Larry Summers and Finance

By James Kwak

I think some people didn’t understand the point I was making about the question of whether the government made money on TARP in my earlier post. Summers said, “The government got back substantially more money than it invested.” This is true, at least if you give him some slack on the word “substantially.” The money repaid, including interest on preferred stock and sales of common stock, exceeded the money invested.

My point begins with the observation that, as of late last year, the government had earned an annual return of less than 0.5%. My point itself is that it is silly to evaluate an investment by whether or not it has a positive return in nominal terms. You can only meaningfully evaluate an investment by comparing it to some benchmark. Saying that a nominal return of 0.5% is greater than 0% is meaningless, since the 0% benchmark is meaningless. Most obviously, it doesn’t account for inflation; since inflation has been about 1–2%, the government lost money in real terms.

Continue reading “Larry Summers and Finance”

Not with a Bang

By James Kwak

In the Times, Neil Barofsky, Special Inspector General for TARP, performed the admirable feat of fitting a clear, comprehensive, sober critique of how TARP was implemented and what its long-term impact will be in fewer than 1,000 words. It’s a perspective I mainly agree with,* and it highlights the different priorities that the administration put on aid to large banks and aid to homeowners, even though both were goals of the bill.

Back in late 2008 and early 2009, there was a lot of talk about how a true solution for the problems of the banking system would require a solution for the problems of homeowners, since the banks’ losses were largely the result of mortgage defaults. One of the major technical achievements of the administration was showing that it was possible to stabilize the financial system and restore the banks to short-term profitability without doing much for homeowners. As Barofsky says, and as the Times reports in yet another article today, the administration’s programs to help homeowners obtain loan modifications had little impact on the behavior of the banks that service mortgages and foreclosures continue unabated. Real housing prices have fallen below the previous lows of 2009 and now look likely to overcorrect on the downside.**

Housing modifications are admittedly more difficult than bailing out banks. It’s administratively easier to write a few $25 billion checks and create unlimited low-interest credit lines for a few of the Federal Reserve’s existing customers than to intervene in millions of mortgages. But the financial crisis was a time of bold action on other fronts. Treasury and the Federal Reserve were willing to push the limits of the law, for example in J.P. Morgan’s takeover of Bear Stearns. (See the chapter in Steven Davidoff’s book Gods at War for the details.) Henry Paulson threatened to declare the nation’s largest banks insolvent if they didn’t agree to sell preferred stock to the government. By contrast, as law professor Katherine Porter says in the Times article, “The banks were so despised, and TARP was so front and center, you could have actually done something. In the midst of real boldness in bailing out the banks, we get this timid, soft, voluntary conditional program.”

The lesson we learned learned is that homeowners were only a priority insofar as their health mattered to the banks’ health. When those two things became unmoored, the administration was willing to declare victory.

* The main thing I don’t agree with is Barofsky’s implied criticism of the Bush administration for using TARP money to buy preferred stock from banks rather than buying mortgage-backed securities directly. While I have often criticized various aspects of the preferred stock purchases, I think it was a more direct way to stop the panic of September-October 2008, and at that point a program to purchase MBS would probably have been an even more blatant transfer to the banks.

** I’m all for prices falling from bubble levels, but the policy goal should have been preventing them from falling through the long-term trend.

“A Healthy Financial System Cannot Be Built On The Expectation Of Bailouts”

By Simon Johnson.  Testimony submitted to the Congressional Oversight Panel, “Hearing on the TARP’s Impact on Financial Stability,” Friday, March 4, 2011.

I.                   Summary

1)      The financial crisis is not over, in the sense that its impact persists and even continues to spread.  Employment remains more than 5 percent below its pre-crisis peak, millions of homeowners are still underwater on their mortgages, and the negative fiscal consequences – at national, state, and local level – remain profound. 

