Business Law Prof Blog

Obama the "Gambler": Read, "Speculator"

With yesterday's budget proposal for next year, even the New York Times has labeled Obama a "gambler."  Gambling is in: Poker players are on television and romanticized in Westerns.  Speculators are out:  They caused our economic crisis and are vilified by Oliver Stone. But gamblers are speculators. I prefer another word entirely: Obama is "Confused."  He wants a stable housing market but is willing to cut back the interest deduction on mortgages; he wants not for profits to flourish but is willing to cut back on deductions for charitable donations; he wants private investors to get back in the market but is willing to up the tax significantly on the returns on new private investments.  He goal of economic recovery is conflicting with his social redistribution goals. Either he is confused or intentionally sacrificing economic recovery for social goals (a deceit).  I prefer "confused." 

RIP GM

GM lost $10B in the last quarter and $31B for the last fiscal year.  The $4 B government loan went in and out immediately to pay creditors and salary.  The current quarter will be worse, with sales declining further.  GM has a deficit of $13B in its pension plan. With a cash reserve of $14B at the end of its fiscal year, this means that the company has probably (given how accounting works) already eaten through its reserve.   The company has to be on the verge of not having the cash to met payroll. Any more government loans will go in and out immediately to creditors and workers.  RIP GM.

TARP II Terms: The New Bank Bailout Program

Treasury today issued the terms for its new Capital Assistance Program (CAP) for handing out TARP funds.  There are some very interesting wrinkles.  First, the government will purchase funny convertible preferred stock instead of preferred stock and warrants (on common).  The conversion ratio is based on a 10% discount from the price of the common stock on Feb. 9th.  Second, the preferred pays 9% for seven years rather than 5% for five and 10% for the second five (that some banks received).  On the seventh year the government can force redemption of the new convertible preferred.  Third, the preferred is convertible into voting common at the option of the issuer (not the holder, the government) with the approval of the government. Previously the warrants were for non-voting common only.  Fourth, banks are encouraged to exchange the new convertible preferred for the old TARP preferred.  The wrinkles are designed to allow banks to convert preferred into common to aid with TCE ratios (Total Common Equity ratios) that are the rage now for assessing bank health.  But to get the issuer conversion flexibility an issuer must sacrifice some short term dividends and give up, potentially, voting stock to the government.  Banks that need the more have no choice but to sell the convertible preferred but should hold on to the old non-convertible preferred issued under TARP I unless pressured by the government to exchange it to the new convertible preferred.  Then there are the new executive compensation caps that apply retroactively.  The stock market rose a bit on the terms and then tanked again after the President appeared on television at about 4:00 to warn of "heavy oversight."  This new cash is going to come with plenty of strings.  At some point bank boards should think about whether they will get more money to shareholders by voluntarily winding up than accepting government cash and government "oversight."  Indeed, the boards have a fiduciary duty to make the calculation and wind the bank up if the calculation favors the process.

Citigroup, of course, is getting a special deal. The government with exchange up to $25B of the old preferred for new convertible preferred (with an 8% rate) if the private shareholders also participate for the same amount. If it works out the government would have potential voting rights on close to 40% of Citigroups common.  The offer hit the markets hard as Citigroup shares broke trading volume records and fell close to 40% on the announcement.   

Bernanke's Reassurance Scare

To reassure the market that the federal government would not nationalization Bank of American and Citigroup the Chairman of the Federal Reserve said "We do not need majority ownership to work with the banks... We have very strong supervisory oversight. We can work with them now to get whatever's necessary."  In other words, "we run the banks without majority control of voting stock."  This to me is worse than the reverse, "we need majority control of voting stock to run the banks."  Couple this with the front page WSJ story that miscellaneous government officials from four or five departments are running around Citigroup issuing orders and making demands, some contradictory.  What a mess; what a scare.

Government Into Car Companies Too Deep to Get Out?

The principals in the auto companies are negotiating in light of a government bailout.  This makes their negotiations difficult and less than satisfactory; everyone is encourage to hold out.  We now find that even if an auto company takes a traditional Chapter 11, we may have the same problem -- the government financing will determine the winners and losers.  Even in a Chapter 11 then the private parties will negotiate in anticipation of government funding.  In or out of bankruptcy, the government will call the shots -- it has owns the problems.

