As the financial crisis peaked in the early part of 2009, the U.S. government launched the Capital Assistance Program, or CAP, a counterpart to TARP and part of a larger financial stability plan. In the first phase of the program, nineteen of the nation’s largest distressed financial institutions — those with $100 billion or more in assets — underwent much-publicized stress tests to estimate how much capital each bank would need to survive a prolonged economic downturn.
The second phase of the program was designed to ensure that the same banks could raise capital in the face of the poor investment climate. Participating banks would raise capital by issuing securities in the form of convertible preferred shares to the Treasury, which would earn dividends on the shares.
The proposal was unique in that the issuer (rather than the buyer) would hold the conversion option: banks participating in CAP would have the option to redeem the shares, convert preferred shares to regular shares, or convert the shares to common equity. Conversion would become mandatory after seven years.
It is this conversion option that made CAP securities a form of contingent capital (in effect, a type of derivative) — a source of common equity a bank can draw on when other means of raising capital are unavailable.
The Treasury would retain the option to buy more shares in the bank in the form of warrants on the bank’s common equity. Warrants are attractive because they become very valuable if and when a bank recovers. “The Treasury doesn’t want to gouge a bank that’s in trouble, but if a bank recovers, the Treasury recovers its investment,” says Professor Paul Glasserman, whose research focuses in large part on risk management and derivatives pricing.
The greatest drawback is that in the event that the bank or the Treasury exercised their options, the bank’s equity would become diluted for all shareholders. Otherwise, CAP represented a very good value for eligible banks, according to work that Glasserman undertook with Zhenyu Wang of the Federal Reserve Bank of New York.
The researchers used a contingent claims framework, accounting for the competing options of each bank and the Treasury, to estimate the value of CAP for each of the 18 banks that participated in the stress tests of early 2009. They found that CAP would have been a very good value to effect of net 30 percent return on average, though with wide variation. Citigroup and First Third bank would have returned about 70 percent. According to the researchers’ estimate, Goldman Sachs would have benefitted the least, but still with an approximately 14 percent net return.
Yet, the program had no takers. If CAP was such a good deal, why did every single eligible bank pass it up?
The deal may have been a good one, but the higher share prices rose, the less banks needed the insurance of CAP: by its November 2009 application deadline, bank shares had regained much of the value they’d lost in the early months of the crisis. And banks may also have been concerned that the market would view participation in CAP as a sign of a bank’s weak condition.
Banks were also probably hesitant to leave themselves open to the regulatory oversight that seemed likely to follow participation in CAP, as had occurred with TARP participants. “If the constraints put on banks are too stringent, it could be too costly to take a government subsidy,” Glasserman says. He points to the particularly pronounced case of Citigroup. Early last year, the Mexican government initiated action that would have forced Citigroup to sell the Mexican bank Banamex on claims that Citigroup was owned by the U.S. government, as Mexican law prohibits foreign governments from owning domestic banks. In the case of CAP, a mandatory review of senior management was one up-front condition.
Glasserman cautions that it would be a mistake to view the dearth of participation in CAP as a failure. Its mere existence probably did a great deal to reduce uncertainty about the ability of the biggest banks to keep operating; the banks knew they could count on the program if their efforts to raise private capital failed. That likely played a role in driving up confidence and share prices. And, had the economy continued its freefall, banks might have found some of the less palatable regulatory oversight worth the cost of survival.
CAP may leave its mark in other ways. Several proposals currently being floated in the private sector, by academics and by regulators use a similar structure to allow banks to raise capital when the market sours and banks find private capital scarce. “The idea is to build a mechanism that would automatically trigger the release of contingent capital,” Glasserman says. One proposal would require banks to hold a certain amount of capital aside that could only be accessed in a moment of crisis. Another proposal involves debt that would automatically convert to equity when a bank finds itself in trouble.
“There is a little irony here in that, in the end, despite all of the bad feelings around derivatives,” Glasserman points out, “the Treasury structured these very complicated programs as part of the bailout.”
Paul Glasserman is the Jack R. Anderson Professor of Business in the Decision, Risk and Operations Division at Columbia Business School.
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"Valuing the Treasury's Capital Assistance Program"