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

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 (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 (MS) has them at $.30, Merrill (MER) at $.32 and Goldman (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.

Comments

[bbzz24:]

hunky paulson will cut a deal for his good fellas and everybody else invoolved for the expense of the taxpayer. just resign to this.

2008 Sep 22 05:26 AM

[Lawrence J....:]

There is one simple test of any rejection on the rescue plan: does the author discuss what he believes is the correct alternative and its consequences. Mr. Ehrenberg has not done that.

The issue here is not the rescue of the investment banks, per se. It is the rescue of of dollar-denominated paper as a world-wide medium of exchange. The world tolerates our trade deficit - and we can survive it - for one simple reason: the paper we give to get back the money we spend on the things we import is worth something. If our AAA paper is not reliably worth having, we won't get any of our money back to use to run our economy. So long as we need more credit than we, ourselves can provide through our savings institutions, our national creditworthiness - not just of the treasury, but of our blue-chip investment banks - is a national imperative.

Moreover, anyone who talks about "the American Taxpayer," when he means "the American-taxpayer-work... is an idiot. None of us is just a taxpayer.

There are people in this world who, if asked what they would want most in the world if they knew that an investment banker would get it double, would opt for one blind eye. And all of them are posting to blogs this week.

2008 Sep 22 08:21 AM

[Lawrence J....:]

The ellipsis inserted by the blog software in my prior comment hides a long list of other roles that "taxpayers" fill. Also, I say that Mr. Ehrenberg has not discussed the consequences of his prescription because what he is proposing deals only with the asset side of the equation, not, for example, how credit ratings are preserved to prevent defaults on covenants that support liabilities we cannot as a nation afford to walk away from, even if that means socializing loss. Not every cost is too high to pay.

2008 Sep 22 08:25 AM

[dcxavier:]

To recapitalize the failing banks, we taxpayers are going to end up buying the crappiest securities at inflated prices. Some securites, like residuals from subprime and HELOC securitizations, are legitimiately carried on books at zero, so many properties have been foreclosed and sold off that they can never have value. Yet watch us pay real tax money to buy them, it will be like finding a winning lottery ticket on the ground for some banks. Here's another game to watch for. Suppose you have a securitiy worth 80 cents on the dollar. Watch it get restructured into two securities, one worth the full dollar and the other worth nothing, then the nothing part gets sold to you know who. That's essentially what the securitization process is all about anyway, it will be done in a special way to exploit this bailout.

And what's really bad about the process is that the same managements that got us into the trouble will remain in place, and they'll probably get big bonuses for bringing home the taxpayer bacon. The comment about TPG is dead nuts on.

2008 Sep 22 08:47 AM

[downtoearth:]

It might not be so bad. If the Treasury is buying poorly performing debt instruments at 30 cents on the dollar, and can actually find and negotiate with the borrowers in these CDO's and MBS's, telling these borrowers that they need only make payments at a 2% rate for awhile....great for the borrowers (workable for the borrowers) and great for the Treasury - since the effective rate on the deal would be 6.67% to the Treasury.

I want to be a stockholder of the Treasury.

Wait a minute..... I already am !

2008 Sep 22 09:07 AM

[Roger Ehren...:]

Remarkl, I have no idea what you are talking about. Read my historical blog posts in order to get a longitudinal view of what I think. I support Government intervention, and everyone who reads my blog knows that. My issue is how it's done. I don't disagree in substance with much of what you say, but your language is inappropriate, your characterization of my views inaccurate, and your overall tone hostile. Not a way to achieve a higher level of understanding or discourse.

Roger

2008 Sep 22 11:12 AM

[Jackson Cash:]

@Remarkl:
"does the author discuss what he believes is the correct alternative and its consequences. Mr. Ehrenberg has not done that."

Nor have you in your remarks. You are not credible from your first sentence on.

"The issue here is not the rescue of the investment banks, per se. It is the rescue of of dollar-denominated paper as a world-wide medium of exchange."

I'm going to throw the bull$hit flag on this wishy-washy statement. The issue here is about fundamental blunders when it comes to old fashioned risk. Wall Street, through the blind oversight of the Fed, Treasury and Congress simply shoveled as much risk as could fit in bags and then stuffed the bags in the attic. The problem is the ceiling collapsed. Now, we're trying to scuttle up something in haste that will only breed more calamity in that it simply protects the rich and elite at the direct and limitless expense of everyone else - worldwide. If you think it purely coincidence that Paulson is running the show you are a fool. This is all about self-preservation of the elite, not dollar delimited paper, nor the obligations it's tied to. The world knows if the dollar fails the rest of the world is in the same boat as us.

We have a financial hurricane contained at the present and thank goodness. The problem is that America is eating crow for the rest of the world for none other than the problems WE are responsible for and yet no one is preaching that each and every "taxpayer" is a hero at the present -- the problem is that we aren't being compensated for the risk we're holding, nor is it in any bailout plan thus far. My ideal compensation is transparency and simplicity not a government check.

"If our AAA paper is not reliably worth having, we won't get any of our money back to use to run our economy. So long as we need more credit than we, ourselves can provide through our savings institutions, our national creditworthiness - not just of the treasury, but of our blue-chip investment banks - is a national imperative."

