It's Official: Treasury to Invest $250 Billion in US Banks, Guarantee Short-Term Debt

The US government will invest $125 billion in the following big banks: Citigroup, Goldman Sachs, Wells Fargo, JP Morgan, Bank of America, Merrill Lynch, Morgan Stanley, State Street, and Bank of New York Mellon.  The government's investment will be in the form of perpetually preferred shares that will pay a dividend.  The capital injections are apparently not voluntary.  Since I am not the CEO of a large bank and was not present at yesterday's meeting at the Fed, I can only imagine how the negotiations went...

Paulson:  We're going to inject $25 billion in preferred equity in each of your organizations and you will pay the government a dividend.

Blankfein: We respectfully decline the capital injection.  But please feel free to guarantee our debt.

Paulson:  You'll take the damn money and like it!

Pandit:  We'll take Goldman's $20 billion!

Mack: Wait a minute!  We want Goldman's $20 billion!

Although I can imagine that the healthier organizations weren't thrilled about the unwanted capital injections, I understand the Treasury's need to spread the money around evenly.  Paulson is trying to prevent systemic risk from a single organization's collapse.  If he pumps money into all institutions simultaneously, this reduces speculation about which organization is likely to fail next that would cause a domino effect.  The complete and total credit market panic that resulted from the consequences (both intended and unintended) of allowing Lehman Brothers to fail is something the Treasury would like to avoid.  Furthermore, with the recent disappearance of Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, Lehman, AIG, and Merrill, the weakest and most leveraged institutions have been "contained" either through a merger or a seizing by the government.   

Perhaps the most important portion of the Treasury's announcement involves the FDIC's guarantee of new debt issued by banks.  This obviously helps the US government's equity investment, as banks should hypothetically be borrowing short term money at rates closer to Treasury securities.  Although this should restore some measure of calm back into the money markets and allow investors to trade debt with more confidence, it too will have a host of unintended consequences.  First of all, Treasuries are going to get pounded.  Technically, all short term debt is now a Treasury, so why not buy short-term bank debt at a higher spread?  Furthermore, if only the short term debt of banks is guaranteed by the government, what happens to the outstanding long term debt of these institutions?  Also, what happens to the outstanding preferred equity of US banks?  I suspect that in the short term, everything rallies because of the decreased likelihood of banking failures, but that dislocations in the markets will emerge when investors actually begin to digest the consequences of these actions.

There are my initial observations.  More to come as I get more details about the plan.  

Update:  According to the joint press release from the Fed, Treasury and FDIC this morning, the capital injections were "voluntary" (they were originally reported as not voluntary in the New York Times) and that nine institutions chose to participate.  Yeah, right.