2)      To the extent that a full evaluation is possible today, the financial crisis produced a pattern of rapid economic decline and slow employment recovery quite unlike any post-war recession – it looks much more like a mini-depression of the kind the US economy used to experience in the 19th century.  In addition, the fiscal costs of the disaster in our banking system so far amount to roughly a 40 percentage point increase in net federal government debt held by the private sector, i.e., roughly a doubling of outstanding debt. 

3)      In this context, TARP played a significant role preventing the mini-depression from becoming a full-blown Great Depression, primarily by providing capital to financial institutions that were close to insolvency or otherwise under market pressure.

4)      But part of the cost is to distort further incentives at the heart of Wall Street.  Neil Barofsky, the Special Inspector General for the Troubled Assets Relief Program put it well in his latest quarterly report, which appeared in late January, emphasizing: “perhaps TARP’s most significant legacy, the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.’” Continue reading ““A Healthy Financial System Cannot Be Built On The Expectation Of Bailouts””

TARP Is Gone – But May Soon Be Back

The Troubled Asset Relief Program, or TARP, is over – more specifically, its legal authority expires on Sunday, so it cannot be used for new “bailout” activities (although legacy programs, with money already disbursed, could last 5 to 10 years.)

The first draft of its history, looking back over the past two years, may be this: TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse — but it was implemented in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle. Continue reading “TARP Is Gone – But May Soon Be Back”

What’s Up with Citigroup?

On Monday, Citigroup received permission from its regulators to buy back the remaining $20 billion in preferred shares held by Treasury because of its investments under TARP. (Treasury invested $25 billion in October 2008 and another $20 billion November 2008; however, $25 billion worth of preferred shares were converted into common shares earlier this year, giving the government about a 34% ownership stake in the bank.) The stock then fell by 6%. What’s going on?

This is another example of a bank doing something stupid in order to say that it is no longer receiving TARP money, and probably more importantly so it can escape executive compensation restrictions. As Citigroup CEO Vikram Pandit himself said last October, TARP capital is really cheap (quoted in David Wessel, In Fed We Trust). Instead of paying an 8% interest rate* on $20 billion in preferred shares, Citigroup chose to issue $17 billion of new common shares while its share price is below $4/share. Citigroup’s cost of equity is certainly more than 8%, so it just increased its overall cost of capital. The stock price fell because existing shareholders are guessing that the dilution they suffered (because new shares were issued) will more than compensate for the fact that Citi no longer has to pay dividends to Treasury.

Continue reading “What’s Up with Citigroup?”

Casey Mulligan’s Straw Man

Casey Mulligan argues that bank recapitalization under TARP was a failure because it did not lead to increased bank lending. He argues that this was a necessary outcome, because (a) public purchases of bank capital crowd out private purchases of bank capital, and (b) new capital does not necessarily flow into lending, and concludes: “This episode is an expensive example of public policy promises that were doomed to failure because they were known at the outset to defy economic theory.”

I have often argued that there were many things wrong with TARP. But this is not one of them.

Continue reading “Casey Mulligan’s Straw Man”

Cash for Trash: Better Never than Late

The following guest post was written by Linus Wilson, a finance professor at the University of Louisiana at Lafayette, the media’s go-to guy on calculating the value of transactions between the government and the banks, and an occasional commenter on this blog. Linus also analyzes government-bank transactions at Seeking Alpha.

The U.S. government does few thing better than create debt.  After a year of talking about it, the government is going to have the chance to throw their good debt, Treasury bills notes and bonds, after bad, non-performing toxic loans and securities.  The Federal Deposit Insurance Corporation (FDIC) and the U.S. Treasury are going their separate ways on their cash for trash schemes at this point.  Accountants and investors should be wary of the big prices they see coming from the FDIC’s auctions, but taxpayers should be afraid of the U.S. Treasury’s efforts to re-inflate the securitization bubble.

