February 10th, 2009 marks yet another step taken by the government to help stabilize the economy with the introduction of The Financial Stability Plan. The overall objective of the plan is quite simple: to provide stability to the financial markets. The plan focuses mainly on the government helping the credit crisis by:
- Injecting capital (money) into the banks that need it.
- Purchasing “toxic” securities (bonds, notes, mortgages, etc.) from banks.
- Supporting banks to give out loans to businesses and people.
However, banks do not receive money just because they exist! The Capital Assistance Program (CAP) decides who gets money by performing a stress test. Here are the steps:
- Banks with undergo stress tests: The stress test, performed on the banks, examines a bank’s capital requirements under two different economic forecasts. The first forecast will examine the bank’s capital requirement under current average economic conditions of unemployment and the housing market. Then, the second forecast will suppose that unemployment hits 10% and housing prices fall by another 25%, and these conditions will be used to examine a bank’s capital requirements.
- If the stress tests indicates that the bank needs more capital, then the bank will have six months to raise the capital requirement in private markets- refers to holding stock in a company that is not public or not quoted on the stock exchange.
- If unable to raise the capital: The government will provide the capital required in a form of convertible preferred stock, which is convertible to common equity. Basically, if the bank cannot repay the preferred shareholders (the government) back in the required time, then whatever is left will convert to common equity.
- After capital is received: After the capital is received by the bank, the bank has 7 years to repay the preferred shareholders (the government), and if they cannot do that the preferred stock will covert to common equity.
Thankfully, some of the largest banks (JP Morgan, Morgan Stanley) have already paid back the capital the government has given them, believe it or not. It seems that the BIG banks are heading in the right direction for financial stability.
Who purchases the “toxic” securities? Both the private market investors and the government will be purchasing the toxic securities or assets under the Public-Private Investment Partnership (PPIP). The private firms get the money from a select group of investment managers, chosen by the government, which will raise funds to invest into legacy securities (toxic securities or assets). Whatever amount the private firm raises to buy toxic securities or assets will be matched by the government. For example, if the private firm raises $100 million the government will match it, and provide the same amount towards buying toxic securities or assets: $100 million. The partnership calls for the government and private inspectors to co-invest in the purchase of $500 billion of legacy assets (toxic securities or assets) that can grow to $1 trillion.
Once the bad assets or securities are bought the BIG banks can now focus their attention to preventing another crisis like this from happening again.
The objective…to loosen the purse strings for borrowing!
