Paulson Will Invest in Thousands of Banks, But Can He Get Them to Lend?

The Treasury has now shifted its strategy in deploying the $700 billion rescue legislation. It will now use $250 billion to directly capitalize "thousands" of "healthy" banks according to Tuesday statements by SecretaryPaulson.

This shift from buying impaired mortgage assets to directly injecting capital was the result of banks intensifying their hoarding of cash, putting a stranglehold on credit. However, some question if he has the leverage to force these banks to deploy the capital.

Credit and lending between financial institutions still remains frozen despite the new US commitment to immediately invest $125 billion within days. The apparent allocation will be $25 billion, each to Bank of America, JP Morgan Chase,Citigroup , and Wells Fargo; $10 billion, each to Morgan Stanley and Goldman Sachs; $3 billion to Bank of New York Mellon; and $2 billion to State Street Corp.

Treasury will gain warrants in the financial institutions with a strike price determined by the bank's share price at the time of the investment. These senior preferred shares will pay dividends of 5 percent in the first five years and 9 percent thereafter. A buy back provision allows the financial institutions to purchase these positions back at par after three years.

This follows a similar plan triggering success and confidence by the UK government, led by Prime Minister Gordon Brown--recapitalizing banks and guaranteeing interbank lending.

Now that the cash is set to be distributed the next big concern is clear in Secretary Paulson's Tuesday statement, "The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it." The fastest and clearest indication of credit markets truly unfreezing will not be theinterbank lending, which is hard for consumers to observe. Rather it will be whether you, as a consumer can get a new car loan, refinance your adjusting mortgage, or buy anew home.