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Will Banks Blow Bailout Money?

 The first phase of the government’s expanded bailout plan came yesterday: Nine of the country’s largest banks will receive a total of $125 billion. But the tricky part is still to come: identifying which banks should have access to the other $125 billion set aside for the capital injection.

The program is officially voluntary, but as the Washington Post reports, government officials won’t be relying on volunteers:

Treasury will set standards for deciding which banks can be helped, and the regulatory agencies will triage the banks they oversee: The institutions faring best and worst will not receive investments. The institutions in the middle, whose fortunes could be improved by putting a little more money in the bank, will be pushed to accept the money from the government

What are those standards? All the Treasury has said so far is that they “will determine eligibility and allocations for interested parties after consultation with the appropriate federal banking agency.”

Deciding which banks to invest in is crucial, not only for the health of the financial system, but also for the prospects of recouping taxpayer money. The nature of the government’s investment is hands-off. Banks are not required to lend the money out (although the big nine reportedly “promised” the Treasury they’d do so). As Bloomberg puts it, “Officials are betting that the government's investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.”

The warnings from experts and economists that the banks will hoard instead of lending are plenty. John Kanas, the former CEO of North Fork Bankcorp, tells the Wall Street Journal that the banks are likely to use the government capital to retire outstanding debt that pays a higher yield than the 5% on the government's preferred shares. Some worry that the banks will simply use the money to pay stockholders, since the plan (unlike the U.K.’s) doesn’t prevent the banks from paying dividends.

If the government were to do a poor job weeding out the poorly performing banks, there’s also an opposite danger. Ross Levine, a Brown University economist, tells the Journal that if owners of already failing banks were allowed to opt into the program, they might try to get out of the hole they’re in by using the government’s money to make big, irresponsible bets.

We’ve put in a call to the Treasury as to when these standards might be announced -- and we’ll let you know when we hear back.

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