Business Law Prof Blog

Fire Paulson; Hire Thain. Paulsen Has No Credibility

In an interview with Larry Kudlow yesterday, Hank Paulsen again showed why he should be fired as the Secretary of the Treasury.  Paulson is behind buying preferred stock at subsidized prices (very low dividend rates).  when confronted by problems he had no answers.

1) Question: Will not banks use the cash to pay down their existing debt (to foreign investors, among others) and not loan the new money out as you want?  In other words, banks may have a duty to their shareholders to take cash from preferred stock sales and pay off debt that has interest rates that are higher than 5% (the dividend payment rate). [Thain predicts banks will "sit on the money"; so far, he is correct.]  Paulson's answer, in essence:  "They will not because they know it will offend me."  But see 2), below.

2)  Question: Some banks do not want the new money because of the "strings" attached, is this government management?  You are affecting their executive salary arrangements and pushing them to change mortgage renegotiation policies.  Paulson answer, in essence:  "No we are a passive investor with no voting rights on their the preferred or the common underlying the warrants."  But see 1), above.

3) Question: Some banks (I.e., Wells Fargo) do not need the money and do not want the money, why force them to take it?  Paulson's answer, in essence: "All banks need to take the money so we do not stigmatize those banks that need the money and will take it."  But see 4), below.

4) Question:  Will taxpayers be on the hook for these payments?  Paulsen's answer, in essence:  "No, the banks that can will have an incentive to redeem the preferred stock within one year."  But see 3) above. [Will not the redemption of preferred by some banks and not others stigmatize those that cannot redeem?]

5)  Question: The market has fallen 25% since you refused to bail out Lehman Bros., did you make a mistake? Paulsen's answer: "There was no buyer in the wings to set up a JP Morgan style deal."  But see Barclay's immediate purchase of brokerage business once Lehman took Chapter 11.

6) Questions:  You said you would do ["X"] on [insert date] yet later you did [not "X"], how can the markets have confidence in what you say.  Paulson's answer:  "[Double Talk]".

He does not know what he is doing.  This is a disaster. Time to try Thain.

Cuomo Has a New Toy: Fraudulent Conveyance Claims

The State Attorney General of New York, Andrew Cuomo, is using the state's fraudulent conveyance statute to threaten AIG into reclaiming paid compensation to AIG executives.  The claim is that the compensation was not for "fair value" and was constructive fraud on AIG creditors.  The claim is a stretch.  Fair value of executive time, itself a highly debatable claim, is one of three elements. An analysis will be based on custom and practice in the industry -- not absolute, personal assessments of worth.   Second the contested salary payments must have been agreed to (when the contracts were signed not when payments were actually made) when AIG was actually insolvent or that the contracts led to the insolvency of AIG.  The amounts could not lead to insolvency; they are not large enough. So the claim must be that AIG was insolvent when it agreed to pay the contested salaries.  This is a technical claim based on AIG financial and cannot be based solely on the government bailout. The third element is that the amounts were large enough to be a fraud on the creditors -- small trifling amounts, even it they should not have been paid, are not large enough to hurt creditors.

Government Bailout Action--Unintended Consequences Abound

The government is using the wrong analogy.  They are using the "finger in the dike" analogy -- it needs to stop the leak.  A more appropriate analogy is "routing a river"; the government is fixing a breach in the river bank in one location only to find that it was led the river's flow to breach its banks in other locations.

When government protects asset-backed commercial paper, unsecured commercial paper money leaves and runs to asset-backed commercial paper.  When the government stops short selling in financial institutions, hedge funds concentrate on uncovered companies and also stop purchasing financial company stock in hedged positions.  When the government hikes FDIC insurance on interest bearing accounts, money market funds hoard cash worrying about heavy redemptions requests from fund investors who want to put funds in the FDIC insured accounts.  When the government backs banks, investors sell bonds in operating companies and run to bank bonds.  When the government gives United States banks better terms that UK bank received in their bailout, foreign money rushes into United States banks.  In each case, the government scrambles to fix the fix.

Did Paulson Get the Incentives Right in the Bank Bailout?

The short answer is -- no.

1) The Banks get below cost capital grants.  Loans would cost 11 to 12 percent.  The government gives them cash at 5 percent for five years and 10 percent thereafter with optional repayment; it is senior preferred stock.  Large banks cumulate foregone dividends on the preferred; small banks do not.  Existing shareholders still get dividends at past levels (no increases) and the government cannot vote any of its stock. Why ever pay it back?  Paulson can point to two incentives to repay. 1) At the market warrants on 15 percent of the value of the initial preferred stock purchase. Note that the market is on the grant date (with a 20 day average), which includes the increased value added by the government's own program.  The strongest incentive is to recapitalize in one year so as to half the warrants.  If this is not possible, the warrant incentive to repay flattens out considerably.  A firm just absorbs the dilution on common dividends; the government cannot vote.   2) Executive compensation control, which is easy to get around, by the way. 3) Pressure to forgive mortgage payments.

