Tyler Cowen quotes from Robert Pozen’s yet-to-be-released book:

“In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.”

Back when people cared about these things, I wrote a couple of posts on the issue of selective protection of creditors.

The point I was trying to make at the time was that it should be at least conceptually possible for a regulator to determine what the ripple effect of default would be and impose haircuts in such away that systemic failure did not result. This would provide a middle way between bankruptcy (complete uncertainty and panic) and blank-check bailout (100% taxpayer guarantee, no losses by creditors). I was envisioning this in the context of government receivership, but I also had this tentative idea:

“I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors.”

But if I am interpreting Pozen correctly, he is suggesting a more elegant way to achieve the same objective. Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi and BAC and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

By James Kwak

Last Wednesday I wrote a highly critical post about the agreement between Bank of America(BAC)  and the government (Treasury, the Fed, and the FDIC) to terminate BAC’s asset guarantee agreement in exchange for a payment of $425 million. I’ve learned some more about this and I think I can reconstruct the government’s perspective on this issue, with the help of someone knowledgeable about the transaction.

A good place to start is Schedule A of the Termination Agreement. A few relevant facts:

• BAC requested the termination on May 6. Note that this is the day after the stress test results were released, although I’m not sure how much of a factor that was. Apparently at this point BAC felt comfortable going without the guarantee. It took an additional four months to work out the terms, but Treasury and BAC decided to use January 16-May 6 as the period that the guarantee was in effect. You could argue that the guarantee was really in effect until the Termination Agreement was signed, because BAC could have changed its mind, but I don’t think using May 6 as an end date is too unreasonable.
• The $118 billion pool of assets was identified in advance of the announcement, but not down to the level of individual securities. Because the assets were mainly or entirely from Merrill Lynch, the vast majority of them were already marked to market. One of the things the government had to do was verify BAC’s marks. Another thing they had to do was verify that the assets did not violate any of the conditions of EESA, the bill that governed the usage of TARP money. This is one reason that negotiations on the initial deal took time.
• By May 6, the parties had already agreed to exclude $14 billion of assets, and disagreed about another $42 billion. For purposes of calculation, then, they assumed that they would have excluded half of that $42 billion, or another $21 billion. This brought the “covered pool” down to $83 billion. (This is a bit of a fiction since the final pool was never identified, but the only purpose of the fiction was to calculate the termination fee.)

If you accept those assumptions, the calculations on Schedule A for the Fed’s loan commitment fee ($57 million) and the foregone dividends ($69 million) more or less make sense. The calculation for the warrants also seems right. They used a strike price of $13.30 and the market price on May 6, pro-rated for the reduction in the asset pool from $118 billion to $83 billion, and came up with a warrant value of $140 million.

I have two quibbles with this so far. The first is this practice of using a preceding 20-day average stock price for the exercise price. Given that most banks are coming to the government when their stocks have just fallen precipitously, this seems like a surefire way to set your exercise price too high. But given that this has been standard practice since early in the bailouts, that has nothing to do with this deal in particular.

The second is pro-rating the amount of preferred stock and warrants by the size of the asset pool. On January 15, when they agreed on $118 billion as the size of the asset pool, both sides knew that the pool had to be verified, and they probably knew that the pool would likely get smaller. In that case, since they both knew that the pool would be adjusted when they agreed on $4 billion as the premium, $4 billion was the appropriate premium for the post-adjustment pool, not the pre-adjustment pool; the adjustment was already priced in.* But that’s a relatively small issue.

The big issue is that BAC and the government pro-rated the $4 billion in preferred stock by the effective term of the guarantee – 4 months, while the original term was 5-10 years, depending on the type of security. Because they came up with a weighted average term of 5.4 years (which I don’t dispute) this reduced the premium for the insurance from $4 billion to about $230 million (pro-rating by the size of the post-adjustment pool brings it down to $159 million).

The government’s argument for this is, roughly, that if you prepay the annual premium on your homeowner’s insurance at the beginning of the year, but then you sell it after four months, you get a rebate for the last eight months. Put another way, if $4 billion is the right price for 5.4 years’ worth of insurance, then $230 million is the right price for four months’ worth. (BAC’s argument, presumably, is that since no definitive agreement was signed they shouldn’t have to pay anything.)

My argument, on the other hand, is that it’s more like buying a homeowner’s policy when there’s a 50% chance that your house has asbestos (which would increase your liability premiums). Four months into your policy period, you get your house inspected and find out there’s no asbestos. Now you can’t get a rebate from your insurer, because in this conceptual example the insurer already priced in a 50% chance of asbestos. A similar example would be someone buying health insurance (in the individual market) at the moment that he has a 50% likelihood of having cancer. In either case, there are two possible states of the world, and you are buying insurance against the bad state of the world. When the good state occurs, you can’t get your money back.

Another way to think of this is as an option. If BAC had bought an asset guarantee for four months, I agree that the premium would have been a lot less than $4 billion because these assets could take many years to deteriorate. (However, you could also argue that since these assets are marked to market, their values deteriorate as soon as expectations of default increase; you don’t need to wait for the actual defaults). But even though BAC only used the guarantee for four months, they got more than that: they got four months of insurance, plus an option to buy another five years of insurance if they found themselves in the bad state of the world.** If the first four months were worth $230 million, then the option was worth a lot more than $230 million.

The other thing that can be said in defense of the Termination Agreement is that to get more, the government would have had to go to court to enforce a term sheet that was largely performed but never finalized as a definitive agreement, and that’s not what the government should be doing with its time these days. I’d say that’s a matter of opinion.

* Alternatively, perhaps the working assumption was that as assets got disqualified from the pool, other assets would be added. In that case, had things gone badly, BAC would have been pushing to replace the assets that got disqualified with new assets, and the effective coverage would have been $118 billion. That is, the fact that the pool only got smaller already reflected the fact that things got better for BAC after January 16, not worse, and therefore that fact should not be used when estimating the value of the guarantee.

** Actually, it’s more complicated and slightly better for BAC, because for some reasonable amount of time (six months?) they had short-term insurance and they had the right to exercise the option on long-term insurance by signing a definitive agreement. Furthermore, if you accept the underlying logic of the Termination Agreement and the metaphor of selling your house and getting an insurance rebate, even after signing the definitive agreement BAC still had the option to terminate the agreement and get a rebate. Refundable level premiums make sense when the risk of loss is uniformly distributed and unchanging over time; when the risk of loss changes over time and the buyer of insurance can see how it changes, then they are an invitation to moral hazard. Come to think of it, if you live in the fire zone of the Oakland Hills and you buy your insurance policy on July 1, should you get a 50% rebate if you cancel it on January 1 after fire season is over?

By James Kwak

I’m trying to figure out if I should be infuriated about the agreement allowing Bank of America to walk away from the asset guarantees it got as part of its January bailout in exchange for a payment of $425 million. I can piece together part of the story from The New York Times, Bloomberg, and NPR, but the complete story is a bit hazy.

