Impact to US Banks:
Of the $35 Billion of GSE preferred stock, US banks owned over 40% of this total – or $15 Billion. This investment was considered Tier 1 capital to these banks. With a properly levered balance sheet, these banks could lend 8 times the amount of this Tier 1 capital – or $120 Billion. Except for JP Morgan Chase, most of the banks that held this preferred stock were community banks, most of which had not participated in the subprime or Alt A mortgage lending or securitizations. For the most part, these were healthy banks.
So on Monday, September 8th, through the structure of a super preferred issuance and warrants for common stock by Secretary Paulson coupled with the suspension of preferred dividends, the $35 Billion of preferred stock became worthless – thereby wiping out $15 Billion of capital in US Banks and eliminating the possibility of these banks to lend up to $120 Billion. Secretary Paulson admitted later that he was unaware that banks owned so much of the preferred stock. An unintended consequence!
Tax Breaks for Banks under TARP:
So this unintended consequence of destroying $15 Billion of Capital from banks was addressed in the TARP through the treatment of GSE losses as ordinary losses (as opposed to capital losses). This allowed banks to recapture approximately 35% of their losses in tax savings. Thus, the government provided a tax cut to banks (and only banks) of approximately $5.25 Billion.
So what if Secretary Paulson continued to pay dividends on the GSE preferred stock?
If Paulson had not suspended the dividends and even if Treasury had to fund the entire GSE dividend of $3 Billion annually for the next few years, then what would have the consequence been of that action?
- Banks would have $15 Billion of Tier 1 capital;
- Banks would have been able to lend $120 Billion;
- The government would have received annual tax revenue on these dividends of approximately $750 million in perpetuity;
- The government would not have given up $5.25 Billion in tax revenue.
