Yet Another Botched Job from Paulson & Co?

Jamie Dimon of JP Morgan leaves the Treasury Building. Courtesy Bloomberg

Jamie Dimon of JP Morgan leaves the Treasury Building. Courtesy Bloomberg

It doesn’t get any easier to give this administration the benefit of the doubt. For a fleeting moment in recent days, it seemed Paulson and his team had seen the relative wisdom of the UK approach and were ready to apply something very like it in the US.

A foolish hope.

If early reports have it right, they’ve mangled a plan of real merit. Seven major US banks have so far been obliged to accept Treasury capital injections totaling US$125 billion. Citibank, JP Morgan, Bank of America and Wells Fargo get $25 billion each, Morgan Stanley and Goldman Sachs $10 billion and Bank of New York Mellon and State Street $2-3 billion each. Another $125 billion is apparently going to be doled out to their many smaller brethren. (The plan is also expected to guarantee all newly issued bank debt and offer an unlimited guarantee to deposits in non-interest bearing accounts).

You’ll note the use of the word obliged. The various CEOs were summoned to Paulson’s office and made an offer they couldn’t refuse. The rationale for this enforced unanimity was apparently the desire that no taint should surround the acceptance of government largesse. Right. A more intriguing question is whether any of them would have been likely to refuse, even had they been allowed. Their expressions as they exited the Treasury building suggest not.

So what is the deal?

Well, all will be revealed at the 08:30 EST press conference tomorrow but early reports suggest the government will receive perpetual preferred stock paying 5% for the first 5 years and 9% thereafter as well as warrants equal to 15% of the face value of the preferred stock. There’s also some debate on the net about whether the stock is intended to be cumulative (unpaid dividends accrue) or non-cumulative. Since apparently only perpetual non-cumulative stock can be treated as Tier I capital, the betting I’ve seen leans that way.

You may recall Buffet struck a deal with Goldman Sachs back in late September. Berkshire Hathaway bought $5 billion of perpetual cumulative preferred stock yielding 10% (with a 10% early redemption premium) and received 5 year warrants entitling them to purchase common stock worth $5 billion at $115 per share (a slight discount to the market at the time).

In other words (pending final details tomorrow), over six times the equity participation ratio of the proposed Treasury deal as well as twice the dividend rate for the first five years. And, to top it off, the government’s stock may be non-cumulative. Given that Buffet’s deal was commercial, it’s hard to see Paulson’s plan as anything but a very large gift to the banks. Albeit, perhaps, an unwelcome one in some cases.

The contrast with the British deal struck yesterday couldn’t be more stark. To begin with, they took a very conservative approach to the capital needs of the banks who had requested help (though I fear events will in due course also overrun these projections*):

So when on Friday Andy Hornby, the chief executive of HBOS, who will stand down when the merger with Lloyds TSB is complete, was asked how much he thought his bank would need and replied £3 billion, he was told that he must be joking.

He was informed that the FSA, Bank of England and the Treasury were insisting on the toughest possible capital ratios core Tier 1, in the jargon to prepare the banks for the worst possible shocks in the future. They were told they had to imagine the grimmest possible financial and economic scenarios a crisis that crops up every decade combining with a four-times-a-century disaster and a once in a lifetime catastrophe when deciding how much they needed.

Secondly, they decided to take direct equity:

When the scale of the sums required became clear, the Treasury made plain that it was ready to underwrite billions worth of ordinary shares, giving the taxpayer voting rights, to finance the rescue. Until then it had been intended that most of the bailout would involve preference shares. But the amounts of taxpayer finance needed had soared as bank shares plummeted last week, and now the Government needed more control.

Nor was any of this mandatory. Indeed Barclays at the last moment declined the Treasury offer of an immediate equity injection and will instead try to raise the needed capital privately. To the extent it fails, the government as underwriter will make up any shortfall. This remarkable day ended with the Treasury holding 63% of RBS after injecting 20 billion stg and an expected 43.5% of the merged Lloyds TSB and HBOS.

Gordon Brown summed it up:

This is not standard public ownership,” he said. “This is the Government buying shares, allowing the banks to be run commercially, making sure that we can encourage other investors into the banking system, then because our holdings are temporary being ready to sell them when the banks are strengthened.

Of course, the government will be heavily involved in their management. Heads have already rolled as part of the deal and the government have made it clear they’ll be monitoring executive pay very closely indeed. All understandable and, in the circumstances, probably entirely appropriate. I’m much less comfortable with some other provisions, such as the requirement that these banks maintain lending for mortgages and small business at a minimum of 2007 levels. Given that a large reduction in overall leverage is both necessary and probably unavoidable, these sorts of mandatory targets could prove quite destructive. One can only hope the commercial nouse they showed in putting together this bailout won’t, under political pressure, entirely disappear in the future.

Paulson’s latest seems, in comparison, a travesty: indiscriminate, mandatory and overly (possibly breathtakingly) generous in financial terms, it will also probably generate fresh outpourings of general confusion and partisan anger.

