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.)
Tag Archives: bailout
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.
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.
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.
At management team meetings at my old company, there was a slogan I was known for: “No wishful thinking.” I would trot it out whenever I felt like our expectations for the future (say, our sales projections, or our product delivery dates) were being influenced by our desires for the future. Let’s say, for example, that you have to hit your sales target, raise more money, or lay people off. It is very easy to plan around hitting your sales target, because the other options are unpleasant. But that would clearly be folly.
I thought of this when listening to an interview Adam Posen did for Monday’s Planet Money (beginning around the 6-minute mark). The Geithner Plan had not yet been announced, but Posen already had the right diagnosis: wishful thinking. The administration, on his analysis, is hoping that it will be able to turn the economy around without having to take tough measures with the banks.
Martin Wolf puts it this way:
[H]oping for the best is what one sees in . . . the new plans for fixing the banking system. . . .
The banking programme seems to be yet another child of the failed interventions of the past one and a half years: optimistic and indecisive.
Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the “Geithner plan,” although maybe Larry Summers is hiding behind him):
In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.
Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.
He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.
I’m not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it’s still a subsidy; it’s just not as obvious as writing a check.)
The Wall Street Journal (subscription required; shorter Bloomberg article here) is reporting that Bank of America will receive billions of dollars more in government aid, probably in a deal that looks something like the second Citigroup bailout, ostensibly to help absorb losses incurred by Merrill Lynch since the acquisition was negotiated in September but more generally to shore up B of A’s increasingly shaky balance sheet. At least someone involved knows how this looks: the reports say the deal will be announced on January 20 – yes, the day of Barack Obama’s inauguration – thereby keeping it from being the main story of the day.
It looks bad for all sorts of reasons:
- Wasn’t B of A supposed to be a healthy bank? Isn’t Ken Lewis (CEO) the person who told Henry Paulson he didn’t need the first round of TARP money, but he would take it to show solidarity and for the public good?
- The money is going to finance an acquisition? Isn’t that the thing that (according to most people) banks aren’t supposed to be doing with their bailout money?
- The B of A-Merrill deal closed on January 1. So it looks like – as the WSJ is reporting – the deal only closed because Treasury gave B of A a verbal commitment to supply the needed bailout money later.
- Isn’t this more policy by deal?
That said, I think some sort of deal has to be done. Even Yves Smith at naked capitalism (one of the most consistent and sharp critics of the way TARP has been implemented), who says this deal “stinks to high heaven,” says that “Merrill is a systemically important player” and “letting the deal with BofA ‘fail’ is a non-starter.” But I predict that when the terms are announced I will think they are too generous – especially since B of A now has all the negotiating power, since they closed the acquisition based on a promise from Treasury.
To recap – because I have this pathological fear of not being understood – I think that TARP’s primary purpose is to protect the financial system against the collapse of any systemically critical financial institutions (I leave it to others to define what those are, but Bank of America definitely is one, GMAC I’m skeptical about), and it has suffered from three main problems:
- The initial round was too small, with banks only getting 3% of assets or $25 billion, whichever was smaller – which is why Citi and now B of A have had to come back.
- The terms were too generous; I can make an exception for the first round, but I don’t understand why Citigroup 2 and GMAC were so favorable to shareholders.
- Except for the very generous initial round, it’s just a pile of money to be used in ad hoc deals, not a comprehensive program with a coherent strategy, so no one is quite sure how or if it will be able to protect the financial system.
The B of A bailout will only sour public and Congressional opinion further against TARP, making it less likely that the second $350 billion will ever be released, and more likely that if it is released it will be packaged with all sorts of conditions (not necessarily bad) or allocated to community banks (beside the point).
It is true that one price we are paying in these bailouts is the creation of a new tier of mega-banks that, because they are Too Big To Fail, have the competitive advantage of being essentially government-guaranteed. What we really need as a condition on TARP money is a new regulatory structure to make sure that these mega-banks do not abuse the oligopolistic position we have just handed them, and perhaps a commitment to break them up when economic circumstances allow. That would be considerably more valuable than a cap on executive salaries and corporate jets. But it will also be a lot more difficult to define and to agree on.
Back on January 2, the Treasury Department announced something called the Targeted Investment Program. I missed this at the time, along with (according to a quick search – thank you Google Reader!) all of the economics blogs that I read. The press release admitted that this was a program announced after the fact to cover the second Citigroup bailout (the first was under the Capital Purchase Program, the main bank recapitalization plan). In essence, the program says that if Treasury thinks a financial institution is at risk of a loss of confidence, Treasury can invest in it under any terms they want. This is very similar to the Systemically Significant Failing Institutions Program, also announced after the fact (in November) to cover the second AIG bailout, which reads almost identically, except instead of talking about a “loss of confidence” it takes about the “disorderly failure” of a systemically important institution.
This isn’t a power grab by Treasury – they already had this power under the EESA (the main bailout bill passed in October, commonly known as TARP). And I happen to agree that if a systemically significant institution – the kind that whose failure would have a major impact on countless other institutions – is going to fail, it should be bailed out. However, I think these programs have two major failings.
