Tuesday, October 14, 2008

Paulson Capitalism

Welcome to the new banking system in the United States. A quick scan of the headlines will tell you that major banks are being partially nationalized. You may remember that this nationalization is in response to the fact that they are insolvent.

Most businesses do not strive to achieve insolvency. In the case of the banks, they managed to find themselves in this state by being badly mismanaged and making poor investments.

The UK recently taught Paulson that (a) his plan to prop up balance sheets by buying toxic waste was flawed (in truth, he just has a big conflict-of-interest as former CEO of Goldman-Sachs) and (b) government taking equity was the proper way to inject capital. The UK version creates obvious dilution for the shareholders and takes board seats in order to clean house of poor management.

Secretary Paulson, in his infinite wisdom, has decided that the current banking management is just fine, their results are not worthy of castigation by firing squad, and that shareholders are to be "protected". Like many statements from the Bush administration, you need to spend time to figure out how they are torturing the language in order to see through to the truth. The truth here is that Paulson is diluting the shareholders as well as addressing symptoms rather than the cause.

The bailout details are actually pretty simple. The Treasury will inject 20-25 billion dollars in each of 9 major banks and take out "perpetual preferred" stock. In the event of bankruptcy, or receivership, these shares stand ahead of the common shares. The shares also pay a dividend. From the NYT:
The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock.
By any reasonable definition of dilution, shareholders should be angry about the warrants. It means that any future increase in stock price will be shared with the government (who will sell those shares and drive the price down.)

From the viewpoint of the economy, the most interesting part of the deal is the 5% dividend. By forcing the banks to take this money, they need to earn at least 5% on the money in order to turn a profit. So they collectively need to figure out $250B in investment deals. Naturally, since they have proven themselves to be such good investors in the past (why do they need a bailout?) they will scour the planet in search of returns. The alternative is for management to find quick investments, continue cooking the books (mark-to-market rules are now suspended), collect bonuses and have cushy jobs. Which do you think is the more likely outcome?

In summary, Paulson thinks that the same management with a demonstrated capacity to lose a trillion dollars is going to somehow grow new neurons and be smarter with the taxpayer's $250B. Good luck with that.

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