New Report Out, TARP Still a Subsidy

Elizabeth Warren’s Congressional Oversight Panel has announced that TARP has so far exchanged $254 billion in exchange for $176 billion worth of assets, which amounts to a cash subsidy of $78 billion (full report). The numbers are based on an analysis of ten specific deals – eight of the largest under the original Capital Purchase Program (not the eight largest, however, as Merrill is missing), plus the second bailouts of AIG and Citigroup. In the former, Treasury received $78 of assets for every $100 expended; in the latter, it received only $41. These results were then extrapolated to the full sample.

This is not really news, since the CBO already forecast a subsidy of $64 billion out of the first $247 billion invested, and the OMB came up with a similar estimate even earlier – and everyone writing back in October realized that the banks were getting a sweetheart deal compared to what was available from private capital, as indicated by Buffett-Goldman and Mitsubishi-Morgan Stanley.

Continue reading “New Report Out, TARP Still a Subsidy”

The Emerging Political Strategy For Bank Recapitalization

Here’s a tough problem. 

  1. The nation’s leading banks are short of capital, and only the government can provide the scale of resources needed to recapitalize, clean up balance sheets, and really get the credit system back into shape.  Any sensible approach will put some trillions of taxpayer money at risk.  We should get most of it back but – as we’ve learned – things can go wrong.
  2. Everyone hates bankers right now, and these feelings only deepen as we learn more about how the first part of the TARP was spent and mis-spent.  No one wants to hear about anything that sounds like a bailout to bankers and their careers.

How does the Administration and Congress sort this one out?  This weekend we seeing an approach take shape which, most likely, will work.  There are five closely related moving pieces. Continue reading “The Emerging Political Strategy For Bank Recapitalization”

Bank of America Gets Quite a Deal

We have a deal.  You, the US taxpayer, have generously provided to Bank of America the following: one Treasury-FDIC guarantee “against the possibility of unusually large losses” on a pool of assets taken over from Merrill Lynch to the tune of $118bn, and a further Fed back stop if the Treasury-FDIC piece is not enough.  In return we receive $4bn of preferred shares and a small amount of warrants “as a fee”.  There is a $10bn “deductible,” i.e., BoA pays the first $10bn in losses, then remaining losses are paid 90% by the government and 10% by BoA.

We are also investing $20bn in preferred equity, with a 8 percent dividend.  There will be constraints on executive compensation and BoA will implement a mortgage loan modification program.  Essentially, this is the same deal that Citigroup received just before Thanksgiving, known as Citigroup II, which was generous to bank shareholders but not good value for the taxpayer.

This is more of the same incoherent Policy By Deal that has failed to stabilize the financial system, while also greatly annoying pretty much everyone on Capitol Hill.  Hopefully, it is the last gasp of the Paulson strategy and the Obama team will shortly unveil a more systematic approach to bank recapitalization; it would be a major mistake to continue in the Citi II/BoA II vein.

In addition, you might ponder the following issues raised by the term sheet

1. The $118bn contains assets with a current book value of up to $37bn plus derivatives with a maximum future loss of up to $81bn.  This is more detail than we got in the Citi deal, so there is evidently greater sensitivity to calls for transparency.  But the maximum future loss is based on “valuations agreed between institution and USG.”  What is the exact basis for these valuations?  From the term sheet, it sounds like we are talking mostly about derivatives that reference underlying residential mortgages.  Absent any other information, my guess is that they can easily lose more than $81bn – depending on how the macroeconomy and housing market turn out.

2. What is the strike price of the warrants?  This was controversial in the Citigroup II deal (because it was unreasonably high), but at least it was quite explicit up front.  The announcement is suspiciously quiet on this point, perhaps due to the recent spotlight on warrant pricing terms.

3. What kind of reporting will there be by BoA to Treasury, and what will be disclosed to Congress, in terms of the exact securities covered by this guarantee and how they perform?  The lack of information is a big reason why TARP became discredited and Capitol Hill is so concerned to see more transparency going forward.  There is nothing in the term sheet that reveals the true governance mechanisms that will be put in place, or how information will be shared with the people whose money is at stake (you and me, or our elected representatives).  I understand there is market-sensitive information present, but there are obviously well-established ways to share confidential information with members of Congress.

Overall, it feels like the latest (and hopefully the last) in a long line of ad hoc deals, which have done very little to help the economy turn the corner.  The new fiscal stimulus needs to be supported by a proper bank recapitalization program, as well as by a large scale initiative on housing.

Here We Go Again . . .

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:

  1. 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.
  2. 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.
  3. 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.

What If You Only Had $350bn To Spend?

Larry Summers made a convincing case yesterday that Congress should release the remaining $350bn of the TARP.  It’s good to see the Obama team emphasizing themes beyond the fiscal stimulus, including banks and housing.  Stronger governance and greater transparency are timely commitments for this program, and who can object to limits on executive compensation in today’s environment?  Some Congressional debate makes sense and could be productive, but it’s hard to see this request being turned down.

