Yet Another Botched Job from Paulson & Co?

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.)