The initial deal was that Treasury, the FDIC, and the Fed would guarantee losses on a $118 billion portfolio of assets; B of A would absorb the first $10 billion and 10% of any further losses, so the government’s maximum exposure would be about $97 billion. Part of that guarantee was a non-recourse loan commitment from the Fed, basically meaning that the Fed would loan money to B of A, take the assets as collateral, and agree to keep the assets in lieu of being paid back at B of A’s option. In exchange, the government would get:

(a) An annual fee of 20 basis points on the Fed’s loan commitment, even when undrawn (if B of A drew down the loan, which it didn’t, it would pay a real interest rate). The loan commitment could be interpreted to be only $97 billion, so this comes to $194 million per year.

(b) $4 billion of preferred stock with an 8% dividend. That’s a dividend of $320 million per year; B of A can buy back the preferred stock by paying $4 billion.

(c) Warrants on $400 million of B of A stock. B of A was at $7.18 the day the bailout was announced and yesterday it closed at $17.61, so if Treasury had gotten an exercise price of $7.18, those warrants would be worth about $580 million now.

Now, at this point I was furious, but then I found this provision in the term sheet:

“Institution has the right to terminate the guarantee at any time (with the consent of USG), and the parties will negotiate in good faith as to an appropriate fee or rebate in connection with any permitted termination.”

The question is, what does this mean? As far as the Fed loan commitment, it’s clear: Bank of America can walk away from that. Since they had the loan commitment for about nine months, their fee should be about 9/12 of $194 million, or $145 million. I’m fine with that.

But what about the preferred stock and the warrants? Is B of A getting all that back as part of the $465 million payment? The news stories aren’t specific on this point, but I’m pretty sure B of A is getting it back. I say that because all three stories refer to the government holding $45 billion of preferred stock in B of A. That $45 billion is quite clearly the $25 billion cash investment from October and the $20 billion cash investment from January – which implies that the $4 billion in preferred stock that Treasury got in exchange for the asset guarantee is gone.

B of A’s position must have been – actually, I’m having a hard time making their position in a reasonable way, because it’s so untenable – something like this: “In January, we all thought we would need that guarantee for a long time, and that’s why we gave you $4 billion in stock for it, but now it turns out we don’t need it, so let’s pretend we never gave you that stock.”

But this is clearly ludicrous. The deal was very clear. The government did something for B of A. In exchange, B of A gave the government $4 billion in stock. If the idea had been for the government to get, say $400 million in stock for each year the guarantee was in force, then that’s what they would have written into the term sheet. The economics of the deal were also very simple. B of A was in trouble; only the government was willing to give them an asset guarantee; that guarantee was worth at least $4 billion to B of A, and probably a lot more; so the government got $4 billion worth of stock.

So I’m still left wondering what this could mean: “the parties will negotiate in good faith as to an appropriate fee or rebate in connection with any permitted termination.” If I’m the government, I’m thinking: “I gave you something that was worth $4 billion at the time; you gave me $4 billion. Now you don’t want the thing I gave you; fine, throw it away. But what’s to negotiate? You already got something worth $4 billion.”

So the government negotiators should have been asking for $4 billion, plus nine months’ worth of dividends ($240 million), plus the value of the warrants ($580 million), plus nine months’ worth of the loan commitment fee ($145 million), for a total of $4.965 billion. But what did they ask for? According to an earlier (no longer available except in Google search results) version of the Bloomberg story, regulators were asking for “$300 million to $500 million.” And they got $425 million – which is basically the loan commitment fee plus one year of dividends on the preferred stock, meaning they got nothing, nada, zilch for the preferred stock or the warrants.

What possible explanation is there for this? Here are a few:

(1) B of A somehow convinced the government negotiators that the deal was really for $4 billion over some period of time, and hence the government didn’t have a right to it, no matter what the term sheet said.

(2) That “negotiate in good faith” clause was meant all along as a way for B of A to get out of the deal. That is, in January the government wanted to claim for PR purposes it was getting $4 billion in exchange for the guarantee, but nudged B of A and said that if things worked out, it wouldn’t actually be $4 billion.

(3) B of A threatened to go even more public with the claim that it only closed the Merrill Lynch acquisition under government pressure (remember, this asset guarantee was widely believed to be a quid pro quo for closing Merrill – see the Bloomberg headline, for example), and the government didn’t want that episode in the news again.

(4) As Bloomberg reports, “while the guarantee was announced in January, an agreement was never signed.” Wait a second. The deal was never signed? What? Why isn’t this a front-page scandal? Remember, the announcement of the guarantee bolstered confidence in B of A’s survival. (It may not have been good for the stock price because of the dilution, but it was a signal that the company would not be allowed to go bankrupt.) Even if nothing was ever signed, there is no way the government would have been able to back out after going public with the guarantee. So the taxpayer was committed. And somebody forgot to get B of A to sign the piece of paper? Or was this a conscious oversight to make it easier for B of A to get out of the deal later?

OK, now I’m infuriated. Shouldn’t you be?

Update: A Congressional source tells me that the deal was never closed because the parties could never agree on which assets to include in the pool to be guaranteed. This, of course, raises the question of why they couldn’t agree – after all, we did it with Bear Stearns, and we did it with AIG. (Did we do it with Citigroup or do we have another of these problems hanging out there?) The point is there’s no reason Treasury couldn’t have gotten this done. But B of A had no reason to want to close the deal – it got a benefit in the markets strictly from the announcement, and if it ever needed the guarantee there’s no way the government would refuse simply because nothing had been signed. So it was up to Treasury to close the deal and get the $4 billion in preferred stock.

My source also says the $425 million payment is supposed to represent the benefit that Bank of America got from the guarantee over the last nine months. But it doesn’t. A guarantee is insurance. Let’s say you pay $1,000 for a one-year insurance policy for your house. At the end of the year, can you go to your insurance company and ask for the $1,000 back because your house didn’t burn down? If B of A and Treasury agreed on a price of $4 billion, then that’s the price; it has nothing to do with what happens later. So even if the deal was never closed, the “regulators” should have been asking for a lot more than $300-500 million as the value that Bank of America got from the relationship. As StatsGuy points out below, they could have gone to court for it; as even a first-year law student knows, an agreement doesn’t have to be written down and signed to be binding (and I assume at least the term sheet was signed by both parties).

By James Kwak

I had a post criticizing John Carney on the topic of bankslaughter. However, I must say I agree with him when it comes to Goldman Sachs. Even more surprising, I largely agree with the Wall Street Journal editorial that Carney links to.

Here’s what the Journal has to say:

We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

. . . Banks that want to be successful will also want to be more like Goldman Sachs, creating an incentive for both larger size and more risk-taking on the taxpayer’s dime.

One policy response to the incentives created by last fall’s bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up.

Did I read that right? The WSJ proposing a new tax?

