How authorization to recapitalize banks via public capital injections (“partial nationalization”) was introduced - indirectly through the back door - into the TARP legislation

For a number of weeks professional economists and experts of banking crises have been arguing that the proper way to resolve a banking crisis is not to buy toxic assets but rather to recapitalize banks directly via injections of public capital (in the form of preferred shares) into distressed but solvent financial institutions. We criticized the TARP legislation just passed by Congress for not allowing for such a recapitalization of banks via public capital (an approach that has been instead now taken by the UK with its $87 bn bank rescue package and even Belgium/Netherlands in the case of the rescue of Fortis).

So how come that "to inject capital into financial institutions" was the first item that Hank Paulson listed as his priority in his press conference yesterday, thus suggesting that now the US, like the UK, will undertake a partial nationalization of its distressed banks?

The reality is that the TARP legislation passed by Congress (formally the Emergency Economic Stabilization Act) does not in any explicit way allow for such recapitalization of banks via injection of public capital. The US Treasury has initially resisted including explicitly such authority in the Act for several reasons: the banking industry that helped drafting the legislation was against it; there was ideological resistance to the idea of the government taking equity – however preferred – in financial institutions; there was concern that being explicit about public recap of banks would lead to banks’ resistance to participate in the toxic asset purchase program. That is why the Treasury formally resisted putting any explicit wording of public recapitalization of banks into the legislation.

So how come Treasury now says that its first priority is to inject public capital in banks? And where is Paulson getting such authority since there is nothing formally explicit in the Act to allow such recapitalization?

This is a fascinating story that is worth telling in full detail. Here are below those details…