A Rush To Capital Or Off A Cliff?

What a difference a stock market crash makes. According to a recent poll of community banks, in October, 66% did not intend to participate in the US Treasury's Capital Purchase Program. Like San Antonio, Texas-based Frost Bank, most community banks thought that they'd tell the U.S. government to keep its filthy lucre. By the end of November, 56% of those banks polled said that they intended to take the money and run. Sure, there are still banks like this one, which trumpets its decision not to participate in the program as proof of its financial stability; however, you've got more banks like this one, or this one, or even this one, which crow publicly that they will be even stronger with the additional capital and, therefore, customers should bank with them. Or, at least, investors shouldn't keep pummeling their stock price.

While the poll report's author claims the principal motivating factor for the change of heart by community banks is an "abundance of caution" engendered by the sudden, disastrous slide in the stock market and the continuing unraveling of the economy as a whole, other anonymous sources we've spoken to have put it more bluntly. "The reasons are fear and a 'follow-the-herd' mentality" said one prominent bank lawyer. When he wiped the sneer off his face, he allowed that the fear might be justified. As to following the herd, my view is that if your competitors are putting themselves into a position where, with a "fortress of capital" (cheaply purchased), they are better able to withstand the hard knocks that are surely coming their way than are you, you might end up as one of the prey when you'd rather be a predator.

Apparently the fact that the government can retroactively change the deal in light of future changes to federal law (discussed here) doesn't faze those banks that have considered it. I'm skeptical whether most of those banks have given Section 5.3 of the Securities Purchase Agreement serious consideration. A few weeks ago, former FDIC Chairman Bill Isaac wrote an opinion piece in the American Banker (paid subscription required) in which he opined that Section 5.3 should be a deal killer.

This provision appears to allow Congress to do virtually anything it wants to banks that participate in the program. For example, dividends on the preferred stock the Treasury buys could be increased, and/or a higher level of warrants could be required. Limitations on salaries and bonuses could be imposed. Increases in lending could be mandated, including loans to certain economic sectors or demographic groups, and foreclosures could be halted.

These are not far-out hypothetical examples. Each has been the subject of debate from the day the program was announced.

Section 5.3 is unconscionable. If bankers included a similar clause in loan agreements, several things would likely happen. First, no borrower, except for the most desperate, would sign up for a loan. Second, the courts would rule the provision is not enforceable. Third, Congress would enact legislation prohibiting the practice.

I suspect that many boards would not allow their banks to enter into a contract of this sort. Moreover, the idea behind the program is to get banks to go to the private capital markets as quickly as possible. Private firms might well be reluctant to invest in banks that are exposed to the political winds under Section 5.3.

I believe the Treasury should delete Section 5.3. At the very least, the contract ought to provide that if the Treasury made changes to the deal terms, banks would have the right to void the deal and return the money within a reasonable period.

Coming from someone of Isaac's stature, this issue ought to at least give potential CPP participants pause. It doesn't appear to be doing so, however. They appear to be stampeding toward the CPP trough and hoping for the best.

Let's hope that participants don't turn out to be a herd of lemmings piling off a cliff.

On the other hand, if there are any more privately held, C Corp. lemmings out there who haven't put their head into the trap yet, you've got until next Monday to do so. Don't delay! Get your glass of cold, refreshing TARP-brand Kool-aid today!