“Government owning a stake in any private U.S. company is objectionable to most Americans – me included,” U.S. Treasury Secretary Henry Paulson said announcing his decision to effectively nationalize the nation’s banking sector. “Yet, the alternative of leaving businesses and consumers without access to financing is totally unacceptable.”

A government investment of $250 billion amounts to about 25% to 30% of the market capitalization for publicly traded banks, Rajiv Sobti, chief investment officer at Nomura Global Alpha, a unit of Nomura Asset Management U.S.A. told BusinessWeek.

The $250 billion investment will be allocated as follows:

• Citigroup Inc. (C) JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC) each get $25 billion.
• Wells Fargo & Co. (WFC) will receive between $20 billion and $25 billion.
• Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) each get $10 billion.
• The Bank of New York Mellon Corp. (BK) and State Street Corp. (STT) receive between $2 billion and $3 billion apiece.

The remainder, between $124 billion and $131 billion, will be dispersed among smaller banks and thrifts.

Each bank will issue preferred stock to the U.S. government that will pay special dividends at a 5% interest rate, which will increase to 9% after five years. Additionally, the government will receive warrants worth 15% of the face value of the preferred stock.

Participating banks will also have to accept limits on executive pay, the abolition of so-called golden parachutes and improper bonuses, and may be forced to reduce or eliminate dividends.

The government, so far, has insisted that the banks will not have to cut their dividends, nor will any executives be forced to resign. The chief executives of Royal Bank of Scotland Group PLC (ADR: RBS), HBOS PLC (OTC: HBOOY), and Lloyds TSB Group PLC (ADR: LYG) were all forced to resign Monday during the British government’s nationalization process.

While the original U.S. bailout plan indicated that banks would be encouraged to participate on a volunteer basis, the chief executives of the nine largest U.S. banks were summoned to Washington and convinced to take part in the recapitalization effort, as a way to avoid stigmatizing any one bank.

Had any one bank asked for help, it would have been a signal to the world that it couldn’t survive, said Daniel Clifton, an analyst for institutional broker Strategas Research Partners.

Therefore, the Treasury had little choice but to “jawbone them into taking the money in a coordinated fashion all at the same time.”

“These are healthy institutions, and they have taken this step for the good of the U.S. economy,” Paulson said of the financial firms.

Afterwards, Paulson further elaborated on the role these institutions must play in restoring liquidity to the market.

“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Paulson said.

In addition to $250 billion recapitalization effort, the U.S. Federal Reserve will start a program to become the buyer of last resort for commercial paper and the Federal Deposit Insurance Corp. (FDIC) will offer an unlimited guarantee on bank deposits in accounts that do not pay interest. The government will also expand deposit insurance to cover all small business deposits.

Over the past several months, small businesses, which typically maintain balances well above insurance limits, have been withdrawing their money in record amounts. The Fed initially tried to solve this problem by raising its deposit insurance limit from $100,000 to $250,000, but that only extended coverage to about 68% of all small business deposits, according to financial services consulting firm Oliver Wyman Group.

Abolishing deposit insurance limits for small businesses altogether would cover the remaining 32%, the New York Times reported.

“Imposing unlimited deposit insurance doesn’t fix the underlying problem, but it does reduce the threat of overnight failures,” Jaret Seiberg, a financial services policy analyst at the Stanford Group in Washington, told the NY Times. “If you reduce the threat of overnight failures, you start to encourage lending to each other overnight, which starts to restore the normal functioning of the credit markets.”

Source: Paulson Announces New Plans to Buy Equity Stakes in Banks and Revive Credit Markets

The sweeping actions followed a pact reached Sunday by members of the European Union, most notably the United Kingdom, Germany, and France.

“The steps taken in Europe are very positive,” billionaire investor George Soros told Bloomberg News. “The European governments have got religion and realized this is a serious problem they have to address.”

The British government, which last week unveiled its own $87 billion bailout plan, spent $64 billion (37 billion pounds) for controlling stakes in three U.K. banks: The Royal Bank of Scotland Group PLC (RBS), HBOS PLC (OTC: HBOOY), and Lloyds TSB Group (LYG).

In exchange for the bailout money, the participating banks will be required to help the homeowners who are struggling to pay mortgages, to cancel board-level bonuses this year, and to accept government-appointed non-executive directors. Dividends will not be paid to shareholders until the government redeems the preferred shares it takes in the banks.

“This does not come cost free,” said Chancellor of the Exchequer Alistair Darling. “There are strings attached. We will put people onto the boards, and they’re there to protect the taxpayers’ interests.”

In exchange for its bailout, RBS – the second-biggest British bank before its shares collapsed last week – was forced to oust Chief Executive Officer Fred Goodwin after eight years of service.

British Prime Minister Gordon Brown was certain to make clear that the stakes would not be permanent, but would instead be held “at arm’s length,” and sold as soon as the banks are sufficiently strengthened.