Still, I guess that’s pretty much what we’ve come to expect from this gang.

(*My enthusiasm for the British approach doesn’t mean I expect it actually solve anything in a final sense. The underlying problems are in my view far too serious for any quick fix and will probably be with us for many years, perhaps as a rolling series of crises. Nevertheless, it does seem to effectively address a critical aspect of the problem.)

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5 Responses to Yet Another Botched Job from Paulson & Co?

  1. JC says:

    I heard they were all told to take the cash because of the salary heat they’re getting from Congress and Main Street. According to the gossip the order came from Congress so as to put a salary cap on all of them.

    Some of them apparently were really pissed as a result.

    However it doesn’t sound plausible as anyone in their right mind would take such cheap cash.

    Some of them did look really unhappy coming out though.

    You gotta have a sense of humor.

    look it may all work out for the most part if they are able to reflate quickly enough which I think they will as there’s more interest rate cuts coming soon. Importantly this would place the Euro at near enough to 2% which is where Credit Suisse believes is the negative rate in Europe.

    Here’s my thesis and why I think it may work.

    1. The combined totals in both the US and EU will meet the level needed to recap the banking system according to a few firms estimates….. about $500-600 billion

    2. The global monetary expansion has just begun. The EU was tight and will go to negative rates as they have just had the shit scared out of them.

    3. China has big room to move both on the interest rate front and releasing more reserves into the banking system seeing they had gone up to 15% approx reserved in the past tightening phase.

    4. The interbank market has basically been socialized and credit spreads will begin to move lower as the governments are now insuring market to all intents and purposes.

    5. No bank will be allowed to fail and a run on a bank is out of the question.

    6. We’re lucky as the problems seem not to be hugely foreign currency denominated where it counts which is the US (dollar as the reserve currency) and the EU (basically a “domestic” problem).

    7. Any sign of a problem and they turn on the spigot.

    What this means is that it “almost” safe to re-enter the stock market as I honestly think the new bull-market particularly in financials has begun. There may be some selling between now and Xmas as a result of the mutual and hedge fund redemptions. However margin call selling has basically all dried up as they were all blown out of the water last week and those grotesque swamp dwellers :-) (the shorts) have been carried out on stretchers overnight.

    The US financials look really really attractive now.

    The final result will be very high level of inflation and very unstable growth that will end in tears…. as always.

  2. Thx for that Ingolf. Hard to keep up with it all, but Paulson is a bit like Brownie after Katrina. He’s doing a heckofa job ya gotta admit.

  3. Ingolf says:

    You’re probably right, JC, at least from a trading point of view, and maybe more.

    In the bigger picture, I see recapitalisation as an essential tactic in a “retreat under fire’ strategy. If that’s right, the question is how long this counterattack will hold. I surely don’t know and all these interventions are sufficiently bold and creative to keep me more open minded than usual about what’s around the corner.

    Apropos nothing, that sale by Mrs. S you brought up a few months ago must be looking so sweet. Wonder if the Russian buyer will soon be a forced seller . . .

    Yes, Nicholas, he rarely disappoints.

  4. JC says:

    Apropos nothing, that sale by Mrs. S you brought up a few months ago must be looking so sweet. Wonder if the Russian buyer will soon be a forced seller . . .

    Wasn’t it just? Mrs. S obviously learned a thing or two from Mr. S. i hope for her sake she got more than a 10% deposit and the settlement date isn’t too far away. :-)

    From what’s going around the oligarchs (including Putin of course) aren’t as rich any longer as they’ve been hit by severe margin calls. But I guess the Russian state going out and buying stocks could hold it up enough so the boys can get out.

    Yea, I’m looking at it from a trading perspective. You know we used to think 1 billion dollar hole was big and a 5 billion was a monster. I can’t quite conceive what 600 billion looks and feels like :-)

  5. Ingolf says:

    Some details of the session at Treasury are finding their way into public view. Here’s the opening paragraph from the NYT account:

    The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left.

    Yves Smith at Naked Capitalism had some interesting comments on this farce:

    I guarantee this will prove to have been a Faustian bargain, not for having taken the government’s juicy deal, but for having allowed themselves be forced to make a decision, under duress, with their peers present and no opportunity to withdraw, think, or confer with advisors.

    She finishes with a quote which sums matters up well:

    I am surprised to be invoking this text a second time in only a few days (if you saw this in comments, forgive me), but it may make the point more clearly. From Robert Bolt’s screenplay about Thomas More, A Man for All Seasons:

    More: Yes. What would you do? Cut a great road through the law to get at the Devil?

    Roper: I`d cut down every law in England to do that.

    More: Oh! (advances on Roper) And when the last law was down, and the Devil turned round on you –where would you hide, Roper, the laws all being flat? (He leaves him) This countrys planted thick with laws –man’s laws, not God’s –and if you cut them down –and youre just the man to do it –d`you really think you could stand upright in the winds that would blow then? (Quietly) Yes, I`d give the Devil benefit of law, for my own safety`s sake.

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