And here’s Carney’s conclusion:

What’s worse, letting CIT fail might not help this situation at all. Rather than clearing the way for market discipline to reassert itself, CIT’s failure might only reify the policy of Too Big To Fail.

Financial firms that are deemed too small to be rescued will find credit hard to come by and expensive, which will incent them to grow or sell themselves to a systemically important firm. In short, we’re increasing the concentration of financial power and hence systemic risk in the largest Wall Street firms that led us into this mess.

To use traditional labels for a moment, the right-wing criticism is that the implicit government guarantees created by Too Big to Fail distort the market. The left-wing criticism is that bailing out large banks enriches capitalists at the expense of ordinary people, and the benefits don’t trickle down into the economy at large (see the number of foreclosures, for example).

The Obama Administration’s defense is that only by enriching those banks can we keep the economy from sinking further and hurting everybody. It’s not an implausible position to defend, but it can’t be fun, especially for people who always thought they were progressives.

By James Kwak

The issue of the day is obviously CIT.  It’s hard to sort out the real news from clever PR/planted stories in this situation, but it looks like the FDIC is coming out strongly against being involved in a rescue package.  Given Sheila Bair’s successful political positioning and strong popular appeal, it’s hard to see how – once dug in – the FDIC can be moved.

The lobbying frenzy has concentrated on CIT’s role in financing small and medium-sized business; “the recession will be deeper if CIT fails” is the refrain.  This is a weak argument – it would be straightforward to refinance this part of CIT’s business without bailing out CIT’s creditors, and definitely without keeping top CIT executives in place; this is the essence of “negotiated conservatorship,” which is a proven model in the US.

More plausible is the concern that given Treasury’s generous handouts to date for financial firms, if they are now tough on CIT’s creditors, this will send a new signal about how they may treat other firms – and maybe raise fears of Hank Paulson-like flipflopping.   Citigroup’s CDS spread is still at worrying levels, and Treasury/National Economic Council watches this closely – for both organizational and personal reasons.

Essentially, by trying to refloat an undercapitalized banking system, Treasury has created pervasive financial vulnerabilities to CIT-sized shocks.  These are now the basis for more bailouts and even great fiscal costs.

If CIT is determined to be “too big to fail” in today’s context, this has far reaching implications.  Instead of financial entities with assets of at least $500bn creating systemic risk, we now have to worry about anyone who has not much more than $50bn.  This is a profound change – and a point that seems to have escaped the Financial Services Roundtable, which is pushing hard for a CIT rescue.

Mr. Geithner is travelling back from the Middle East today.  Once he lands, I would guess that a bailout package will go through (on the weekend, if they can get that far) and creditors are unscathed.  But I still suspect that there will be management change at CIT.

How the CIT deal impacts current Capitol Hill discussion on system risk and regulatory reform remains to be seen.  The effects there could be more profound than expected.

By Simon Johnson

Some discussion of these issues with TNR is here.

Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.

I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.

Cowen also has an accurate read of the current situation:

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns.

Or, there’s an implicit expectation that creditors of large financial institutions will be protected, but that expectation periodically wears off and has to be bolstered by some confidence-boosting measure, but that measure can never be an explicit guarantee . . . and so on.

Cowen has some suggestions for how to fix this problem in future regulation. But what should we do right now? As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.

By James Kwak

This post was written, at my request, by Carson Gross, one of our regular readers and a multi-talented person I have worked with in the past. (We met one night when I needed help debugging a classpath error I was getting on my computer.) I don’t necessarily agree with what he says,  but I think he has something valuable to say. Everything below is by Carson.

James asked me to elaborate on a comment in which I worried about the public’s reaction to the real or perceived wealth transfers occurring during this financial crisis – in particular, how that reaction would manifest itself culturally.

“Wealth transfers” is a charged term, and a lot of smart people have spent a lot of time patiently explaining that, in fact, most of the bailout thus far involves loans and that, under some models (which, apparently, don’t include housing prices regressing to roughly 3x incomes, where they have been for most of history) we, the taxpayers, may actually end up making money on this whole thing.  I think that’s fanciful, but I’m not going to debate that here.  Rather, I want to focus on the bailout’s cultural impact.

I assert, without proof, that the proverbial man on the street sees the words “bailout” blaring on his TV and computer screen day in and day out, and doesn’t care to look too deeply into the details.  Who can blame him?  He has enough of his own problems to deal with without attempting to decipher deliberately impenetrable financial jargon.  Even if the government is getting reasonable compensation for the capital injections in some cases, the man on the street just sees more of his tax dollars going into banks to pay out people who make orders of magnitude more money than he’ll ever see.  That’s his reality.

And, despite the tut-tuting that this is a shallow view of what is happening currently, I think his view is correct in a deeper sense: the wealth transfers have already occurred, during the boom, when no one was looking.  The money has already been sucked out, we all know it, and now it comes down to who holds the multi-trillion dollar bag.  The banking industry doesn’t produce wealth: it is there to efficiently allocate capital between alternative uses in the broader economy.  Therefore the replacement wealth will have to come from somewhere else.  People in the real economy sense, correctly, that it’s going to come from them, be it through inflation, higher interest rates, higher taxes, or some combination thereof.

How will this realization affect the culture and how will that, in turn, affect our economy?  Here are three changes that I see: one that is happening, one that is imminent and one that has already occurred:

• Currently, in the broad culture, a “where’s my bailout?” meme is becoming increasingly dominant.  You can see it written on the faces of auto executives as they go before Congress and you can see it in the debt-relief ads playing off the various bailout programs that have sprung up on TV.  This dependent mentality has been devastating in other countries and ages, and will lead to decreases in productivity as people simply give up, muting an economic recovery.
• Imminently, in industries other than banking, high earners will increasingly resent the higher taxation they are being asked to shoulder to fund the bailout.  This will cause further, and more severe, decreases in productivity.  This is speculation on my part, since no one has been asked to pay higher taxes yet.  However, based on the conversations I’ve had with friends and colleagues over the past few months, I believe that this will indeed happen.  When smart, dynamic people start throwing in the towel, the real economy loses a huge source of productivity.
• Finally, consider the astonishing revolution in homeowners’ attitudes towards defaulting on a mortgage that has occurred in just the last 18 months.  Defaulting has gone from being a mark of shame, to an understandable misfortune to, almost overnight, a smart financial move.  Eric Hovde comments on this radical change in this CNBC video at the 9:30 mark. It’s a truly scary sort of cultural change.  Mortgages were the most stable private financial transactions we had to build our banking system on.  Can banks in good faith offer the mortgage rates that they once did, after the government has withdrawn pressure from them?  We’ve fundamentally changed the risk of holding mortgages, making them more risky.  Eventually the market will reflect this, whether we like it or not.