Still, what exactly should the money be spent on?  I’m tempted to say: housing, because this continues to be a major unresolved problem that looms over both consumers and their balance sheets.  Unfortunately, however, the banks remain a greater priority.  The latest developments for both Citigroup and Bank of America suggest the banking situation is (again) seen by insiders as more desperate than we outsiders wished to believe.

The next round of bank recapitalization (again) needs to be big and bold, for example along the lines we have been suggesting for some time (but I’ll take another comprehensive plan, if you have one, with strong expected taxpayer value).  The problem today is that we just don’t know if any major bank is well capitalized; there are too many black boxes that may contain toxic assets.  At best, this is a brake on the positive effects that should come from the fiscal stimulus.  At worst, we still have a major system issue on our hands.

And there is no reason to think that $350bn is enough to handle this problem.  The original $700bn was obviously an arbitrarily chosen number, and the money has been spent so far in a rather unplanned manner.  What we do next should not be constrained by the fact that there is a check for $350bn waiting to be picked up.  We should design a systematic recapitalization program, figure out what it will cost, and get on with it.  My working assumption, based on the published analysis of the IMF regarding losses relative to private capital raising, is that $1trn – properly deployed – should do the trick. 

Then we should get to work on housing (yes, this needs more money).

Update: Ben Bernanke seems to be thinking aloud along similar lines.

More TARP Programs, More Policy by Deal

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.

Continue reading “More TARP Programs, More Policy by Deal”

Paulson v. Buffett

Bloomberg has a new story out comparing the investment terms achieved by TARP with those achieved by Warren Buffett when he invested $5 billion in Goldman back in September. The results aren’t pretty for the U.S. taxpayer: the government received warrants worth $13.8 billion in connection with its 25 largest equity injections; under the terms Buffett got from Goldman, those warrants would be worth $130.8 billion. (The calculations were done using the Black-Scholes option pricing formula, which has its critics, but which I think is still a good way of estimating the relative difference between similar options.) That’s on top of the fact that TARP is getting a lower interest rate (5%) on its preferred stock investments than is Buffett (10%), which costs taxpayers $48 billion in aggregate over 5 years, according to Bloomberg. The difference in the value of the warrants themselves is due to two factors: (1) Treasury got warrants for a much smaller percentage of the initial investment amount; and (2) those warrants are at a higher strike price – the average price over the 20 days prior to investment, while Buffett got a discount to market price on the date of investment.

The comparison isn’t a new one – we recommended that TARP emulate Buffett back in October – but Bloomberg’s analysis has put the performance gap in striking perspective. Simon has a quote in the article, using the word “egregious,” but the really harsh words came from Nobel prize-winner economist Joseph Stiglitz, who said, “Paulson said he had to make it attractive to banks, which is code for ‘I’m going to give money away,'” and “If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired.”

Continue reading “Paulson v. Buffett”

Some Questions about GMAC

I’m a little late to the GMAC bailout story, but after reading all the newspapers and blogs I usually read, there are still some things I don’t understand. I’m particularly confused about the announcement that GMAC will start lending to anyone with a credit score above 620, down from their previous minimum of 700. (The median credit score in the U.S. is 723.)

1. What is the relationship between GM and GMAC? I know that Cerberus owns 51% of GMAC and GM owns the other 49%. I also know that, in order to become a bank holding company, both were forced to reduce their ownership stakes. In any case, GMAC is an independent company that should not be run for the benefit of GM. Its obvious that GM benefits if GMAC reduces its lending standards. But how does GMAC benefit?

2. If a loan to someone with a credit score of 621 was a bad idea on Monday, why was it a good idea on Tuesday? The only theory I can think of under which this makes sense is that GMAC thinks that loans to people with credit scores of 621 are profitable, but they couldn’t get the capital cheaply enough until they got their government bailout money.

3. Who is going to pay the bill when these loans go bad? It looks to me like GMAC is making a big gamble by trying to pump up its lending volume with higher-risk borrowers, right in the middle of the worst recession since . . . 1981? the 1930s? (In any case, it won’t be able to get anything like the lending volume it used to have, simply because fewer people are buying cars.) Isn’t this a situation where a company is choosing a high-risk strategy because its only option is to watch its revenues shrink away to nothing because the demand for credit has plummeted? But if that’s the case, how smart is it to go chasing after high-risk borrowers because the low-risk ones are suddenly saving their money? And now that GMAC has gotten the Henry Paulson seal of approval (remember, TARP money was not supposed to go to unhealthy “banks”), I think there’s a fair chance they are counting on Treasury to bail them out of their next round of bad loans.

Of course, it could be said in GMAC’s defense that they are just doing what Congress wants them to do: take TARP money and use it to make loans more available to consumers. But this goes back to the fundamental schizophrenia of TARP: it was conceived to keep banks from failing, but most people think its purpose should be to increase credit. And in this case I suspect GMAC’s taxpayer money is being used to sell GM cars that people wouldn’t buy otherwise, and when it runs out GMAC will be back for more.