An Intriquing Legal Issue

Some banks who took TARP I money did so under a clause that allows the government to unilaterally change the terms of the deal.  What is the legal effect of such a clause.  Assume the government now wants to cap salaries and bonuses and demands that the bank do so; the bank does not take any new TARP money.  Must the bank comply?  I would say not. Either the clause is unenforceable (no standards for evaluating whether the government is in breach) or there is no contract at all (no mutual agreement on significant terms).  The bank could refuse and the government cannot vote its non-voting preferred (or common, if it exercises its warrants) stock to force compliance.  In the extreme case, there is no contract and the bank can even ignore the terms of TARP I's deal and force the government to sue for restitution and rescission of the funds (with the result no obvious).  In any event, none of this will happen as the government has the banks running scared of its other regulatory authority. 

Who Is the Sucker??

Now that the new Administration's economic proposals are trickling out we can add them all up and see who is taking it on the chin, who is getting played for the sucker.  The old advice for players at the poker table holds: If you do not know who the sucker at the table is, it is you.  Our economic system runs on voluntary compliance linked to cultural norms, not fear of getting caught and prosecuted.  The cultural norms, in pre-PC days, used to be called the Protestant Work Ethic or the like.  People who put themselves in position to find work and earn some income, did not over-spend their budget, bought and paid for a home they could afford, saved a bit for their children are the suckers.  They will pay for others who did over-spend and saved nothing.  They will pay in increased taxes, both in income and estate taxes (and their social security repayments will be means tested), and in inflation (their savings will be eaten up by inflation).  Those who voluntarily complied with the rules and lived within their means are the suckers.

Obama's Homeowner Affordability and Stability Initiative

The President announced and Treasury published details of a new Homeowner Affordability and Stability Initiative today.  The press is struggling to get the details correct. Here is the basis of the Initiative. To be eligible, a homeowner must have defaulted on his/her mortgage payments (due to economic distress or limited income)  or otherwise hold a mortgage that is "underwater" (there is no equity left in the house once the mortgage obligation is subtracted).  If mortgage owners on such mortgages reduce mortgage payments to 38% of income of the mortgage payee (with reductions on interest and/or principle) for five years, the government will match, dollar for dollar, further mortgage payment reductions to 31% of mortgage payee income.  Treasury would also kick in a "partial guarantee" payment to the mortgage owner for a "reserve" in case the property further declines in value.  The mortgage reductions are standardized under a program to be announced March 4th and the standardization will provide "legal cover" to mortgage "servicers" that act for investors in a mortgage pool and provide guidance to the many government agencies that hold or guarantee mortgages.  All mortgage owners that take government payments under the Initiative must use the program conditions.  The cost of the Initiative is projected at $75 B.

The Initiative comes with a host of modest but significant cash grant incentive payments to mortgage owners to modify mortgages and to mortgage payees to discourage defaults on the eve of modification requests and after modifications have been accepted.

A second part of the plan is designed to help homeowners who have less than 20% equity left in their homes (but do not owe more than 105% of the homes value) and are current on payments.  They can qualify for Fannie and Freddie guarantees if they refinance--remortgage.

The back-end of the Initiative is interesting.  If the program is to the benefit of mortgage owners as well as mortgage payees, then the value of outstanding mortgages should increase once the program starts.  Yet the government is also increasing by $200B, a program to purchase preferred stock issued by Fannie Mae and Freddie Mac.  The government will also buy Fannie and Freddie MBSs through its TALF program.  In other words, the government is pouring money into Fannie Mae and Freddie Mac to support the mortgage modification program because it believes private investors will not.  Why not?  If the Initiative increases the value of outstanding mortgage portfolios, Fannie and Freddie should not need the new funds.

Will it work?  No.  Our real estate problem is and has been that cheap credit (under market interest rates) produced a bubble in real estate prices.  Housing prices in the problem markets have yet to fall enough to new equilibrium level. They have another 5 to 10% to drop.  The market needs to bottom before it stabilizes and returns to modest growth.  Artificially holding up housing prices, as this plan does, will post phone for a short period but will not stop the market from seeking an accurate bottom.  The delay will increase the pain, not mitigate it and there will be new class of suckers, who bought on the way down.      