Brown said that the United Kingdom had to be a “rock of stability” during this time of economic crisis and lead the way in restoring confidence in the country’s financial sector. The bailout was “unprecedented but essential for all of us,” he told reporters.

The U.K. Treasury last week said it would provide $43.5 billion (25 billion pounds) to recapitalize banks and boost Tier 1 capital ratios – a measure of the strength of a bank’s balance sheet. An additional $43.5 billion (25 billion pounds) will also be available, if needed. The government hopes to have all banks reach a Tier 1 capital ratio of 9%.

U.S. economist Paul Krugman, who won the Nobel Economics Prize on Monday, said in his New York Times newspaper column Sunday that Brown and Darling “have defined the character of the worldwide rescue effort, with other wealthy nations playing catch-up.

“The Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions,” Krugman rote. “And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own.” [For an article on Krugman’s Nobel Prize, check out this article elsewhere in today’s issue of Money Morning.]

Europe United Behind Brown

Other European nations followed Prime Minister Brown’s lead yesterday, with France, Germany, Spain, the Netherlands, and Austria having committed $1.8 trillion (1.3 trillion euros) of their own to guarantee bank loans and recapitalize lenders, Bloomberg reported.

“Instead of tearing us apart, this global crisis has strengthened the necessity of dialogue, understanding and compromise,” French President Nicolas Sarkozy said Sunday. “It’s not so easy. We don’t have the same traditions, for some we don’t share the same currency, we have different regulators. And with this crisis, in a few hours, day and night, we’ve had to learn and understand each other’s problems and find a common solution.”

Sarkozy said France would guarantee $436 billion (320 billion euros) of bank loans and set up a fund that could spend up to $55 billion (40 billion euros) – 2% of the nation’s gross domestic product (GDP) – to recapitalize banks. Those figures represent a maximum, which Sarkozy said may not be required if the markets resume functioning on a more normal basis.

France will also establish a new company to ensure bank liquidity and purchase commercial paper.

Germany, meanwhile, pledged as much as $681 billion (500 billion euros) in aid for the financial sector. About $545 billion (400 billion euros) has been earmarked for loan guarantees, $109 billion (80 billion euros) will be used to recapitalized banks, and the remaining $27 billion will be set aside to cover potential losses from loans.

The rescue package will amount to about 20% of the Germany’s GDP, but German Chancellor Angela Merkel believes the measures are totally necessary.

“We’re taking measures in order to prevent a repeat of what we’ve just experienced,” Merkel said. “These are sweeping steps but they’re necessary to restore market confidence.”

Like the U.K. deal, the German government could influence management decisions and limit dividends at banks that get capital. The package is due to be ratified by Germany’s two houses of parliament by the end of the week.

Spanish Prime Minister Jose Luis Rodriguez Zapatero said his country’s government would guarantee up to $135 billion (100 billion euros) in bank bond issuance this year. Zapatero said measure is to guarantee credit operations by Spanish banks up to end of 2008, but that the amount for 2009 had yet to be studied.

The Dutch government will guarantee up to $272 billion of inter-bank loans, and Norway will provide $57 billion in liquidity for its commercial banks.

Austria will spend up to $115 billion (85 billion euros) to prop up its troubled banks, and pledged an additional $20 billion (15 billion euros) in capital.

Source: United Kingdom Leads European Nations in Coordinated Effort to Cut Off the Credit Crisis

“The global market has ceased to function,” British Prime Minister Gordon Brown said yesterday at a press conference in London. “The banking system must be sounder, and that is why we are putting the capital in.”

Under the plan, the U.K. Treasury will provide $43.5 billion (25 billion pounds) to recapitalize banks and boost their Tier 1 capital ratio. A bank’s Tier 1 capital ratio is a key indicator of the firm’s financial strength. An additional $43.5 billion (25 billion pounds) will be available if needed.

In addition, the Bank of England, the nation’s central bank, will increase the amount of funds available for short-term lending to $346 billion (200 billion pounds). The plan further guarantees an additional $432 billion (250 billion pounds) in loans.

“The Bank of England will take all actions necessary to ensure that the banking system has access to sufficient liquidity,” the central bank said in a statement, The Financial Times reported. “In its provision of short-term liquidity the Bank will extend and widen its facilities in whatever way is necessary to ensure the stability of the system.”

The Bank of England also cut its benchmark lending rate a half-point bringing it to 4.5%. [Please click here for a related story on the coordinated global central bank rate cuts in today’s issue of Money Morning.]

The following banks plan to take advantage of the government assistance:

• Abbey National PLC, a wholly owned subsidiary of Spain’s Banco Santander SA (ADR: STD),
• Barclays PLC (ADR: BCS),
• HBOS PLC (ADR: HBOOY),
• HSBC Holdings PLC (ADR: HBC),
• Lloyds TSB Group PLC (ADR: LYG),
• Royal Bank of Scotland Group PLC (ADR: RBS),
• Standard Chartered PLC,
• And Nationwide Building Society.