There may be technical solutions to the banking problem.  However, if those solutions do enough damage to the cultural framework on which the system was based in the first place, even the most brilliant among them will be useless.  The eye-rolling from both the academy and Wall Street when people make moral arguments regarding the bailout is short-sighted and, ultimately, ignorantly technocratic.  Paraphrasing C.S. Lewis: we must not saw off the bough that we are sitting on.

Step one: stop cutting.

Posted by James Kwak

If I had infinite time, I would respond to all reader questions and suggestions. Unfortunately, I can’t. But I’m hoping to occasionally post some in-depth responses to some of the tougher questions we get.

Chris Uregian, one of our readers, sent us three questions by email. In summary, he thought that we were overlooking some of the problems with nationalization and the reasons why Treasury might be moving more slowly than we would like. I originally answered him in email but we later decided this would be good to post to everyone, and Chris gave us his permission. I am going to copy his questions here and add a response after each one.

1. Question:

We have heard plenty about the Swedish model. But how about the US model. The last time a bank was nationalized in the US, it was Continental Illinois in 1984 – 1994.  That was the 7th biggest bank at the time.

If we nationalize Citi (ideally only Citi, although no one outside the Treasury, even Simon or Paul Krugman have any idea how many banks we need to nationalize), that is X times larger than Continental, how long do we have to hold it for? What is the cost to the taxpayer?

If we have to nationalize even 2 out of the 4 biggest banks in the US, that is around 30% of total banking sector assets according to Martin Wolf. So the US Government will officially be in charge of at least a third, more likely half the US banking sector for anywhere between 5-10 years.You guys do excellent forecasts, so tell me is that a reasonable forecast of what nationalization would look like? If so, and you were Tim Giethner, wouldn’t you try to avoid this at almost any cost? Shouldn’t nationalization be your very very LAST resort?

Roubini, for all his gloom, is currently the most reasonable of our nationalization crew. He recognizes that the Treasury really wants to avoid nationalization for political but also genuine economic reasons, but that is why their plan gives banks 6 months to find private capital. His argument is that in 6 months time,’ in the depth of the recession, we will really know which banks are really insolvent, and which ones could be solvent with a little government help. The notion that there is a clear distinction between insolvent banks and illiquid banks is a little strange to me given my experience… there’s a grey area with many shades and defining clearly which banks are insolvent in this economic environment is not easy. Again, that suggests caution and moving slowly, not jumping at solutions Paulson style.

Guessing how long the government would be in charge of these banks is basically impossible, but I think 5-10 years is not an unreasonable guess. I don’t think that means it should be the last resort, however. The problem is the real economy. The longer we have uncertainty, the worse the real economy gets. On the one hand, I agree with you and Roubini that time will give us a clearer picture. On the other hand, I think that the banking sector is not going to fix itself on its own, and the longer we wait the bigger the output gap (and the higher the unemployment rate) will be by the time the economy does recover. So I think reasonable minds can disagree on this.

2. Question:

Further, I think Simon’s point about if you covered the name of the country, then your IMF officials would give the same advice to the US as for any emerging market economy strikes me as missing one crucial detail. Citibank is not your typical Latin American bank – if a Latin American bank goes bankrupt, that doesn’t carry the risk of freaking out markets globally the way Lehman’s bankruptcy did due to counterparty risk, it does not have the number of creditors, bondholders fearing they will get a massive haircut that Citi has; You simply cannot tell me that if 2 out of 4 largest banks were nationalized overnight, that would not carry a very serious risk of freaking out the markets at least as badly as Lehman’s bankruptcy did, and potentially lead to the collapse of the stockholder confidence in a whole bunch of financial institutions that may well be healthy.

I think market freakout depends on the form of the takeover. As I have written (maybe since you sent this email), the main determinant of market freakout will be how creditors are treated. One possibility, which Krugman somewhat hesitantly endorsed, was to guarantee the bank liabilities. Another, which Bebchuk suggested, was to guarantee the liabilities up to some level (which could vary by type of creditor), where that level was engineered to minimize the risk of major collateral damage. I think with sufficient time to study the situation, it seems like you should be able to force some degree of debt-for-equity swaps without causing a huge domino effect. But a blanket guarantee is still an option.

3. Question:

Finally, let me remind you that Peter and Simon wrote a piece in the FT just over a month ago arguing AGAINST nationalization. Now, they are all for it. Yes, when the facts change, we change our minds…. but recognize that Tim Geithner  and Ben Bernanke do NOT have the option to change their minds. And they are NOT suddenly sell-outs or economic illiterates. But maybe they know too much about how close we came to the precipice and have become excessively risk averse. Perhaps. But quite honestly, I am not sure I blame them for wanting to be extra prudent. Back in  September, the vast majority of the financial commentariat said  Paulson made the right decision to let Lehman fail – it was not too big to fail. Now it’s the biggest mistake since Mellon liquidated the US banking sector. In such a crisis, certainty is not justified and should be left to the Rick Santellis of this world. At a time when Paul Krugman is disagreeing with Alan Blinder, maybe each side needs to listen more to the arguments of the other.

About the argument against nationalization back in January: I think the honest answer is that the thing we proposed then would have been preferable to nationalization, but it had very little chance of working. We made the mistake of describing an economically elegant solution that did not take political realities into account. Our proposal was for the government to buy toxic assets at market value (or something close to it) and then recapitalize the banks directly, at the same time. This would remove balance sheet uncertainty from the banks while minimizing the taxpayer subsidy. The mistake was in overestimating the power of the government to force such a solution. The problem that I have since realized is that as long as the banks can negotiate on their own, they will win that particular game of chicken. They will just say, “no, I won’t sell to you at that price” and wait for the government to propose a sweeter plan – because the government can’t walk away, because it’s responsible for the economic well-being of the country.

At the end, Chris wrote: “I fear you have not been as clear on the downsides of nationalization as you have been on the benefits, which might help explain why the Administration is ‘dithering’.” I think that’s a fair criticism. Hopefully I’ve helped redress that.

By James Kwak

According to The New York Times and the The Wall Street Journal, the Treasury Department is set to announce its plan for troubled assets early next week. It will include three components. The details aren’t clear since these are anticipatory news stories, but it will be something like this (combining bits of information from the two stories):

1. The FDIC will create a new entity to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide non-recourse loans* for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.
2. Treasury will create multiple new investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.
3. The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities** (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy “legacy” assets – those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Instead of coming up with one plan to buy troubled assets, it looks like the government has come up with three. (As Calculated Risk said, however, ” More approaches doesn’t make a better plan” (emphasis in original).) For now, I think the concerns I expressed last month still hold. If we take as given that the government will only negotiate at arm’s length with the banks (meaning the banks can decide at what price they are willing to sell the assets), then the most important thing is for the plan to work. But it’s not clear if the degree of subsidy offered will be enough to close the gap between what investors are willing to pay and what banks are willing to sell at. Having multiple buyers and using cheap Fed financing will increase the willingness-to-pay for these assets, but we won’t know a priori if it will exceed the reserve price of the sellers.