2)  Banks get $2.25 trillion, yes trillion, in free or below cost loan guarantees.  A government guarantee on new senior secured debt is cheap; a unlimited guarantee on non-interest bearing deposits is free.   Why not up the guarantee on interest bearing accounts, presently at 250,000?  Money from other world banks will flow into the US to take advantage of the federal guarantee which is stronger than other government's guarantees.  We are worried about sucking up the world's cash in our banks.

3)  Lehman, J.P. Morgan and AIG look like AAA suckers.  They paid dearly for their capital infusions.  Greenberg, the ex-CEO of AIG and a major shareholder, is, sensibly, asking the government to renegotiate the AIG bailout package.  The lesson for future crises?  Stall, stall, stall.

4)  The world's banks look like AAA suckers.  In the UK, banks give management power to the government (voting rights, seats on the board) and can no longer pay dividends on common until the government grant has been paid back. 

Did you expect Paulson to create the proper incentives?  What should American banks do?  Take the money and run; hold it as long as dividend rates on preferred stock in the market are over the 5 and then 10 percent rates (five years at minimum and perhaps considerably longer). Issue as much senior short term guaranteed debt as they can get away with and continue to pay executives whatever they want (with promises that comport with the new Treasury regs).  Use the new debt to lever up on some new sucker play -- tax subsidized biofuel companies??

Terms of Government Purchase of Bank Stock

The Treasury has announced the terms of its offer to purchase bank stock.  The government will buy the lesser of $25 billion or 3 percent or risk-weighted assets from banks that elect to participate.  Nine large banks have already agreed to sell.

The banks will offer senior preferred shares with a cumulative dividend rate of 5 percent of five years and 9 percent thereafter. I assume purchases will be a par [but I do not know].  With the preferred the bank must offer "at the market" warrants in an amount equal to 15 percent of the purchase price of the preferred.  The preferred shares and the common underlying the warrants do not vote (they have with some minimal protective covenants).  The preferred is callable in three years and redeemable before then with the proceeds of an issuer equity offering.  The banks must comply with the Treasury's executive compensation limits which, most significantly stop golden parachute agreements.

The terms are very reasonable. A five percent dividend rate is a gift; a nine percent rate is still a few points under market.  The incentive to redeem or call will rest on a bank's desire to get out from under the executive compensation regulations.

AIG's terms for a loan, not an equity grant, look like a mugging. AIG eat your heart out. 

How to Spot a "Bottom"

Savvy investors are closely watching the securities markets in an attempt to spot a "bottom," a point at which prices stop failing and begin rising and do not "test" or hit the low point again for some time (if ever).  Once investors with cash spot a bottom they become buyers, accelerating the price rise.  So what are the indicators of a "bottom." 

1) The technical definition of a bottom is a price at which buyers begin to out number sellers and this imbalance sustains itself for some time.  But using this definition we only identify a bottom once it has already happened.  What are contemporaneous indicators, if any.

2) A strong contemporaneous indicator is when forced sellers have been tapped out.  The traditional forced seller is the investors subject to margin calls, stock bought with borrowed money.  Once more important than now, the market on Friday show strong evidence of margin calls, even on company insiders.  Also acting as forced sellers are mutual funds and private equity funds that face investor redemptions.  Investors demand cash and the funds' managers have to sell securities, often their strongest, to raise cash to pay their departing investors. Other forced sellers include banks and financial institutions that are falling short of capital requirements and must sell hard assets to raise cash to meet the specific requirements of a capital maintenance rule.  When the forced sellers have been tapped out, the heavy selling pressure retreats and buyers often return to the markets.  Friday may have been such a day.

3)  Others who attempt to project bottoms appeal more to the psychology of traders. When stock prices tumble and then have a day of wide and wild up and down swings, the self-styled market psychologists "smell a bottom."  Other psychologists look to the degree of winning and weeping among populists, when the amateurs start to notice and complain, and the forecasts of doom and catastrophe get severe and emotional, it is time to buy -- "there is blood in the streets." Friday was such a day.

Government Delay in Control of AIG

AIG has spent over $120 billion of government money. Part of the exchange is government ownership, through senior convertible preferred stock, of 79.9 percent of the shareholder voting power.  The catch?  The government will act through a "trust" that holds the stock.  Although AIG has spent our money, the trustees to the trust, that will control AIG management have yet to be appointed.  We may get them in two weeks or so.  Ten days after the trustees are appointed, AIG must change the composition of its board to satisfy the trustees.  It would have been better had the trustees been in place when existing AIG managers spent our $120 billion.