Other U.K. banks and building societies are invited to apply for the program as well, The FT reported.

Britain’s blue-chip FTSE 100 Index hit a four-year closing low as it dropped 5.2% despite the government’s bailout package and the rate cut.

“These measures will not, of course, prevent the recession which is already underway. The aim is to reduce the risk that recession turns into depression,” Citigroup Inc. (C) economist Michael Saunders told MarketWatch.

Saunders cautioned that additional government measures could be needed to stabilize the British economy, including further capital infusions.

“We are probably not even half way through the decline in U.K. house prices. We are not even close to half way through the U.K. recession,” Saunders said. “Much of the economic pain still lies ahead.”

Source: U.K. Unveils Its Own Banking Bailout Package

At the New York close, the blue-chip Dow Jones Industrial Average Index plunged 508.39 points, or 5.11%, to close at 9,447.11. The tech-laden Nasdaq Composite Index plummeted 108.08 points, or 5.80%, to close at 1,754.88. And the broader Standard & Poor’s 500 Index dived 60.66 points, or 5.74%, to finish the day at 996.23.

The S&P 500 closed below 1,000 for the first time since 2003.

The Dow is down 29% year-to-date, while the S&P 500 is down over 32% over the same time period. With such huge declines, 2008 marks the worst year for the domestic markets since 1937, Bloomberg News reported.

“Capital markets are very tight right now,” Douglas Christopher, a partner at Crowell Weeden & Co. in Los Angeles, told Bloomberg. “Companies that need external financing or are perceived to need external financing are going to be given a discount in the current environment.”

The Fed’s Latest Gambit

The new Commercial Paper Funding Facility (CPFF) will provide a backstop to the commercial paper market that has been brought to a standstill, even for those firms far removed from the financial sector.

“The immediate threat to the real economy is that large corporations are having difficulty obtaining funds via the commercial paper market,” Mark Gertler, a New York University economist, told Bloomberg.

The commercial paper market reached a three-year low of $1.6 trillion as money-market fund managers, typically huge buyers of commercial paper, became extremely risk averse after a handful of funds “broke the buck.” In a flight to quality mainly into U.S. Treasuries, money market funds liquidated commercial paper holdings by $200.3 billion, or 29%, in the final two weeks of September, according to data compiled by IMoneyNet Inc., Bloomberg reported.

Auto manufacturers, utilities and others make use of short-term lending in the commercial paper market – borrowing money for periods ranging from just overnight to three months – to cover occasional gaps in daily cash flows. The commercial paper market is vital to the ongoing operations for many large corporations, which use the short-term funds to make payroll or pay bills.

“By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market,” the U.S. Federal Reserve said in a statement released yesterday (Tuesday) morning.

“An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households,” the statement concluded.

The CPFF will remain in place until Apr. 30, 2009, at which point the Fed Board of Governors would need to vote to extend it if necessary.

“While we have continued to fund without disruption, the Fed announcement today is an important development that will help restore confidence in the market and facilitate more lending,” General Electric Co. (GE) spokesman Russell Wilkerson said, Bloomberg reported. “This is a positive move and we applaud the Fed’s decisive action.”

GE is the largest domestic commercial paper issuer through GE Capital, its financial subsidiary.

Gloomy Economic Outlook

Speaking yesterday afternoon at the National Association for Business Economics 50th Annual Meeting in Washington, D.C., Fed Chairman Ben S. Bernanke tried to strike a reassuring tone that the recent economic measures enacted by the government would have the intended effect, while also acknowledging the dire economic data.

“Over all, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased,” Bernanke said in his speech.

Some analysts felt this was an indication that the Fed would move to cut interest rates at the next Federal Open Market Committee meeting slated for Oct. 28 – 29.

“The steps being taken now to restore confidence in our institutions and markets will go far to resolving the current dislocations in the markets. I believe that the bold actions taken by the Congress, the Treasury, the Federal Reserve, and other agencies, together with the natural recuperative powers of the financial markets, will lay the groundwork for financial and economic recovery,” Bernanke said.

Britain’s Own Bank Bailout

Meanwhile, the global impact of the credit crisis is hitting British banks hard. In the United Kingdom, Prime Minister Gordon Brown’s government is preparing a rescue package in response to diving British bank shares. Royal Bank of Scotland PLC (ADR: RBS) Barclays PLC (ADR: BCS), HBOS PLC (OTC ADR: HBOOY) and Lloyds TSB Group PLC (ADR: LYG) are all in need or recapitalization, The Wall Street Journal reported.

It is unknown if Britain’s largest bank, HSBC Holdings Ltd., would need government assistance. Its capital position is currently seen as the strongest.

The U.K. government plans to announce its plan today (Wednesday).

Source: Federal Reserve to Buy Commercial Paper to Free Up Frozen Market