The Auto Bailout: A de facto Nationalization

General Motors and Chrysler have petitioned the government for another $22 B in loans to keep both companies solvent and running.  In exchange for the new money they have offered restructuring plans that, among other things, fire workers.  GM promises to fire 47,000 workers.  This makes it very tough for the President.  He justifies bailouts are to save jobs and a condition of the auto bailouts is firing workers??  The irony is thick indeed.  The details of the restructuring proposals show what insiders already know -- it is smoke and mirrors. The affected parties, shareholders, bondholders, the union, and management have not come to a workable deal -- they are waiting government direction.  Everyone was negotiating in anticipation of the government bailout, not in anticipation of Chapter 11.  The sensible negotiation strategy is not to put everything on the table until a huge uncertainty, the government's positions, is made clear.  There is no deal yet among affected parties; there is only posturing to government officials.  Treasury officials are pouring over books trying to figure out how many jobs GM should keep, what cars and lines of cars it should drop, how it should treat dealers.  What a mess.  Folks, we do not want Treasury in this position, in  de facto effect, running the auto companies.

One Bright Spot in the Bailout--Commerical Paper

The Fed's program to help commercial funds has worked well. Worried about the Reserve Primary Fund's "busting the buck," the Fed offered to guarantee price levels in money market funds and buy from such funds illiquid assets (ABSs).  The effect has been dramatic; the program has re-invigorated money market funds and the funds are buying commercial paper and short term asset backed securities (ABSs), both of which support operating businesses.  The Fed charges fees for the guarantees and, so far, has not had to make any payments. This site has long favored supporting the commerical paper market. The money market funds hold very high quality short term paper, easy to value and standardized to make it fungible -- the opposite of the mortgage backed securities (MBSs) that are held by our large financial institutions.  I continue to believe that the only way to handle the large banks that hold MBSs is to put the worse ones through insolency proceedings. An important byproduct of the proceedings will, of course, feature bids by vulture funds for the banks MBS portofolio that will help re-establish a market price for these otherwise impossible to value securities.

Kansas and California Short on Cash

Kansas and California have suspendend tax refund checks and appear to be unable to met their state payrolls. http://www.kansas.com/735/story/701750.html They are desperate for cash and can no longer borrow, even against healthy accounts.  This all comes after the passage of the Obama stimulus bill that promises them extra cash.  Several other states are in similar budgetary straights; they just have a better cash flow.

Now We Can Read the Stimulus Bill

After the Stimulus Bill passed Congress in a rush, over 1,000 pages drafted late Thursday night and passed early Friday morning in the House and late Friday night in the Senate, we now have time to read the bill.  There are many, many surprises.  First, Wall Street has "discovered" a late Thursday night insertion by Chris Dodd that substantially increases executive compensation limits on all companies that have or will get federal TARP funds.  {Will the President refuse to enforce the new limits with an "executive reservation" ?] Second, state and local governments have "discovered" that getting a slice of the bailout money designated for states and local governments puts their fate in the hands of obscure federal officials when have substantial discretion. [How to lobby??] There will be more surprises, many more.  I look forward to the President's signing speech Tuesday [he is on vacation]; it ought to be interesting. 

Law Firm Layoffs

Blogs are reporting large law firm layoffs this week.  E.g., http://blogs.wsj.com/law/2009/02/12/21209-the-darkest-day-ever-for-big-law-firms/

CBO Stays Stimulus Bill Worse that Doing Nothing

The Congressional Budget Office, hardly a Republican bastion, has reported that the stimulus bill will lead to a lower GDP 5 to 10 years out than if Congress did nothing.  The bill will crowd out private investment that has a higher chance of increasing GDP than the spending in the stimulus bill. Correction: Here is the cite to the letter. http://www.cbo.gov/ftpdocs/99xx/doc9987/Gregg_Year-by-Year_Stimulus.pdf