I admit – I have auto bailout fatigue. But given the amount of virtual ink that has been spilled on this topic here, I think I owe you a place where you can express your thoughts on the current plan.
The Times says we are close to a vote, although Senate Republicans may block it. Here is the draft bill. The news article says it would take the form of $15 billion in short-term emergency loans. Reading the bill itself, though, I can’t find the number “$15 billion” anywhere. This is what I read:
- The President can appoint a person (or persons) to implement the bill, apparently colloquially known as the car czar.
- Once the bill passes, the car czar can make bridge loans or lines of credit right now. Those loans can be for as much as is needed under the plans submitted to Congress last week.
- The money is coming from “section 129 of division A of the Consolidated Security, Disaster Assistance, and Continuing Appropriations Act, 2009, relating to funding for the manufacture of advanced technology vehicles,” which I’m guessing is the pre-existing bill providing $25 billion in loans for R&D for fuel-efficient vehicles. That money will be then be replenished. It’s not clear whether this creates a $25 billion cap or not (how many times can the car czar draw on that money after it’s been replenished?).
- The loans are at 5%, increasing to 9% after 5 years. The government also gets a warrant to buy up to 20% of the loan amount in stock, at a price equal to the average price during the 15 days prior to December 2.
- The short-term loans are conditional on the government, the automakers, and all interested parties (including unions and creditors) being able to agree on a comprehensive, long-term restructuring plan by March 31, 2009. The car czar can extend this deadline by 30 days, but that’s it.
- The car czar has a lot of power to monitor the auto companies and make sure they are meeting the targets of their restructuring plans; if they aren’t, he can call in the loans.
- There are some other fun but peripheral provisions, like getting rid of corporate aircraft, dropping lawsuits against state greenhouse gas regulation, and executive compensation limitations.
The big point is #5 (in my list). In short, this isn’t a comprehensive bailout: it’s a bridge loan to buy time to come up with a comprehensive bailout. This is roughly what Simon predicted (although I can’t remember where). It enables the Bush administration to avoid having a car company fail on its watch, and enables the Democratic majority to say that they are doing something for the automakers, while deferring the hard questions. I assume that all of the controversial questions, like how big a concession the unions have to make, and whether or not it’s possible to force creditors to take equity in place of debt, will re-emerge over the next few months.
Of course, we may still have the live TV drama of not quite knowing if the Republicans will provide the needed votes, like we had with the first TARP vote. I would also be shocked to see President Bush sign a bill that requires car companies to drop their lawsuits against greenhouse gas regulation.
Let me know if I read the bill wrong.
Update: More from Felix Salmon on why it may be hard to get bondholders to agree to restructuring short of bankruptcy.
The New York Times has an arresting chart on the government’s new financial commitments made during the financial crisis. According to the Times, the government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender. Wow, you may think, that’s a lot of money. US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range. But wait, there’s more: the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet (although they were always implicitly there).
All that said, though, there’s a big difference between these “commitments” and ordinary government spending. Ordinary government spending simply evaporates into the economy: for example, Medicare expenses go to pay for people’s health care, and the government will never get them back. Making financial commitments is what banks and other financial institutions do, and they do it because they expect to get their money back. What we are seeing is the growth of a massive financial institution within the government. This one’s primary goal is the public interest – in this case, the health of the economy – rather than getting its money back. But still, it should get most of the money back.
According to the Wall Street Journal, the deal is done. Here are the terms. In short: (a) the government gives Citi $20 billion in cash in exchange for $27 billion of preferred on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01 per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets, made up of residential and commercial mortgage-backed securities. (If triggered, some of that guarantee will be provided as a loan from the Fed.) There is also a warrant to buy up to $2.7 billion worth of common stock (I presume) at a staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).
The government (should have) had two goals for this bailout. First, since everyone assumes Citi is too big to fail, the bailout had to be big enough that it would settle the matter once and for all. Second, it had to define a standard set of terms that other banks could rely on and, more importantly, the market could rely on being there for other banks. This plan fails on both counts.
The arithmetic on this deal doesn’t seem to work for me (feel free to help me out). Citi has over $2 trillion in assets and several hundred billions of dollars in off-balance sheet liabilities. $20 billion is a drop in the bucket. Friedman Billings Ramsey last week estimated that Citi needed $160 billion in new capital. (I’m not sure I agree with the exact number, but that’s the ballpark.) Yes, there is a guarantee on $306 billion in assets (which will not get triggered until that $20 billion is wiped out), but that leaves another $2 trillion in other assets, many of which are not looking particularly healthy. If I’m an investor, I’m thinking that Citi is going to have to come back again for more money.
In addition, the plan is arbitrary and cannot possibly set an expectation for future deals. In particular, by saying that the government will back some of Citi’s assets but not others, it doesn’t even establish a principle that can be followed in future bailouts. In effect, the message to the market was and has been: “We will protect some (unnamed) large banks from failing, but we won’t tell you how and we’ll decide at the last minute.)” As long as that’s the message, investors will continue to worry about all U.S. banks.