News Flash: Ray Charles could see that our creditworthiness is and has been undeserved and frankly, the rest of the world finally caught on. If this was a "national imperative" where the hell were you 10 years ago when prudent assessment of risk, transparency and ACCOUNTABILITY was abandoned!? Your silence contributed to the crisis, and don't waste my time trying to play both sides of the issue when you assert preservation of the rich is warranted by socializing losses. THAT'S SIMPLY NOT OKAY.

We're fat and bloated and deserve all of this, and anyone that thinks that the "greater good" is at hand through ANY bailout is irresponsibly looking short term.

Here is how to get through this:

1. STOP! This isn't about Congressional breaks, an election, etc. This is an opportunity to fix $Trillions of dollars in complete leveraged vapor and restore the true "value" of which to base the future on (literally). The "horse is out of the barn" but not out of the pasture. The problem is contained on the backs of every US citizen. The world can thank us later, particularly all the illegal immigrants that obtained a free house.

2. LOOK! The root of confidence, risk, etc is all about transparency. No one knows what the values of collateral, leverage, etc actually are because of citizen complacency and no one looking. This will take some time to "unwind" to use a buzzword. My advice is to revoke the license of every single appraiser that contributed to the problem, and get new boots on the ground to assess real estate consistent with the long trending average of valuation, not the last 15 years. Meanwhile all those Wall Street "tools" that created the leverage mess can start to unwind it from the top as part of their unemployment compensation obligations. Perhaps unemployment might go down.

3. LISTEN!! For God's sakes listen not to what IS said, but rather what ISN'T!! All the vague speeches and optimistic assessments of today's situation is all garbage and lies again and again. The American public needs leadership that is talking honestly about the real situation, not some arbitrary warm fuzzy feeling.

If you the reader consider the endless lies that the current administration is responsible for, perhaps it be noted that they aren't telling the truth this time either; particularly with estimates, AND the way out of this hole. My confidence is based on leadership, and the last eight years have eroded all of my confidence. Whichever party wins the upcoming election need to be the one's addressing this crisis, not the present administration. This includes the removal of Bernanke and Paulson, if not the protectionist Federal Reserve too.

This crisis has an invisible hand, that even Congress doesn't understand, not to mention Joe/Jane/Pedro Q. Taxpayer, but many on these forums certainly do. There is history in the making for sure, and it's more consistent with mafia dictatorship than patriotism. Challenge your leaders, and LISTEN to what ISNT BEING SAID, note the freedom of which is being stolen by every decision.

4. PARTICIPATE!! Write your Congressional representation, call them, take them for lunch and for God's sake get involved. This is messy and requires as much insight as possible. Because of the lack of "voice" this crisis was allowed to grow... and now it's a monetary risk pandemic.

2008 Sep 22 11:25 AM

[Kinabalu:]

"Valuation of troubled assets is clearly the thorniest issue"

I just wanted to reiterate the biggest problem that is getting the least attention. I don't believe the Wall Street Journals suggestion of a reverse auction will work. Nobody's buying anything now. But the authors suggestion, "Buying assets at anything other than fair market alue is against every principle we should be enforcing", doesn't work for the same reason. We don't have an objective measure of fair value.

I'm sure this is why Paulson doesn't want any oversight, but it's also why he won't get it.

2008 Sep 22 01:07 PM

[Chris Santiago:]

everyone's always talking about, "the expense of taxpayers".
i realize what i'm about to say sounds a little socialist, however, ...
...there are many to blame for the current problems- and they are all taxpayers; irresponsible borrowers, irresponsible lenders, companies and boards making poor decisions, politicians making horrible decisions.
at least this plan spreads the burden around; although i imagine some defaulting on their loans may not even pay taxes- but nothing's perfect.

i am just tired of hearing defense of the "taxpayers" and attacks on wall st. it is taxpayers, though not all of us, that are at fault.

2008 Sep 22 01:16 PM

[dcxavier:]

"Valuation of troubled assets is clearly the thorniest issue"

That's where the 1990's RTC concept looks good. Make failure a prerequisite for government takeover, don't buy assets from solvent firms. Don't reward the managers that got us into this mess. Then auction the assets to the highest bidder. It will establish a true market price for the assets and encourage new capital.

2008 Sep 22 01:36 PM

[mollytjm:]

thank you for a good article!

while it's true that we're all responsible for this mess...some of these people were actually elected to public office and the SEC let the greediest of the financial institutions make loans at levels that would have been illegal before and no one stopped them.
but individuals who were also greedy and borrowed to buy houses they never intended to live in, 'for investment' are also to blame...so there's a lot to go around.
but it's impossible to believe anything this government says after all the stuff we've been told. i seem to remember a speech from a ship by our president saying it was 'all over' since 'we got him'. that was 6 years ago and the real 'him' is still in some cave in afghanistan, most likely.
so it makes it hard to have confidence in these new 'plans'. it's also true that most people aren't really interested in getting involved enough to even find out the facts. if we don't wake up soon, democracy will be over.

