Robin Hood in Reverse: In Defense of the U.S. Taxpayer

 |  Includes: GS, MS, WMIH
by: Roger Ehrenberg

Exactly how the U.S. Government will pay for bolstering the calcified credit system is still up for grabs. But there is one thing for sure: if the Executive and Legislative branches are concerned with ethics, morality, and the well-being of the everyman, they will think long and hard about the details of how capital will be provided. Because based upon Friday's market action, investors are expecting a bailout of institutions deemed "too big to fail," with benefits flowing directly to those firms' equity holders instead of the U.S. taxpayer who is providing the funds.

This is clearly at odds with free market principles, as the common stockholders become "free riders." Does this need to be in order to stave off financial catastrophe? I'd say not. And whoever says this is the case has something to gain, like being bailed out from poor investment decisions. Those at the Treasury, the Fed and Congress: JUST SAY NO.

Robin Hood in Reverse

Here are some thoughts following Friday's surge across certain financial issues from the New York Times:

The news quickly revived investors in those and other firms. Lloyd C. Blankfein of Goldman Sachs, for example, did not seem to need a rapid infusion of capital for his firm. Irreverent commentators pointed out that Goldman’s former chief executive, Henry M. Paulson Jr., now the Treasury secretary, had administered medicine that would, as it turned out, help his old friends.

Another battered firm, Morgan Stanley, continued merger talks with Wachovia but with considerably less urgency, since the government said it was willing to buy up depressed mortgage assets to keep the financial system working more smoothly. That relieved pressure on its chief executive, John J. Mack, because short sellers betting heavily against Morgan Stanley’s stock were forced to call off their relentless assault — at least temporarily — under the new market rules.

The only remaining independent banks, Morgan Stanley and Goldman Sachs, were once again the golden boys of Wall Street. But all manner of financial institutions could benefit from the plan, from Citigroup and its big investors, like the Abu Dhabi Investment Authority; to Washington Mutual and its large private investor, David Bonderman; to perhaps even the American International Group and its former chairman and chief executive, Maurice R. Greenberg.

Among the surprising twists was that A.I.G. shareholders raised the prospect of repaying the government’s $85 billion loan quickly so that the government would not take a majority stake, as announced just days earlier.


Although Washington Mutual’s stock closed Friday at $4.25 a share, several analysts said its options looked much brighter with a government bailout. The thrift’s business must change, said Howard Shapiro, who follows the bank for Fox-Pitt Kelton, but its deposit base would make it attractive.

“Though we don’t know the terms of a government bailout,” he said, “I think WaMu could be worth between $7 a share and $20 a share.”

While I'm not much of a conspiracy theorist, I may become one in short order if the likes of TPG and Maurice Greenberg are written a check for several billion dollars off the backs of the U.S. taxpayer. Messrs. Bonderman and Greenberg are legendary investors who deserve kudos for the legitimate profits they've made in the past, but that is not the situation here. TPG was early in their deal with WaMu (NYSE:WM) , and not even their stock-settled put spread that was supposed to protect against a down round financing could protect them. They waived this right in order to raise fresh capital at any cost. The stock was on its way to zero. But now it got a bump because of the probability that an ill-conceived bailout plan might just save WaMu and, by extension, TPG. WaMu was not a good investment, yet somehow Bonderman et al might just come out of this smelling like roses. Problem is, it smells really, really bad to pretty much everyone except TPG's partners and LPs. TPG does not need to be paid in order for the credit markets to become unlocked and for the bailout to succeed.

Valuation is the Key

Valuation of troubled assets is clearly the thorniest issue to be confronted when constructing the bailout plan. As outlined in the Wall Street Journal:

The Treasury would buy assets through a process to be determined, hold them until the market stabilizes and then sell them back into the private market. That would remove the toxic assets at the root of the current crisis.

Valuing these assets will be one of the trickiest questions. For the plan to succeed, financial institutions must be able to get these assets off their books at a high enough price that their balance sheets aren't further pinched.

The government is, in some respects, constrained in driving a hard bargain because the whole point of the program is to help banks get back on solid footing -- not to force them into deep write-downs, potentially exacerbating their pain. At the same time, the market turmoil has complicated efforts to determine the "real" value of the assets.

The mechanics of any sale are expected to be worked out between the asset managers and the Treasury. One option is a reverse auction. In that case, the Treasury could determine a type of assets it wants to buy (say, all AAA-rated mortgage-backed securities) and would then buy securities from financial institutions that offer to sell at the lowest price.

The key issue with full or partial Good Bank/Bad Bank deals is how the bad assets get capitalized. If the Treasury buys the assets cheap and forces further markdowns, the remaining Good Bank will be under-capitalized. Conversely, if the Treasury buys the assets rich, the U.S. taxpayer gets screwed and the common stockholders get a windfall. Neither of these situations is optimal. And let's remember, the difference between the RTC circa 1989 and the proposed 2008 solution is that the RTC took over entire institutions, while the new plan envisions only purchasing troubled assets (which may potentially encompass mortgage loans, mortgage securities and derivatives). So how do we bridge the gap, ensuring that troubled institutions are adequately capitalized after offloading bad assets at depressed prices while protecting the U.S. taxpayer?

Fixing the Problem - the Right Way

Buying assets at anything other than fair market value is against every principle we should be enforcing. Transparency. Accuracy. Full disclosure. This is a non-starter. Who cares where the assets are carried on a firm's books? If Morgan Stanley (NYSE:MS) has them at $.30, Merrill (MER) at $.32 and Goldman (NYSE:GS) at $.50, this is not the point and should play no part in the analysis. There should be a reverse auction to determine price, with the Treasury buying the cheapest and moving up the line. Depending on where firms are carrying these assets, it might require a write-down that would threaten its solvency. If not, great. The firm has liquefied the assets and the U.S. taxpayer gets the upside over time (monetizing the liquidity option, in my parlance).

However, if there is a capital gap I'd suggest that the Treasury gets issued convertible preferred stock on attractive terms, supporting the firm in its operations while substantially diluting common equity holders. In this case jobs are saved, the institution continues to operate as a smaller, leaner, hopefully more prudent firm while the U.S. taxpayer, once again, owns the liquidity option.

As time goes by, the markets stabilize and the convertible preferred moves in the money, the U.S. Treasury can "privatize" its holding thorugh a public offering or a private sale, recouping funds that bridged the firm to health and hopefully making a profit for the U.S. taxpayer in the process. This would be a win/win. The only losers here are the common stockholders of troubled institutions. And this is as it should be. Losers shouldn't become winners overnight because of Government largesse, and hopefully our policy-makers know that we're watching. As is the rest of the world.