In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks.

Most encouragingly, the headline in the Times was “Toxic Asset Plan Foresees Big Subsidies for Investors,” indicating that the mainstream media have figured out the game. (By contrast, the Times headline announcing the bank-friendly terms of the Capital Assistance Program was “Government Offers Details of Bank Stress Test.”) I may soon be out of a job. (Wait a sec, no one is paying me for this . . .)

* A non-recourse loan is made for a particular asset or set of assets. If the borrower fails to pay off the loan, the most the lender can get is the asset (he cannot go after the borrower’s other assets or income streams), so the borrower’s loss is capped at the amount he pays himself. Mortgage loans are non-recourse loans where the borrower’s loss is capped by his down payment.

** Technically, the Fed would loan money to financial institutions and take asset-backed securities as collateral. However, these would be non-recourse loans, so the financial institution could pay off the loan simply by ceding the collateral to the Fed. (It seems to me that because these are loans, if the assets appreciate in value, the financial institutions could choose to pay back the loans and take the collateral back, thereby getting all the upside, but I’m not certain about that.) The TALF will be capitalized by some money (10-20% of the total) coming from Treasury, which will absorb the first losses.

By James Kwak

Simon and I wrote on op-ed in the New York Times today, trying to debunk the idea that, as we put it, “A.I.G.’s traders are the people that we must depend on to save the United States economy.” The AIG bonus fiasco, as I’ve written earlier, has been particularly useful in raising the political cost of the administration’s current bailout strategy. But, as I said then, “$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another.” And as far as the cost to the taxpayer is concerned, the big bill is for bailing out AIG’s creditors. In his op-ed in the Wall Street Journal today, Lucian Bebchuk wants to know why.

Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps, from AIG and were counting on being paid. And a major usage of bailout money has been to make whole AIG’s counterparties holding those credit default swaps, primarily investment banks trading on their own account or on behalf of their hedge fund customers.

I still think it was a mistake to let Lehman fail, because of the sudden panic it created. But we are in a very different situation today. Many people now believe that the government may decide to let bank creditors lose some of their money. As Bebchuk says, instead of continually giving AIG taxpayer money that is effectively used to bail out other banks (many of which are in Europe, allowing European governments to free ride on the U.S.), the government could let AIG fail and bail out those other banks directly, thereby at least getting increased ownership stakes in return. Bebchuck also explains that AIG’s insurance subsidiaries would not become insolvent if the AIG holding company went bankrupt, because they have their own reserves. (Insurance operations are regulated on a state-by-state basis, and state regulators establish reserve requirements for insurers.)  Furthermore, he argues, failure is not an all-or-nothing proposition:

For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors.

I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors (not to mention employees – bankruptcy would settle this whole question of whether the bonus contracts are legally binding once and for all).

There was clearly no time to do this between September 15 and September 16. But the government by now has had six months to study the books of AIG and its major domestic counterparties. People are no longer willing to take it on faith that the future of the free world depends on an implicit blanket guarantee for AIG. At least we want to see some evidence.

Update: Matthew Yglesias puts it very well.

I, for one, don’t think that “saving” the too-big-to-fail financial institutions is or was among the legitimate purposes of our financial policy. The idea is—or at least ought to be—that we’re trying to prevent them from failing in a way that causes everyone else’s business to go under.

(Yglesias also has just given me a massive insecurity complex, since he’s written nine posts so far today. I also liked this one.)

Update 2: I wish I had read James Hamilton earlier. Here’s the bottom line:

I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?

The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund. But if they are to contribute, the plan must be something other than doling out another $100 billion every few months to try to keep the operation going a little longer, but instead requires seizing this bull by the horns. Split AIG into a core business we want to protect– with enough equity to be a viable operation, and a hefty fraction of the existing management team fired– and a derivatives business that’s going to be systematically liquidated in large part by abrogation of outstanding contracts.

By James Kwak

$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel’s back.

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

• The bonus contracts – which have still not been released to the public – reflect the instinct of Wall Street to favor its employees over any other stakeholders. In the companies I worked at, it was common practice that all bonus plans were contingent on overall company performance: if the company had no money, you didn’t get any, either. Even our commission plans for sales people included the caveat that the plan could be changed by the CEO at any time for any reason. The fact that AIG did not similarly protect itself shows the Wall Street habit of putting itself first, or a failure to recognize the possibility of a bad year, or, most likely, both.
• The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall – despite the fact that the plans had been public knowledge since May – reflects the rushed, ad hoc nature of the deals that were struck. Or it reflects the understanding in Washington that the ways of Wall Street had to be respected. Or, again, both. And the failure to even say anything about the bonus plans since the initial bailout – even just to get ahead of the obvious public relations fiasco – reflects an overall strategy that amounts to hoping that problems will go away.
• The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. The fact that this is happening at AIG – the one the government has owned 80% of since September – shows that any “nationalization” so far has been a red herring. In a bankruptcy, or a government conservatorship, employees and other creditors would not have a legal right to all of their money. In the current situation, by contrast, AIG management can choose whom it wants to make whole, which is what makes self-dealing and other sweetheart deals possible. In this context, $165 million in employee bonuses pales against tens of billions of dollars of collateral provided to counterparties – beginning with Goldman Sachs. Yes, this was to cover open trading positions. But if AIG had gone bankrupt or had been taken over, it’s not clear that Goldman would have been first in line.
• The testaments to “the best and the brightest” – here, referring to the people of AIG Financial Products – reflect, I don’t know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

However, this scandal may yet serve a purpose. One characteristic of both administrations’ responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversion for Citigroup. Employee bonuses, by contrast, are strikingly easy to understand.

The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position – propping up financial institutions in their current form and insisting everything will be OK – when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration’s hand toward the decisive action that we need.

Since I’ve been writing about preferred and common stock so much this week, I thought I would just try to explain the arithmetic of the Citigroup deal announced today. (By the way, it isn’t a done deal: all it says is that Citi is offering a preferred-for-common conversion to its outside investors, and the government will match them dollar-for-dollar, although the WSJ says that several investors have agreed to participate.)

Right now, according to Google Finance, Citi has 5.45 billion common shares outstanding. It is offering to convert up to $27.5 billion of preferred shares held by “private” investors other than the U.S. government (like the government of Singapore and Prince Alwaleed) into common shares, at a conversion price of $3.25. That would create another 8.46 billion shares. For every dollar that is converted, the U.S. government will also convert one dollar of its preferred stock, up to $25 billion; that is the $25 billion from the first round of recapitalization back in October, which is paying a 5% dividend. (Fortunately someone realized we should convert that before converting the second chunk, which pays 8%.) That would create another 7.69 billion shares. So if everyone converts as much as possible, there will be 21.60 billion shares outstanding, of which the U.S. government will own 7.69, for an ownership stake of 36%, the number you read in the papers. (Actually, if the private investors convert exactly $25 billion and not $27.5 billion, the government would own 37%, but that’s a detail.) The other private investors would own 39%, and current shareholders would own 25%.

