Was Paulson Right?

By James Kwak

The New York Times has a story about how the government is making a profit on its TARP investments: “The profits, collected from eight of the biggest banks that have fully repaid their obligations to the government, come to about $4 billion, or the equivalent of about 15 percent annually.” The article has plenty of appropriate caveats – the total bailout went well beyond TARP, the Citigroup (C) and Bank of America (BAC) investments and asset guarantees are still out there, we still have a ton of money sunk into AIG (AIG) – but the fact remains that some of the investments are getting paid back, with interest and with a modest bonus from the warrants issued to Treasury.

There is also an ongoing debate about whether Treasury is getting full value for its warrants, which we’ve covered previously, but let’s leave that aside for now. The bigger question, I think, is this: Did Treasury get a fair deal for its investments at the peak of the crisis?

At the time I said no, and I still think the answer is no. The most important principle to bear in mind is that how a decision turns out has no effect on whether it was a good decision to begin with. In honor of the changing seasons, imagine it’s the first quarter of a football game and you have fourth-and-one at the other team’s 40-yard line. Anyone who studies football statistics will say you should go for it; it’s not even close. (Some people have run the numbers and said that a football team should never – that’s right, never – kick a punt.) If the offense fails to make it, the announcer, and the commentators the next day, will all say that it was a bad decision. That’s completely wrong. It was a good decision; it just didn’t work out.

The same holds true for investing. In this case, Treasury bought some securities from the banks and underpaid significantly, according to both the Congressional Oversight Panel and the Congressional Budget Office. The difference between the amount paid for the securities and their fair value at the time was a subsidy to the banks. What happened here was that Treasury made what was in strictly financial terms a bad investment and then got bailed out by later events. Or, you might say, it bailed itself out by undertaking a series of bank-friendly policies that had the effect of bolstering banks’ share prices and making it easier for them to raise capital. Which raises a whole other question: whether Treasury was counting on their ability to themselves out, and thereby avoid any eventual criticism for losing money on the deal – but which, at the same time, gave them the incentive to do what was best for bank shareholders.

Comments

[apppro:]

Why shouldn't he be right! He drove the CDO values down so hard and so fast that BoA (among others) was lucky to survive. Then when he figured they had suffered enough he decided that those CDO's weren't worthless just worth_less, so he bought up the shares of the very same banks that he called for the trash heep just a few months earlier.

Hey, if I had the money and the guts I could manipulate things like that too!

Aug 31 01:47 PM

[SalmonEater:]

These banks are paying tremendous amounts in dividends to the U.S. Government for those loans. They weren't free no-name blogger. How the U.S discloses what they are doing with this repayment of funds is where the problem lies... Our politicians made a deal to loan the banks with taxpayer money and the politicians are keeping the interest earned. If you want your children to grow up with unlimited earnings potential and safe and free from law and regulations, encourage them to become a polotician in the U.S. Best gig out there

Aug 31 01:48 PM

[E Nuff Sed:]

Buy low, sell high. Why complicate it with politics?

Aug 31 02:11 PM

[Charles Lie...:]

Paulson certainly knew what he was doing in lending money to banks that he pushed to the edge of failure. So after helping to drive down the value of those major businesses, he could lock in some calls on those companies at severely depressed values. Yes, that was extremely profitable for the government. If anyoine else did that, it would be unambiguously manipulative and they would be in jail. Oddly, it is interesting that Paulson never claimed the government would make money on those deals, even though he should have known that they would be extremely lucrative, since he placed the government ahead of all other creditors. (Nothing like being able to barge to the front of the line.) Also, he gave money to a number of institutions that didn't want it and also didn't need it, which was another way to lock in profits.

Lastly, for all the hue and outcry over how Paulson contributed to the credit crisis by letting Lehman fail, I don't think he has taken even half the heat he deserves. He wanted to actively punish stock investors because the companies took too much risk and he wanted the investors to suffer because of it, the moral hazard argument. But his focus on moral hazard came at a huge price, the near death experience of the entire financial system of the U.S. Paulson's message was don't expect the government to bail you out if your company can't survive in the marketplace and he contributed to that fear of failure. His handling of Bear Stearns clearly sent that message. And then he reinforced it by destroying the preferred shares of Fannie and Freddie, not just the common share investors. And who owned the preferreds? Banks. So he undermined capital in the banking sector at the very time banks were having difficulty raising capital. And he also contributed to the collapse of the entire preferred market, precluding any financial firm from being able to raise capital via preferred share issuance. Letting Lehman fail was just the icing on the cake of a string of policy decisions that greatly worsened the credit crisis. Despite the many billions in profits that I expect to come from the government's lending activity, Paulson's decisions made a bad situation much worse and allowed the financial system to approach collapse when it was all avoidable. Bernanke and Geithner have both distanced themselves from some of these decisions and for good reason. Paulson may have been one of the worst Treasury Secretaries ever.

Aug 31 02:45 PM

[MudEngineer:]

So the Government made 4 billion dollars on the TARP funds so far. Big deal, they have to collect the rest of the money loaned out before we will know if there will be an actual profit. I suspect that the Government will never see so much as one third of the money that went to GM and Chrysler and will most likely never see one cent back from the 182 billion that went to AIG. This is like saying your are ahead because you were able to recover a few chickens and some eggs after a pack of wolves broke in and devoured most of the chickens. Crappy accounting indeed!

Aug 31 04:05 PM

[contango:]

4 billion WOW!

That takes some masterful book cookin'

Fire up the corporate jets!

Let's celebrate!

Sep 01 01:09 AM

[thannagan:]

Paulson acted. The rest of the government, including the Fed was little more than a deer in the headlights. He did more than anyone else to avoid complete collapse. Was it perfect in hindsight? Of course not. Did it work better than any alternative that anyone else thought of at the time? Defintely. Sorry, but he stands out the hero of that time.

Sep 01 09:00 AM

[Dmoon:]

Keep politics out of the discussion. $4B is $4B. As far as Paulson driving down the prices, these banks didn't need any help and were already down when he stepped in. Lets not politicize the issue any further. Those who profited from BAC and others on their way up are not complaining.

Sep 01 09:03 AM

[LKofEnglish:]

treasury good, Fed BAD. follow zero hedge which is all OVER this thread. How the NY times and WSJ only now are picking up on this meltdown goes a long way towards showing how ignorant and cowardly PRINT media is. It's all about talking up the regime left or right. nobody cares about truth in PRINT media no less. very fortunate to sources such as this. funny part? those lie-machines are raising prices. i laugh at those who pay for it.

Sep 01 06:40 PM