all new issues of unsecured bank debt until June 30, 2009. The third part provided full FDIC insurance coverage on all non-interest-bearing deposits.
The study analyses the impact of Paulson’s plan by looking at the change in the market value of banks’ equity, debt, and derivative liabilities before and after the announcement.Looking at the changes in bank Credit Default Swap (CDS) rates between October 10 and 14, 2008, and at the same time controlling for movements in the CDS rate of the largest financial firm that was not involved in the intervention (GE Capital), the study finds that bond holders of the 10 participating banks gained $120.5 billion from the announcement of the Paulson plan. Citigroup and the three former investment banks gained the most.
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