More Mortgages in Trouble: Neg-Am and Option-Am

The housing crisis is not over if we address subprime or even alt-A mortgages. While the subprime crisis may be peaking, there's another tsunami of defaults coming, this time from "prime" borrowers. Option Arms, Neg-Am's, and Alt-A mortgages, totaling in size of 2-3 times larger than the subprime market, are expected to default in percentages reaching 85% default rate. There are $500B of option arms alone. These products are exotic variations of "interest only" mortgages, but allow the borrower opportunities to pay only part of the interest, while having the rest of the interest charge added to the outstanding principal. Thus, the principal loan on these mortgages actually grows over time. These products usually reset (full interest and principal payments due) 5 years out. There will be a wave of resets beginning in late 2009, peaking in 2010, and ending in 2012. Thus far, only a few have reset, but almost 40% of them are already 2 months delinquent. Against their original plan, borrowers cannot refinance these mortgages because they are upside down on their loans (owe more than their house is worth) due to home price declines. This will be a wave of defaults that will further cripple the financial sector, as holders of these mortgages are the same holders of the toxic subprime debts. Most of these negative amortization mortgages were given to folks with good credit, "prime" borrowers, not the subprime market. Often, they also allowed borrowers to "state" their income rather than "verify" it, and the loans were traditionally "jumbo" in size (but with serious and unique problems that traditional jumbo's did not encompass). Obviously the reason you'd take a negative amortization loan is because you can't afford the purchase price now (or are flipping), but are betting prices will increase so you can refinance later. But that didn't happen, and as principal increased and home value decreased, any equity in the home was/is devastated.

These products were not disbursed across the country evenly like subprime loans, and are located almost entirely in a few states such as California and Florida. The current Senate's plan to stimulate housing with 4% interest rates and a $15,000 credit for homes bought in 2009 will not help this looming wave of defaults.

Arguments Over the History of Government Stimulus Packages

We all know the familiar quote: "Those who do not know history are doomed to repeat it."  But there is another: "Those who know history are doomed to spin it."  The history of the government works packages in Japan in the 90s and in the United States in the 30s is the subject of competition theories.  All who study both periods agree that neither worked well.  There was tremendous waste and the programs did not solve either economic crisis, other conditions did (the War in the United States and growth of demand for exports from Japan).  There is stops.  Big spenders argue 1) waste can be avoided and 2) the programs were not big enough.  The United States, for example, hesitated in 1936 -- the debt was unnerving--and lost momentum.  If we want to "go big", bigger than their Japan or the United States in the 30s, we will need to at least double the current spending bill -- we need to spend at least $2 Trillion.  I am on the other side.  The history shows the reverse: government spending bills do not work and they are inherently wasteful.  Japan's history shows in detail that a spending bill written by a democratically elected legislature will necessarily include pork for everyone and will necessarily be wasteful (and backward looking).  Our current bill is more evidence of the same.  We are shocked, shocked, that the government has mispriced $78 b in TARP securities, has failed to follow the effects of $350 billion in TARP payments, and is currently fighting over obscure cash grants for golf courses.  I am not; I expect it.  The President's arrogant attempt at mocking critics "Of course, it's a spending bill...that's the point." is hilarious.  We fools thought it was a "jobs bill" or  a "GDP increase bill."

Keep in mind that on top of this $800 to $900 b "spending bill,"  we will spend another $350 b in TARP and another $600 b in the Fed rediscount purchases and may have another round of $1 T bank bailout packages in the works.  We should ask our representatives in Congress first how we will pay it back, before we spend it.  The payback debate should accompany the debate over whether we could use the babbles.  Have you heard any serious discussion by Pelosi or Reid on how we pay it back??? The debates should not be over whether we need new schools and road, of course we do (Obama's arguments on the merits of the spending programs was disingenuous--of course, given no cost, we'd rather have the stuff), the debates should be over whether we can afford new schools 

The Bank of America/ Merrill Lynch Deal: Questions, Questions

The Wall Street Journal's excellent front page story on the details behind the Bank of America purchase of Merrill Lynch raises many, many questions, both political and legal.  The story reveals a Secretary of Treasury that forces an unwilling CEO of one of the country's largest banks to close a deal for one of the country's largest brokerage firm.   The Secretary of the Treasury 1) impliedly threaten to fire the CEO through the country's bank regulatory system (even though it holds no-voting stock), 2) offered the CEO more government cash (which only came out several week later) to close and 3) appealed to the CEO's patriotism.  The CEO took the cash, did not tell shareholders who have to vote on the deal a few days later, and later told reporters "he did it for the good of the country."  As the Bank of America stock tanks on worries that the government will have to nationalize the bank, plaintiffs' lawyers are have a feeding frenzy, suing on allegations of, among other things, insufficient disclosure around the shareholder vote.  If the government does nationalize the bank, the government will pay damages, if any, from the shareholder suits. 