The government got some warrants on common shares in connection with the earlier recapitalizations. I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”), but the warrants on the second investment, if exercised, would presumably push the government up a couple percentage points.

Where did the $3.25 price come from? Who knows. Yesterday’s closing price was $2.46. If that price had been used, the government’s target ownership percentage would have been 38% instead of 36%, which seems immaterial. Presumably it was the product of a negotiation, since it’s hard to see how the investors involved – especially the ones that are not the U.S. government – would have wanted to pay more than the current stock price for a company that is clearly in trouble. At least they didn’t use $3.46, which is the price that any future Citigroup convertible preferred stock can be converted at.

And why did the stock plummet (now $1.57), despite the fact that the preferred shareholders are “paying” $3.25 per share? Probably because the common shareholders realize this is largely an accounting game, and the preferred stock wasn’t worth its face value to begin with. The current shareholders’ ownership stake could fall from 100% to 25%, but the stock is only down 36%. This implies that the market thinks that the total common shareholders’ stake will more than double in value, but won’t quadruple in value (the amount required to offset the dilution). Their stake increased in value because (a) Citigroup can avoid paying dividends on all the preferred stock that gets converted and (b) that much less money will have to get paid back to preferred shareholders in case of liquidation. But there’s still a large cloud hanging over Citi, and it’s on the asset side of the balance sheet.

AKA, Convertible Preferred Stock for Beginners.

There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a “preference,” which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department’s new Capital Assistance Program has this precisely backwards.

Under the new Capital Assistance Program (CAP), the government will invest in banks by buying preferred shares with a 9% dividend. This is like the old Capital Purchase Program (used last fall for the first round of recapitalizations), but with one huge twist. Now the bank, AT ITS OPTION, can choose to convert the preferred shares into common, at 90% of the average closing share price during the 20 days ending on February 9 (the day before the new Financial Stability Plan was “announced”).

An example would probably help here. Let’s say that Bank of America (BAC) needs another $25 billion in capital. The government will give BAC $25 billion in cash, which BAC has to pay back in 7 years (that’s the mandatory conversion date). In the meantime, BAC has to pay 9% interest, or $2.25 billion, per year. But, at any time, BAC can convert any amount of that to common shares, at $5.49 per share. (The average closing price over the 20 days was $6.10.) If it converted $5 billion into common, the government would get about 910 million (5 billion divided by 5.49) common shares, but now BAC only owes the government $20 billion and is paying 9% interest on only $20 billion.

In short, BAC has just sold the government 910 million shares for $5.49 each.

This is called a put option. At any time, BAC can sell (“put”) shares to the government for $5.49, but it never has to. (The convertible shares the Silicon Valley VCs get are like call options; at any time, they can buy common shares by trading in preferred shares, but they never have to.) Having an option is always good.

What will BAC do with this option? If its stock price is above $5.49, it can either do nothing, or it can issue new common shares and sell them to private investors, say at $8. Then it can use that $8 to buy back preferred shares from the government, or just hold onto it. If its stock price falls below $5.49, things get interesting. Then BAC can buy up its shares on the market for, say, $3, and then immediately sell them to the government for $5.49. It won’t get $5.49 in new cash, but it will reduce its debt to the government – because preferred shares that have to be bought back and pay interest are basically debt – by $5.49, which is almost as good.

(This would have the side effect of supporting BAC’s stock price, because it means there is a buyer (BAC) who is theoretically always willing to pay $5.48 for the stock. Ricardo Caballero must be smiling)

In practice, it’s not quite this simple, because the bank will require Treasury’s permission to buy back common shares from other investors. But even if BAC doesn’t buy back any shares, it still has the option – whenever its stock price is below $5.49 – of reducing its debt to the government by $5.49 simply by giving the government a share worth less than $5.49.

What’s wrong with this? Well, nothing, if your goal is to give banks money. What you’ve just done is stick the government with the downside risk – we could get paid back in worthless stock – while the bank shareholders get all the upside potential. You’ve done this by giving the bank, for free, an option that has value. Back of the envelope, Peter thinks this option is worth about 65 cents per dollar of money invested. (It’s worth so much because bank stocks are so volatile these days.) Put another way, for every $10 billion of capital we invest this way, we are giving away another $6.5 billion. I think it’s probably a little less, because the option is not as flexible as the holder would like it to be, but you get the point.

As I’ve said many times before, if you think the banks need money, and you want to give it to them (instead of, say, nationalizing them), just give it to them already. Don’t come up with these ridiculously fancy schemes to hide it. Yesterday Krugman gave Simon and me credit for writing this sentence:

This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

But to tell you the truth, at the time we wrote that I didn’t realize just how much brainpower went into this one.

There are some other worrying things in the term sheet I’ll just touch on here:

• Any qualifying financial institution can get anywhere from 1 to 2% of the value of its assets under this program, simply by asking – even if it doesn’t need it. I guess if you’re going to be giving gifts (free put options) to the banks that need to be saved, you need to be fair and give the same gifts to banks that don’t need to be saved. Banks will need regulatory permission to get more than 2% – a clear sign that getting money under this program is a good thing for banks.
• On top of that 2%, any qualifying financial institution can get additional money under this program in order to retire the preferred stock it sold last fall under the Capital Purchase Program. This means they can take back non-convertible preferred stock and give the government convertible preferred stock instead, with no cash changing hands.The dividend rate on the new stuff is higher (9% vs. 5%), so a bank wouldn’t necessarily do this. But if its stock price is lower than its conversion price (the average price on the 20 days ending on February 9), then it should do the swap, and then immediately convert the preferred into common (so the dividend goes away). That way, instead of owing the government, say, $10 billion and paying interest on it, it can give the government $5 billion worth of common stock instead. (For those asking the obvious question: Citigroup’s conversion price is $3.46. Yesterday it closed at $2.52. You might call this one the “Citigroup clause,” not to be confused with Santa Claus.)
• The convertible preferred stock will have no voting rights. This is hardly surprising, given that the whole point of the exercise is to avoid government control. But it’s by no means necessary. For example, VC firms always get voting rights for their convertible preferred shares.

There are some very clever people in Treasury these days.

Update: Oh, I forgot the most important point. This still does nothing for the asset side of the balance sheet, which is where the big monsters are hiding.

For a complete list of Beginners articles, see Financial Crisis for Beginners.

You may have seen in the news that the government is thinking about exchanging its “preferred stock” in Citigroup for “common stock.” Here’s one of many articles. Which, if you are at all sensible and have any sense of proportion in your life, should be complete gobbledygook. The first part of this article will try to explain the gobbledygood; advanced readers can skim it. The second part will offer some of the usual commentary.