2008 Sep 22 02:49 PM

[MoroseMax:]

There is no reason to blame the borrowers. The fault lies entirely with the banks who made the loans. They were the ones who had money at risk and thus should have been the most diligent in determining the terms at which to loan at. They failed to verify the quality of the buyers, and the collateral which is their job and so they lose their jobs. End of debate.

2008 Sep 22 06:37 PM

[stark naked:]

We are allowing the fox to watch the henhouse. The very people who brought this down AKA Paulson and Cox (wasnt Mr. P CEO of Goldman that promoted exeactly what brought this about?). Bush - AKA mission accomplished - and his brrod of merry druken men have no incentive to do this in any resonable manner as they will have whashed their hands and walked away from it all in 4 months.

2008 Sep 22 06:38 PM

[Alan von Al...:]

Excellent, rigourous, fair proposal, Roger. Thank you.

2008 Sep 22 10:01 PM

[RatWatcher:]

Mr Paulson is our very own Andrew Mellon. Welcome to 1929.

I did in fact write to both my Senators and my Rep, and Mdm Speaker asking for tough negotiations on bailout terms, including judicial review and exclusion of foreign institiutions.

I appreciate this board though I am not on your level of competence.

'In God We Trust' had better pay off :)

2008 Sep 22 11:30 PM

[daytrading:]

I dont like this one way street arrangement. Why should I have to help bail out these people who created this mess, got fithy rich in the process and gets a government guarantee. Thats not fair. If my business went under and I asked the government to bail me out, they'd tell me to go shit in a hat. I dont want to help these people.

So heres what I propose, since all these filthy rich people all know each other either directly or indirectly and somehow benefited from all this corruption, I think its only fair for these people (the ones that left the companies with millions after driving them into the ground and the politicians who had a hand in all this) bail each other out and leave the rest of us out of this. If we cant benefit on the upside I dont see why we all have to be punished. If these politicians were really for the average american they would punish the rich crooks who sucked the system dry. The bloodsuckers. If it were reversed and average people committed such a crime of this magnitude, the bloodsuckers would convict them in a week. Mostly for interrupting their cushy jet set lives. Its not right. Elitism is alive and well in this country and this people are well above the law.

2008 Sep 23 12:06 AM

[Kinja Rules:]

I guess to understand this problem completely you must be right in the middle of it. We seem to have had some problems lately...Money Mkt funds under $1, 90 day Treasury's w/negative interest. This is Nothing Compared to the Domino Effect that Lehman Caused. AIG, MER, UBS, the list goes on. There is alot to be said for MS & GS ducking under the FDIC...help!!!

No One, likes this. The Pigs Get Nothing! Unfortunately if any of us are going to keep the value of our Ret Funds, Money Mkt, FDIC Ins Funds, CD's, Insurance Co's, Bonds & Pension Funds. Something Drastic has to be done Quickly.

This is basic: If the Teacher's Pension Fund of some State Purchased some or enough of this Trash-They are Done, The Pension Relief Fund was in Hard Times Before This Happened. What about a City or State for that matter? Does this have to do w/Wall St? How about the Mutual Funds that people have NO Idea about what they hold X the top 10% of Holdings? OK...International Banks, nasty topic but valid. They trade Everything w/Everyone All Over the World, are Counter Party to Risk & or Ins...Systemic Collapes?

IMO The Author has his pt & remark! has his. This Debate is Unfortunately what may delay the Emergency Funding that must happen if we want the ATM's to keep working. IF there is big enough whiff of broad based bank runs, everything will simply stop until it can be sorted out. It has happened before...Banks were closed, the Exchanges were Closed. This would happen b/c when there is a panic, good institutions are destroyed as well as bad ones. JMO, but we don't have much time, Tues or Wed? If they let this go on too long it will destroy the Credibility of the US Financial System. RatWatcher, you are wise.

The Men in Long White Robes Opened the NY. This Should have been Reassuring...Governmen... Around the World are Supporting their "Free Markets." This is a Global Event w/Long Term Global Consequences. There is No Assurance that this plan will work but the failure to act may be more lengthy & costly. I don't TRUST this Administration, nor have I ever-yet I believe time is of the essence.
Also, Vanity or EGO. No One wants to be remembered in the History Books as the folks that finally Busted the Capital Mkt's & Bankrupted Millions of Innocent Citizens around the World. You Think? Power & Ego are twin souls.

I'm not a depressed long, rather a stone cold Bear that was short Jan of '07. I've been All About Gold for a Very Long Time. Yet, this potential systemic disaster is worse than I could have ever imagined. WyoSteve, if you are in the Oil Sands...We really Need to Avoid a Depression as Oil was @ $11 back in '98 & that was only a Failure of a 1/4 of the World. Depression = Deflation on Everything. There is an Economist from NYU who has called this thing as long as 2yrs ago: Nourbini Brilliant!

2008 Sep 23 02:46 AM

[PeteK:]

Remember, only 45% of Americans pay income tax,
So, the other 55% are not really Taxpayers. Stop using Taxpayers as talking point, please.

2008 Sep 23 04:22 AM