Capital Purchase Program

This morning Secretary Hank Paulson made a statement regarding the $250B Capital Purchase Program component of the financial rescue package. Critics of the CPP and TARP question the role of government in the capital markets and believe that the US Government is privatizing profits, while socializing losses.

Although drastic, CPP and TARP are well within the bounds of Treasury’s duties. The following is an excerpt from Department of the Treasury’s mission:

The Treasury Department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. The Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions.

CPP is the direct result of the later two goals. Paulson notes in his statement, “Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital.” The restored confidence should open up the credit markets, prudent deployment of capital will enable sound businesses, aspiring students, and honest homeowners to continue the sustainable growth the United States has exhibited since 1776.

Additionally, the Treasury is utilizing market mechanisms to institute additional regulation. Qualifying Financial Institutions (QFI) will only have access to CPP if the institutions agree to caps on executive compensation, clawback provisions, and bans on golden parachutes. The Government is not ruling with an iron fist, rather the Treasury is providing a carrot for banks and thrifts to exercise increased prudence and to incent greater alignment of interest between all stakeholders.

In the near-term, the Treasury may have socialized losses; however, Paulson highlights the CPP is an investment by the Treasury, not an expenditure of the Treasury. The CPP investments will be in the form of preferred stock (5% dividend yield) with warrants for common stock. Assuming confidence is restored and sustainable economic growth persists, the warrants should provide the Government with substantial upside. As Tier 1 Capital, CPP investments will improve the banks’ capitalization and coupled with an improved balance sheet through other TARP initiatives, bank common equity valuations should improve.

Such investments are not risk free; the Treasury cannot guarantee a return OF capital, never mind a return ON capital. In April TPG appeared to have structured their way into a sound investment of preferred equity in Washington Mutual; however, the investment has turned out to be an expenditure. In reviewing the Interim Final Rule for the TARP CPP, as noted earlier, the qualifications are focused primarily around corporate governance and are not focused on the soundness of the preferred equity investment. A return on capital should yield a return to a prosperous United States.

For more information see the CPP FAQ and Application Guidelines.