Banks, like all companies, have balance sheets. On one side they have assets – stuff they own. On the other side they have liabilities – money they owe other people – and equity. Equity can be thought of in two ways. First, it is the money that the initial owners put in to start the business; before you can borrow money from someone else, you usually have to have some money or other assets of your own that you put in. Added to that money are retained earnings – all the profits the company has made but has not paid out to the owners as dividends. Second, equity is what is left over after you pay off all your creditors. If you sold the assets and paid off the liabilities, the rest would go to the company’s owners.

That equity “belongs” to the owners of the company; if it’s a publicly-owned company, those are the shareholders. The market value of the equity is the total amount that people would pay today to own all of that balance sheet equity: it’s the total number of shares times the share price. The market value of equity is generally different from the “book value” (balance sheet value) of equity, because if you own a company, you own not only today’s equity, but also all the profits the company will make in the future. Under certain circumstances the market value of equity can be less than the book value of equity – that’s the case if investors think that the company’s management is destroying value, or that the book value of equity on the balance sheet inflates its true worth.

The complication is that there are different kinds of equity. The way to think about this is to think about the various ways that companies can raise cash from investors. At one extreme there is secured debt: the company goes to a bank, takes out a loan, and pledges some of its assets as collateral. If it doesn’t repay the loan, the bank gets the collateral. Then there is unsecured debt: the company issues a bond, which is just a promise to pay in the future, and the investor pays money for this bond, hoping to be repaid with interest. At the other extreme there are common shares. These give you no rights in particular, except the right to control the company, through the board of directors. Conceptually, the common shareholders own the equity, and benefit from the future profits, but the company has no obligation to give them any of the equity, or to pay out any of the profits as dividends. Then in between debt and common shares there are these things called preferred shares, which come in many flavors. Preferred shares are like debt: they may pay a required dividend, which is like interest on a debt; there may be rules on when they have to be bought back by the company, such as in case of a major transaction. They are also like equity: in case of bankruptcy, preferred shareholders only get paid back only after all the debt holders have been paid back; in some cases, preferred shares can be converted for common shares at a predetermined price, which allows preferred shareholders to benefit if the common stock goes up in value.

In summary, there is a spectrum of instruments through which companies raise money, and these instruments have differing priority in making claims on the company. They also differ in how likely the investor is to be paid back. Secured debt comes first, common shares come last, and everything else comes in between.

Trust me, we’re getting closer to the question I started with.

Ordinarily, you don’t need to debate whether preferred shares should count as debt or equity. However, for banks in particular, there is a concept called capital adequacy. A capital adequacy ratio is the ratio between some measure of capital to total assets. Imagine for a moment that there was only one kind of debt – say, deposits – and one kind of capital – ordinary shares. Say my bank has $100 in assets. As we all know, assets can go up or down in value. If I have $90 in debt, then I have $10 in capital, and my ratio is 10%. This means that my assets could fall in value by up to 10% and I would still be able to pay back my depositors. If, instead, I have $99 in debt, then my ratio is only 1%. If my assets fall by more than 1% in value, I won’t be able to pay back my depositors, I’ll be insolvent, and the FDIC will take me over so it can pay off the deposit guarantees at minimum risk to itself. This is why the capital adequacy ratio matters, especially to bank regulators. What minimum capital ratios should be is a complex topic, most of which I will avoid, but you can see why they matter.

The part I can’t avoid is how the capital – the numerator of the ratio – is calculated. As I said above, there are many different types of capital. Besides common shares and preferred shares, believe it or not, you can count deferred tax assets (credits you gain by losing money in one year, which you can apply against taxes in future years where you make money) as capital. One commonly used measure of capital is called Tier 1 Capital, which includes common shares, preferred shares, and deferred tax assets. A less commonly used measure is Tangible Common Equity (TCE), which includes only common shares. Obviously, TCE will yield a lower percentage than Tier 1.

Which of these measures is better? That’s sort of an arbitrary question. The fact that you change the numbers you type into your spreadsheet doesn’t change the actual health of the bank any. They just measure different things. Each one measures the ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised. One difference between the two is whether you count preferred shares as liabilities, which depends on how bad you think it is that preferred shareholders don’t get their money back. Another difference depends on what you think the deferred tax credits are worth in a worst-case scenario. In any case, the skeptics, like Friedman Billings Ramsey, have been insisting since the beginning of the crisis that TCE is the proper measure of bank solvency. And most immediately, Tim Geithner has said that the new bank stress tests will focus on TCE. So if your bank doesn’t have enough TCE, it will fail the stress test, and then . . . who knows what the administration has the stomach to do.

Getting back to the current situation . . . The initial government investments in Citigroup, back in October and November, were in the form of preferred shares. Between the two bailouts, the government put in $45 billion in cash and got $52 billion in preferred stock (the $7 billion difference was the fee for the guarantee on $300 billion of Citi assets). That preferred stock was designed to be much closer to debt than to equity: it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years. In fact, it is hard to distinguish from debt, except perhaps for the fact that, if Citi defaults on it (cannot buy the shares back) we don’t need to worry about systemic instability, because the government can absorb the loss. As preferred stock, these bailouts boosted Citi’s Tier 1 capital, but not its TCE.

Because of the newly perceived need for TCE, the bailout plan under discussion is to convert some of the preferred stock into common stock. Citi wouldn’t actually get any new cash from the government, but it would be relieved some of the dividend payments (currently close to $3 billion per year), and of the obligation to buy back the shares in five years. (For the impact on Citi’s capital ratios, see FT Alphaville.) This is a real benefit to the bank’s bottom line, and hence to the common shareholders. At the same time, though, Citi would issue new common shares to the government, diluting the existing common shareholders (meaning that they now own a smaller percentage of the bank than before). In theory, the amount by which the shareholders in aggregate are better off should balance the amount of dilution to the existing shareholders.

The trick is deciding what price to convert the shares at. All of Citi’s common shares today are worth around $12 billion, so if you converted $52 billion of preferred shares into common, the government would suddenly own over 80% of Citi. (In the conversion, you divide the value of the preferred stock you are converting by the price of the common stock, and that yields the number of common shares the government now owns.) The Geithner team is still continuing the Paulson policy of avoiding anything that looks like nationalization, so the talk is that the government ownership will be capped at 40%; that means the government could only convert about $8 billion of its preferred stock. There will probably be some clever manipulation of the numbers to say that the preferred stock is actually worth less than $52 billion, or that it should be converted at a higher price than the current market price of the stock. (This seems like a blatant subsidy to me, since new investors buying large blocks of stock in a public company typically pay less than the current market price.) There is also talk of trying to get some of Citi’s other preferred stock holders to convert as well, because the more they convert, the more common shares, and hence the more the government can have without going over the 40% limit.