Continue reading “Cash for Trash: Better Never than Late”

The Two Sides of the Balance Sheet

Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”

This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)

Continue reading “The Two Sides of the Balance Sheet”

Option Pricing for Beginners

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

I’ve had two posts so far on the terms under which Treasury sold back to Old National the warrants on Old National stock that Treasury got in exchange for its TARP investment, so I thought it was time for an introduction to warrant/option pricing.

The warrants received by Treasury give Treasury the right to buy common stock in the issuing bank under predefined terms. Buying the stock is called exercising the warrant. The warrant specifies how many shares Treasury can buy; the price that it must pay to buy them (the exercise price); and the term of the warrant, meaning how long Treasury has to decide whether or not it wants to exercise the warrant. If Treasury never exercises the warrant, then it expires and nothing happens. For our purposes, a warrant is the same as a call option; there are some differences I will ignore, which are outlined here.

Continue reading “Option Pricing for Beginners”

Warrant Sales Could Cost Government $10 Billion

Mark Pittman at Bloomberg estimates the total potential cost to taxpayers of selling warrants back to banks at low prices: $10 billion.  These are the warrants that banks had to issue to Treasury in exchange for preferred stock investments under TARP. Pittman uses the Old National example as a benchmark: Old National paid $1.2 million to buy back warrants that he estimates at $5.8 million. (Linus Wilson, the first person I know of to do the calculations, estimated a range of values from $1.5 million to $6.9 million.) Extrapolating that “discount” to all the other warrants that Treasury currently holds, Pittman finds:

Under the Old National warrants formula, Bank of America Corp. would save $2.03 billion, followed by Wells Fargo & Co. at $1.48 billion and JPMorgan Chase & Co. at $1.46 billion. Morgan Stanley’s benefit would be $983 million, Citigroup Inc.’s would come in at $965 million and Goldman Sachs Group Inc. would have $693 million, according to the data compiled by Bloomberg.

If you are concerned about banks’ capital levels, that’s one way to help them out. The alternative, suggested by Wilson and others, would be for Treasury to auction off the warrants; if the bids were too low, it could create a trust, transfer them from Treasury to the trust, and release the banks of any TARP obligations triggered by those warrants.

It also contrasts sharply with the treatment of private (not publicly-traded) banks such as Centra, as documented by David Kestenbaum of Planet Money.

I’ll have more on option pricing later.

By James Kwak

Geithner Plan vs. Paulson Plan

Dennis Snower works out the arithmetic behind the Public-Private Investment Program and shows something that we’ve suspected: if the assets are really toxic (the gap between book value and long-term expected value is big), the subsidy just isn’t big enough. He also shows that if the assets are only a little toxic, the government subsidy induces private sector bidders to overbid, making the subsidy bigger than it needs to be.

Snower’s hypothetical asset has an expected value of $50. According to his calculations:

  • If the bank has it on its books at $70, the private sector will bid it up to $85 because of the government subsidy. The government would have been better off under the original Paulson Plan (just buy it off the bank at book value, in this case $70).
  • If the bank has it on its books above $85, the private sector will not buy it at all and the plan will do nothing.

Now, his asset has different characteristics than the assets out there in the real world, whose expected values are not knowable, let alone known. That may change the analysis, but I doubt it changes the ultimate result.

Thanks to the reader who recommended this.

By James Kwak

First Buy High; Then Sell Low

On Monday last week, Old National Bancorp bought back the warrants it had granted Treasury as part of its participation in TARP, after buying back its preferred stock on March 31. Today, the New York Times ran a story saying that Old National only paid $1.2 million to buy back the warrants, while the warrants were almost certainly worth more.

The main authority cited by the Times was Linus Wilson, a finance professor at the University of Louisiana, Lafayette and a sometime commenter on this blog, so let’s go straight to the source.

Continue reading “First Buy High; Then Sell Low”

More Accounting Games

The New York Times is reporting that the administration is thinking of stretching its TARP funds further by converting its preferred shareholdings to common stock.