To Lend or Not To Lend, Fed Edition

This is so brilliant I’m going to just copy Mark Thoma’s entire post right here:

Tim Duy emails:

Discordant headlines in Bloomberg:

Fed’s Kohn Says Regulators Should Encourage More Bank Lending Amid Turmoil: U.S. regulators should rise to the “challenge” of encouraging an expansion in bank lending amid a weakening economy and continuing financial-market turmoil, Federal Reserve Vice Chairman Donald Kohn said.

Fed’s Kroszner Urges Banks to Increase Capital Reserves to Buffer Losses: Federal Reserve Governor Randall Kroszner urged banks to hold more reserve capital to protect themselves from future “cascading losses,” as potential market fixes are “no guarantee” against another credit crisis.

It’s nice to see the Fed getting its communication problems under control.

This is the inconsistency I pointed out in the goals of the financial sector bailout. Banks need new capital to protect themselves against falling values of their existing assets. But if they use the new capital to make new loans, you defeat the purpose of the new capital, because that new capital is no longer helping support the existing assets. These are two separate and somewhat contradictory goals. Note that, according to Bloomberg (see the second link above), financial institutions have taken $978 billion in writedowns – so far – and raised only $872 billion in new capital. So while politicians rail against banks that took TARP money but haven’t expanded lending, the banks at least have logic on their side. I’ve been surprised that no one in Washington that I’m aware of has been willing to point this out.

(And do visit Mark’s blog – it’s a great place to get a variety of perspectives, updated throughout the day.)

The Bad Private Equity Fund

What seems like years ago, Simon and I wrote an op-ed in which we compared the initial proposal that became TARP to a bad hedge fund – a fund whose purpose was to overpay for illiquid securities and thereby shore up banks. Now that the original plan is dead, I think we can say that TARP has become a bad private equity fund, whose purpose is to buy preferred stock on overly generous terms (compare the 5% dividend taxpayers get to the 10% divided Buffett got from Goldman) in order to shore up banks and bank-like institutions (and maybe others as well). I don’t mean “bad” as a criticism here: the purpose of the Treasury Department is to protect and advance the public good, and that goes beyond the profitability of the investments themselves.

However, I do think it’s a problem that the goals of this private equity fund haven’t been well defined. Right now the bulk of the political pressure seems to be to (a) expand the scope of the bailout to other companies and industries that are being hurt by the recession (which could mean just about everyone) and (b) force bailoutees to do things in the public interest, like increase lending. (See the New York Times on both of these topics.) So the fund is being torn in two directions. To make a very broad generalization, if you want to increase lending, you should give capital to a healthy bank, like Saigon National (in the NYT article); but if you want to keep the financial system from collapsing, you should give it to very large banks (too big to fail) with balance sheet problems, like Citigroup, and they are not going to increase lending, precisely because they need the money themselves.

Paulson’s initial bet, which most but not all observers agreed with, was that the top priority was keeping a handful of core banks – Bank of America, Citi, JPMorgan Chase, Wells – from collapsing. One risk is that to protect that position, they will need more capital for those core banks (especially, apparently, Citi). While these banks were struggling with a liquidity crisis in September-October, now they are struggling with a good old-fashioned recession, in which all sorts of borrowers can’t pay them back, so they could be looking at writedowns for many months to come. (Perhaps as a result, CDS spreads on BofA, Citi, and JPMorgan are all up 30-50% from their lows right after recapitalization was announced.)

So I think Treasury needs to be clear on its goals. We know one goal is to protect the core of the system, which will not necessarily increase lending in the short term. From Paulson’s recent statements, it looks like one new goal is to increase lending. It’s not clear that $700 billion is enough for both of these goals. And $700 billion is certainly not enough to bail out everyone out there who will be hurt by the recession, including smaller banks that are unhealthy but not “too big to fail” – who will, therefore, fail.

Not with a Bang but a Whimper

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.

Paulson’s Bank Recapitalization Plan

The big news today is that Henry Paulson claims to have found, in the $700 billion TARP package passed last Friday, the power to invest some of that money directly in banks to shore up their capital. As one of the people who actually read the bill (OK, I skimmed most of it), I was puzzled by this, because my reading (like everyone else’s) was that Treasury would only be allowed to take equity stakes in companies who participated in the sale of troubled assets to Congress. However, if you look at the comments by Congressmen in the Time article and on Calculated Risk, you’ll see that there are statements in the Congressional record saying that the intent of the bill is to allow direct equity purchases. A curious fact that you learn in law school is that, in interpreting a bill, it is not just the words of the bill that matter; the record of committee and floor discussions can also be used in interpreting a bill. So it seems like, in this case, Congress consciously inserted language into the discussion in order to give Treasury this power, or Treasury is seizing on some passages in the discussion to claim that power.

At this point this is unlikely to generate too much controversy, because most people involved, including the authors of this blog, think it would be a good thing for Treasury to take some of the $700 billion and invest it directly in recapitalizing banks (which is what the UK is doing). Of course there will be issues of detail to be worked out, and the Treasury Secretary has an awful lot of discretion in this matter, but this is definitely a step forward.

Oh, and I should mention: Planet Money broke this story first.