I still don’t understand why people care so much about whether the government owns more or less than 50% of the common shares. This just seems like a fig leaf. The more important issue which people can argue about is whether government is controlling Citigroup’s day-to-day operations. (Some say that’s good, some say it’s bad.) According to The New York Times, this is already happening. Alternatively, if you want to minimize government control, the government could tie its own hands; for example, no matter what its percentage ownership, the government’s stock purchase agreement could say that it has the right to appoint a minority of the board of directors but no more than that.

I think the situation we want to avoid is what is going on at AIG, where the government owns 80% of the company but still seems to be negotiating at arm’s length with the company. This is the worst of all worlds, because even though it already bears the vast majority of the losses, and has the power to clean up AIG (by writing down all its assets to their worst-case scenario values and then recapitalizing the firm sufficiently), the government is treating AIG like an independent entity. For example, if the government did a radical cleanup, it’s hard to see how AIG would still be in danager of ratings downgrades – which are the immediate problem it faces. But that story may have to wait for another post.

Update: Changed “private company” to “publicly-owned company” in the 1st line of the 3rd paragraph. Someday I’ll learn to proof-read before posting.  Thanks to Manu for catching that.

Back in September, Simon and I wrote two op-eds on the governance and pricing challenges of buying toxic assets. As many people have noted, those problems have not gone away. The latter, in particular, represents a formidable barrier to Tim Geithner’s latest proposal to create a public-private partnership to relieve banks of their toxic assets. (In summary, the problem is that banks do not want to sell at the price the free market will offer, because (a) they think the assets will be worth more later and (b) doing so would force them to take writedowns that might make them insolvent.)

Lucian Bebchuk also wrote an op-ed on this topic in September, and to his credit he is still trying to turn “TARP II” into something feasible in his new paper, “How to Make Tarp II Work.” The paper has some good ideas but I’m not sure it solves the basic problem, which unfortunately has to do with the laws of arithmetic.

One of Bebchuk’s key points is that there should be multiple funds buying toxic assets rather than one super-aggregator fund, for the basic reason of price competition:

The existence of such a significant number of private buyers armed with substantial capital will produce a well-functioning market for troubled assets. This will be a market in which many potential sellers (banks) face a significant number of potential buyers (the funds). The profit share captured by the funds’ private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets. At the same time, the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets. As a result, we can expect the market for troubled assets to function well, with prices set around the fundamental economic value of purchased troubled assets.

More on that last sentence later.

He also has a clever idea for how to create that competition: Have private-sector fund managers bid for government money (capital or loans – more on that in a second) by bidding the maximum percentage of capital they are willing to provide (the rest of the funding coming from the government). The fund managers willing to put up the most of their own money will get the government funding. This will use the market to minimize the amount of government money that has to be contributed.

Bebchuk also recommends lock-up provisions that ensure that investors – whether private or public – cannot withdraw money from the funds for at least three years. This will help fund managers focus on long-term value without having to worry about having to sell assets into an illiquid market in order to meet demands for redemptions.

These are good ideas. But I’m not sure they are enough to make the market work, and this is where the laws of arithmetic come in. In fact, here’s Bebchuk’s statement of the problem:

A well-functioning market will convert some of the troubled assets held by banks into cash and, perhaps more importantly, provide more reliable valuations for the troubled assets that banks will retain. While this might confirm the claims made by some banks about the value of their assets, it might lead to realization that some other banks are insolvent or inadequately capitalized, which would require infusions of additional capital. Thus, restarting the market for troubled assets might well be insufficient by itself to solve banks’ problems.

Even if you have multiple buyers willing to pay “economic value” for the assets, and multiple banks who want to sell them, you could still have a market failure; those banks could refuse to sell because it would force them to recognize losses that might make them insolvent (and no CEO wants to be CEO of an insolvent bank). In fact, this is what many people think is the case right now. All the people who might invest in a public-private partnership could buy those toxic assets right now, but they can’t agree on prices with the banks who hold those assets.

So if we want TARP II to work, it has to make it easier for buyers and sellers to agree on prices. Lock-up provisions could help, but presumably if there are private investors willing to agree to three-year lock-ups, then private fund managers could raise money from them right now. What is Geither’s public-private partnership going to change? In order to get to a price that buyers and sellers can agree on, buyers have to be willing to pay more than they are currently willing to pay (because the banks aren’t selling at their current willingness-to-pay). There’s only one way the government can do that: by sweetening the deal.

Here is Bebchuk’s example of how this might work:

Consider a $1 billion fund established with a $50 million equity investment contributed by the private manager and $950 million in debt financing from the government’s Investment Fund. In this case, while the private manager will be the first to bear any losses of the portfolio, the private manager’s potential loss from the fund’s $1 billion portfolio will be capped at $50 million. On the upside, however, the private manager will fully capture any profits that the government’s capital of $950 billion generates above the loan’s low interest.

Let’s say that I’m a fund manager, and without government money I’m willing to pay 30 cents for some asset.  That means that when I run my valuation models, there is some chance I will be able to sell it for more than 30 cents, and some chance that I will have to sell it for less, and those distributions balance each other. Government money doesn’t change that distribution of outcomes; it just changes the share of the gains or losses that I incur. In Bebchuk’s example, out of those 30 cents, only 1.5 cents (5%) are mine, so I don’t have to worry about the risk of the price falling below 28.5 cents. But I still get all of the upside. You can see how that shifts my expected outcome in my favor. Because my losses are capped at 5% of my purchase price, I might be willing to pay 40 cents intsead of 30 cents: even though my chances of making money are small (the distribution of eventual sale prices hasn’t changed), my losses are capped at 2 cents (5% of 40 cents), so I don’t need a lot of upside to compensate for my limited downside.

In short, the larger the proportion of government funding, the higher my willingness-to-pay. The purpose of Bebchuk’s auction is to find the fund managers willing to do the job with the least government funding.

This all makes sense, but here are the issues. First, the government financing in this example is a government subsidy. If the taxpayer is taking on the downside (after the first 5%), but none of the upside, and charging the fund manager a low interest rate, then that’s a losing proposition. Looked at from another perspective, if the fund manager’s expected take has gone up, then someone else’s expected take has gone down. Maybe it’s a subsidy we have to grant for the public interest, but there’s still no free lunch. (The government could contribute some capital instead of debt, but then the government’s capital has the same characteristics as the private capital, and the same amount of debt will be required to sweeten the deal sufficiently.)

Second, it still might not work. We don’t really know what the gap right now is between buyers’ willingness-to-pay and sellers’ reservation prices. A government sweetener will increase buyers’ willingness-to-pay, but there is a limit: if buyers think that an asset is worth 30 cents, and the chances of it ever being worth more than 50 cents are infinitesimal, then they will never pay more than 50 cents – and we don’t know if that’s enough to get the banks to sell. So it’s possible that we could set up the most efficient possible mechanism for distributing government financing to the most well-incented fund managers, and the market could still fail.

In the end, if Treasury is going to go down the public-private toxic-asset-purchasing path, then I think Bebchuk has some good suggestions. But there’s still no magic bullet here.