The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

I hope this is one of those trial balloons they float and later think better of. Most importantly, it makes no sense. That is, there’s nothing fundamentally wrong with converting preferred for common, but it doesn’t create anything of value out of thin air. I wrote a long article about preferred and common stock a while back, but here are some of the highlights.

  • If you don’t give a bank any more money, it doesn’t have any more money. By converting preferred into common, you haven’t changed the chances of the bank going bankrupt, because its assets haven’t changed, and its liabilities haven’t changed. If it had enough money to cover its liabilities, but it couldn’t buy back its preferred shares from Treasury, it’s not like the government would have forced it into bankruptcy anyway.
  • If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place. From a capital perspective, then, the initial TARP “recapitalizations” did nothing, and nothing happens until the conversion. You can’t say that JPMorgan got $25 billion of capital last fall and it’s going to get another $25 billion now just by virtue of the conversion.
  • Tangible common equity and Tier 1 capital are just two ways of measuring the health of a bank. Taking money that wasn’t TCE and calling it TCE doesn’t serve any economic purpose. There is a minor benefit to the bank because now it doesn’t have to pay dividends on the preferred. But otherwise you’ve just shuffled together the claims of the last two groups of claimants – the preferred and the common shareholders. You’ve made things look better from the perspective of the common shareholders as a group, because they no longer have preferred shareholders standing in front of them, but the total amount available to all shareholders hasn’t changed.

Is there another way to explain this even more simply?

Update: I made a mistake in interpretation last night. They aren’t floating a possible strategy here; this is already what is going to happen. I forgot that the Capital Assistance Program already announced by Treasury – the mechanism for giving more capital to banks that need it after the stress tests – specifies the use of convertible preferred shares. So imagine you are a bank with $5 billion in TARP capital already. You issue $5 billion of convertible preferred under the CAP, use the proceeds to redeem the initial TARP, and then – if and when you choose – convert the convertible preferred into common. So the mechanism to do it is there already. I guess they are floating the spin to see if anyone believes this would actually make healthier banks.

Update 2: In case it wasn’t clear from the above, I don’t have any problem with converting preferred for common. I am probably mildly in favor of it, even, for roughly the same reasons as Matt Yglesias: as a taxpayer, I’d rather have the upside and control that come with common shares.

By James Kwak

Why Bail Out Life Insurers?

That’s the question I woke up with this morning. Sad, isn’t it.

The Wall Street Journal reported this week that Treasury will soon announce that it will use TARP funds to invest in life insurers, or at least those who snuck under the federal regulatory umbrella by buying a bank of some sort. The argument for the bailout is a version of the “No more Lehmans” theory: the failure of a large financial institution could have ripple effects on other financial markets and institutions that could cause systemic damage. For a bank, the ripple effect is primarily caused by two things: (a) defaulting on liabilities hurts bank creditors, and (b) defaulting on trades (primarily derivatives) hurts bank counterparties, if they aren’t sufficiently collateralized (think AIG).

My thought this morning was that life insurance policies are long-term liabilities that are already guaranteed by state guarantee funds, so we don’t have to worry about (a), and hopefully most life insurers were not doing (b) – large, one-sided bets on credit risk like AIG. So why not just let them fail and let the states take over their subsidiaries? But then I checked the facts, and it turns out that the limits on state guarantee fund payouts are pretty low. So the scenario is this: you hear bad things about your life insurer, you decide to redeem your policy (usually at a significant loss to yourself), turning it into a short-term liability, and then the insurer has to start dumping assets into a lousy market, pushing the prices of everything further down and hurting everyone holding those assets. Would this really cause a systemic crisis worse than we’ve already got? I don’t know, but no one in Washington wants to take that risk.

Continue reading “Why Bail Out Life Insurers?”

Can the Public-Private Plan Work?

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.

Continue reading “Can the Public-Private Plan Work?”