The third goal should have been getting a good deal for the U.S. taxpayer, but instead Citi got the same generous terms as the original recapitalization. 8% is still less than the 10% Buffett got from Goldman; a cap on dividends is a nice touch but shouldn’t affect the value of equity any. By refusing to ask for convertible shares, the government achieved its goal of not diluting shareholders and limiting its influence over the bank. And an exercise price of $10.61 for the warrants? It is justified as the average closing price for the preceding 20 days, but basically that amounts to substituting what people really would like to believe the stock is worth for what it really is worth ($3.77).
How does this kind of thing happen? A weekend is really just not that much time to work out a deal. Maybe next time Treasury and the Fed should have a plan before going into the weekend?
Update: Bloggers start trying to be funny, world to end soon:
- Calculated Risk (on the aborted plan to divide Citi into a “good bank” and a “bad bank”): “Hey, I thought Citi WAS the bad bank!”
- Tyler Cowen (on the same plan, which morphed into the government’s guarantee of the “bad bank” part of Citi): “Didn’t Paulson tell us just a few days ago that TARP wasn’t needed after all? Doesn’t this mean that Paulson should speak less frequently?”
Update 2: I made a mistake in the original post: although the government is getting $27 billion “worth” of non-convertible preferred stock, it is only paying $20 billion in cash. $7 billion is being granted as the fee for the government guarantee. Thanks to Nemo for catching this. (Note to self: No posts after midnight!)
My two earlier posts on the auto industry and GM have been among the most-commented-on posts in our brief history. For those who want a crash course on GM’s problems and whether or not bankruptcy is a possible solution, I strongly recommend two podcasts from Planet Money.
- Kimberly Rodriguez, an economist, talks about the importance of the industry, but also the problems with simply giving GM an operational loan.
- Steve Jakubowski, a bankruptcy lawyer, explains the risks of GM entering Chapter 11 (if you’re curious about the market for debtor-in-possession financing, listen to this), but also explains how a “prepackaged” bankruptcy, possibly funded by the government, could work.
Simon also tells me he talked through the arguments on both sides of the GM issue in his latest installment for the MIT Sloan podcast. (I haven’t had time to listen to it yet.)
If there’s a consensus between them, I’d say it’s that some kind of brokered solution is better than either simply leaving GM alone or simply handing them a loan without strings attached. (It is possible, however, that a loan might be necessary just to buy enough time to broker the solution.)
The New York Times is reporting that it could all be academic, since Senate Republicans and President Bush are opposed to doing anything for GM, and GM could be unable to pay its bills by the time Obama takes office.
Two days ago, in my post about AIG, I had the following passage:
In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)
I meant to expand on that throwaway parenthesis, but I was busy all day today and didn’t get around to it. By the time I got home, I found out that Henry Paulson had scrapped the idea of buying troubled assets altogether (something we’ve favored for a while), saving me the effort of arguing against it.
Unfortunately, after reading Bloomberg, The New York Times, the Wall Street Journal, and the text of Paulson’s remarks, I can’t figure out what they’re doing with the remaining money instead. The main emphasis of the news articles was on the new idea to create a new entity, seeded by TARP money, to lend money against consumer loans, in order to stimulate demand for those loans and hence consumer lending. But this was just one of three possibilities that Paulson mentioned: the others were additional recapitalizations (potentially with a public-private structure, or expanded to a broader range of financial institutions) and a loan-modification program.
While I agree with Andrew Ross Sorkin that it’s a good thing Paulson was able to change his mind about buying illiquid assets, I would feel better if he knew what he was changing his mind to.
GM is mounting a massive PR campaign to convince Washington that a GM bankruptcy would be catastrophic to the national economy, resulting in the loss of millions of jobs, costing taxpayers over $100 billion, and plunging the economy into a depression (whatever that is). In addition to Nancy Pelosi and Harry Reed, Barack Obama has now called for an auto bailout.
I don’t want the US auto industry to go away. Yes, if GM and every one of its suppliers and dealers stopped operating tomorrow, that would cost hundreds of thousands or millions of jobs. But it’s not clear to me why bankruptcy would have the same effect. Ordinarily, when a company goes bankrupt – especially a big one – it goes right along doing whatever it was doing before, except now it doesn’t have to pay off all its creditors, and its operations are monitored by a court. The bankruptcy process is intended to find a reasonable outcome for all of the stakeholders that reflects the order of priority of their claims, but also (in the case of a company as big as GM) reflects the public interest. Airlines, for example, have been going in and out of bankruptcy for years in order to force their unions to negotiate long-term cost reductions, and even use the threat of bankruptcy as a negotiating tool.
Way back in the heady days of September, we criticized the original version of TARP because it seemed designed to ensure the government would overpay for toxic assets. Instead, we recommended splitting the transaction into two parts: (a) buy the assets at market (cheap) prices, and (b) explicitly recapitalize the banks. In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)
Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.
The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.
Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.