Treasury plan fails to stem carnage

But some say investment proposal may get banks to open their lending spigots

Specialist Justin Bohan reacts to the stock market's plunge yesterday. The Dow Jones industrials fell to their lowest level in five years. (Richard Drew/Associated Press)

In normal times, bankers would be loath to invite the federal government in as an investor in their institution. But these are not normal times.

Analysts and academics who follow the banking industry said the US Treasury's latest proposal to restore confidence in financial markets and free up the flow of credit - by injecting cash and taking ownership stakes in struggling banks - is not only attractive in the current environment, but might help get banks lending again.

"We need some type of dramatic change," said Frank L. Farone, managing director at the Darling Consulting Group, a Newburyport firm that advises banks around the country. "It's important that the Treasury used its broad powers to go into the market and assist these institutions that have liquidity problems."

However, the disclosure that Treasury Secretary Henry Paulson intends to shore up banks with direct government investment did nothing for markets yesterday.

Stocks suffered another near-record plunge as panic selling in the final hour of trading drove the Dow Jones industrial average to its lowest level in five years. The Dow shed nearly 700 points, its third worst day ever, and went under the 9,000 level for the first time since 2003, closing at 8,579.19.

After markets closed, the White House said President Bush will address the nation today to tell Ameri cans they should remain "confident" amid falling stock markets and a worldwide credit crisis.

It was the seventh straight day of losses for the Dow, despite numerous efforts to try to calm financial markets, including coordinated interest rate cuts by the Federal Reserve Bank and other central banks around the world, and the passage by Congress of a $700 billion financial rescue package.

The legislation authorized the government to buy mortgage-backed securities and allow banks to get them off their balance sheets, making it easier to raise capital to make loans to businesses and consumers.

The new plan, to invest directly in banks under authority granted to Treasury by the rescue legislation, would put taxpayers' money to work quickly, rather than waiting a month or more to start buying mortgage-backed securities and related assets from financial institutions, analysts said.

In the United States, capital injections could start by the end of this month, Reuters reported. Under the plan, details of which were still sparse yesterday, the Treasury would tap the $700 billion bailout fund to buy preferred shares in banks that ask. Preferred shares, unlike common stock, do not come with voting rights. They typically pay large dividends and give investors some voice at the table.

Sweden took similar action during its banking crisis in the 1990s. When the financial system improved, the government sold off its stake in banks and recovered more than half the initial cost to Swedish taxpayers.

Tuesday, the British government said it would adopt a similar program, injecting up to $87 billion into that country's banks in exchange for ownership stakes. Several banks, including Citizens Bank parent Royal Bank of Scotland, are expected to participate, the British government said.

The Royal Bank of Scotland ran short on capital after years of aggressive acquisitions followed by the global meltdown in the mortgage and credit markets. Citizens, part of Citizens Financial Group of Providence, has said it has a relatively high ratio of assets to capital and is positioned to weather the current financial crisis.

"The major problem is banks have to be recapitalized and this is the most direct way," said Simon Gilchrist, an economics professor at Boston University. "You have to reduce the fear that banks are going to become insolvent, and get them lending to each other."

None of the major area banks contacted by the Globe yesterday would say whether they would take up the Treasury on its offer. Bank of America, Citizens, Sovereign Bank, TD Banknorth, and State Street Corp. all declined to comment. Several said that without more detailed information, the plan was too unclear to judge.

But Darling Consulting Group's Farone thinks many will take the government's capital infusion. "Absolutely. Some would have no choice," he said.

The question is how large the government's voice would be in exchange for these investments.

Banking specialist Cornelius Hurley, a professor at Boston University's School of Law, said direct capital from the government could help loosen up banks' purse strings, but equity investors generally expect some degree of control or influence. "How do we draw the line on how the government throws its weight around with these institutions?" he asked. "Is it going to be an active investor or a passive investor?"

It was not clear yesterday whether the government would be looking for board seats at banks in which it invests, or influence over management decisions or strategy. Under the broader terms of the $700 billion bailout fund, Treasury officials could limit executive compensation, including golden parachutes that corporate executives often get when they leave companies.

In a speech at the University of Wisconsin yesterday, Eric Rosengren, the president of the Federal Reserve Bank of Boston, said the current situation has gone beyond a traditional credit crunch. The economy is struggling with a "liquidity lock" in which fearful investors and lenders won't finance short-term loans for even the strongest and healthiest firms, which use them to cover normal operating expenses.

Such loans help keep the economy operating, too.

The Fed has taken several steps to keep credit flowing, including a program to purchase commercial paper that corporations issue to get short-term financing. That market has seized up, too.

"Well-functioning credit markets are essential for restoring economic health," Rosengren said. "Measures taken by the Federal Reserve should help restore confidence in credit markets, and allow the financial system to efficiently link borrowers and lenders in ways that promote economic growth."

Robert Gavin can be reached at rgavin@globe.com; Beth Healy can be reached at bhealy@globe.com. Material from Globe wire services was used in this report.