Which banks live or die? U.S. may decide

By flooding the U.S. banking system with hundreds of billions of dollars in cheap capital, the government could find itself funding the most dramatic change in the nation’s financial landscape since the deregulation drive of the 1980s.

That’s because the Treasury secretary and bank regulators will decide which banks get an infusion of government money, and which will be denied. Many of the nation’s 8,400 banks -- especially the smaller and weaker among them -- may be allowed to fail or be swallowed by bigger rivals, industry analysts say.

“It will hasten consolidation, no doubt about it,” said Frederick Cannon, chief equity strategist at investment bank Keefe, Bruyette & Woods Inc.

The stock market reflected that fact Tuesday, he said, noting that investors bid up the shares of banks more likely to be helped by the government, while shares of capital-starved institutions considered unlikely to get government funds declined.

The program is also likely to hasten the evolution of the country’s financial system from a conglomeration of community banks into a network of bigger, interconnected institutions, said Timothy J. Yeager, a former economist for the Federal Reserve Bank of St. Louis and a finance professor at the University of Arkansas.

But not everyone agrees. Gerard S. Cassidy, managing director of bank equity research at RBC Capital Markets, said he believed the program would help some weaker banks stay in business, because they will be eligible for the same favorable terms the big banks will get for government capital.

“This plan by the Treasury blurs the lines between the haves and have-nots,” Cassidy said. “The natural course of Darwinian banking has been interrupted by this plan.”

The program’s centerpiece is an infusion of $250 billion into the banking system through the government’s purchase of nonvoting preferred shares in financial institutions.

As outlined Tuesday by Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke and Federal Deposit Insurance Corp. Chairwoman Sheila C. Bair, the banks will be required to pay dividends of 5% a year on the shares -- an attractively low rate for new capital -- rising to 9% after five years. The rate jump is designed to provide an incentive for banks to repay the taxpayers before the five-year mark.

The government will also take warrants for each bank it gives capital, which gives it the right to buy stock in the bank later. The device is aimed at giving taxpayers a chance to profit if the bank’s stock rises during the period the bank is using the government’s money.

Banks accepting the federal help will also face constraints on how much they can pay their top executives.

Although the three financial regulators tried to spell out the program in great detail Tuesday, much about it remains murky. One question is whether individual banking firms will find the government financing attractive.

Cannon contends that the government terms will be hard to resist.

“This is very inexpensive capital,” he said. “Most boards will say it’s very appealing, and I think we’ll see a lot of participation.”

Treasury officials tried to eliminate any stigma that might attach to the government assistance by announcing huge disbursements of capital to nine top financial firms Tuesday. Whether they succeeded in removing the stain is open to question.

“A lot of stronger banks will say, ‘Thanks but no thanks -- why should I wear that scarlet letter?’ ” said Bert Ely, an independent bank consultant in Alexandria, Va.

Some bankers said that other elements of the Treasury’s rescue plan, including an expansion of FDIC insurance to beyond $250,000 for non-interest-bearing accounts (those used mostly by business customers) might play a more important role in shoring up confidence in medium-sized and small banks.

“That will level the playing field,” said Russell Goldsmith, chief executive of Beverly Hills-based City National Bank, the largest commercial bank in Los Angeles County.

Goldsmith said his management would “run some numbers” to decide whether it should apply for the government capital but said his institution was “well capitalized, and we haven’t been looking for more capital.”

There is little question that America’s small banks are struggling to raise cash in a difficult environment, as bank consultant Jeff Rigsby of San Juan Capistrano can attest.

Many of the community banks Rigsby works with have been pressured by regulators over the last year to build up their capital, while others have wanted new funds to expand their business, he said. Both types of bank have struggled to sell new stock this year as investors have shied away from putting money into a banking business that has fallen under stress.

Stock offerings at existing banks with $3 billion or less in assets declined to 41 in the first half of this year, compared with 114 in the same period last year, according to a study by Rigsby’s Community Bank Ventures.

It is likely that many weaker banks will be refused the assistance, although no one is sure where regulators will draw the line. Cannon said he expected regulators to use CAMELS ratings -- an acronym for capital adequacy, asset quality, management ability, earnings, liquidity and sensitivity to interest-rate risk. Banks are graded on each of the six factors, but regulators do not disclose the ranks for particular institutions.

The biggest question about the program is the most crucial: whether it will prompt the assisted institutions to return to the lending market.

Paulson left no doubt Tuesday that unfreezing the credit market was the program’s chief goal, saying, “The needs of our economy require that financial institutions not take this new capital to hoard it, but to deploy it.”

But the secretary’s authority to mandate such an outcome is almost nonexistent.

“You can’t force a bank to make a loan,” Cannon said. “The leap of faith is that now that they’ve got the capital, they’ll go out and lend it.”

The government’s hope is that the flow of new capital, combined with other steps it is taking to improve confidence in the banking and credit systems, will trigger more interbank lending first, followed by lending to companies, finally thawing the consumer loan market.

Even with the best intentions, some banks may face obstacles making loans on responsible terms in today’s deteriorating economy.

“Our question is whether there’s enough business out there” for old-fashioned mortgage loans in which borrowers are willing to fully document their income and make large down payments, said Babette Heimbuch, CEO of FirstFed Financial Corp. of Los Angeles, the parent of savings and loan First Federal Bank of California.

“Are there enough people who are qualified and are looking for housing?” she asked. “If you were worried about your job at a manufacturing facility, or in retail, would you go out and buy a house right now?”

The capital infusion program represents a dramatic turnaround from the Treasury’s original financial bailout plan, a complicated program to take bad mortgage loans off the banks’ books. That program, which now will take a back seat to the capital injections, was widely seen as favoring big institutions -- investment banks and large commercial banks that played a key role in creating and investing in what proved to be toxic mortgage-backed securities.

The new approach is also more broadly targeted, at least on the surface.

Spokesmen for the Independent Community Bankers of America and the American Bankers Assn. said Tuesday that they had lobbied successfully to ensure that every bank and thrift in the country would be allowed to apply for aid from the government.

Still, by its nature the program is steeply oriented toward large institutions, on whose health the survival of the financial system is highly dependent. Their importance was made evident by the Treasury’s announcement that half the initial $250-billion infusion would be spread among nine huge financial firms: Citigroup Inc.; JPMorgan Chase & Co.; Bank of America Corp.; Wells Fargo & Co.; Morgan Stanley; Goldman Sachs Group Inc.; Merrill Lynch & Co.; Bank of New York Mellon Corp.; and State Street Corp.

As though to signify that the nine institutions stand to be big winners, shares of all but one rose sharply in trading Tuesday, ranging from a 21.2% increase for Morgan Stanley to 10.3% for Wells Fargo.

The lone exception was JPMorgan Chase, which fell 3%. JPMorgan is strong and didn’t need the extra capital, Cannon noted, so investors thought its relative position was hurt as other banks got a boost.

Shares of Newport Beach-based Downey Financial Corp. declined 10.7%, to $2.41. The bank, which has suffered large losses from adjustable-rate loans, is an example of what Cannon said is a regional bank that may not get federal capital. Downey executives declined to comment.

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michael.hiltzik@latimes.com

scott.reckard@latimes.com