Man; this is a story for the ages.  We will learn more when the inevitable best-selling book comes out on the deal.

The political issues:.  1) Do we want a Treasury Secretary making these kinds of calls on deals?  2) on leadership in major private banks?  On the legal issues:  1) How could BofA lawyers give advice not to disclose on the shareholder vote? 2)Why should Lewis pay attention to Fed lawyers on the MAC clause?  3) How can Lewis not put BofA shareholders first (BofA is a Delaware corporation and Delaware has no constituency statute)?  The over-riding management issue:  Why did Lewis not have the guts to tell Paulson to go to hell -- that he was not closing a deal that would kill his company?

Executive Pay Caps: Goldman in the Driver's Seat -- Again

After the Treasury announcement at 11:00 of caps on executive salaries the stock market dropped from positive to negative and Goldman stock price shot up 6 percent will Bank of America stock price dropped like a rock.  Goldman is in the catbird's seat; it has already collected $10 or 25 billion that it did not need (at a very low cost of a 5 percent dividend on preferred) and will be free of the salary caps (not asking for more) and able to hire all the best talent in the many companies that will still need money.  Those companies that still need funds, like Bank of American and Citigroup, will bleed talent to Goldman (and Morgan, also in good shape) and only those not good enough to leave (to go to Goldman or to a hedge fund or to another financial institution that is not claiming money-- "boutique banks") will be left to deal with a struggling company, which, of course, rises on falls on the talent of its managers.  The market sees the salary cap ruling as the potential final straw on the nationalization of the Bank of America and perhaps Citigroup.  Well, maybe Bank of America can get the benefit of its old talent working now for Goldman by paying a fat consulting fee, $1 million a year perhaps, to Goldman.

The New Treasury Caps on Salary

Treasury has released new rules on executive compensation for financial institutional that receive federal bailout funds.  In essence, those that get exceptional amounts cannot pay executives more than $500,000 in cash and, if they use stock or stock options, the equity cannot vest until the company has repaid all government loans or grants.  Those firms that dip into government bailout funds in "normal" ways can waive the caps only if their shareholders vote to approve to waiver.  Much ink will be spilled over this new announcement.  But I have three comments.  First, the government has discovered a very effective way to force companies to repay government grants and loans.  These caps will be very unpopular with management, who will rush to escape the provision by repaying the government as quickly as possible.  Second, the provisions are not retroactive and they could be.  Treasury could have forced companies to repay the "shameful" bonuses already paid and could have forced companies who have already accepted money but will accept no more to adhere to the caps.  So a bank that has taken $25 billion and will not take anymore, can pay under the old rules.  And third, interestingly, a bank that needs funds could refuse them, go through the take Chapter 11 like reorganization procedure for banks, and still pay executives, in the reorganization and thereafter, more than the caps provide.  Is this an incentive to go through insolvency proceedings?    

Dow's Busted Deal for Rohm and Haas

Dow Chemical agreed to buy Rohm and Haas and signed a very, very seller biased contract.  Now Dow wants out and seeks court sanction to do so.  Is there room in the contract language?  The Material Adverse Change Clause is very tight, excluding market conditions, even if they have a disproportionate effect on Dow.  The remedy clause purports to give Rohm and Hass a contractual right to specific performance.  Dow's only nugget in the language is an anti-third party beneficiary rule that may stop Rohm from claiming damages to shareholders from the loss of a purchase premium and that may stop Rohm shareholders from suing under the contract for damages.  Dow has three arguments: 1) There was no breach; 2) The specific performance clause is not binding on a court; and 3) Rohm and Haas cannot argue for damages to its shareholders.  3) looks to be a winner; 1) and 2) depend on an appeal to the inherent power of a court to look beyond contract language, an uphill struggle.  2) appeals to a court's "equity powers" to order or not order specific performance that, arguably cannot be limited by contract.  1) will appeal to fringe contract doctrine cases (sometimes from the House of Lords or the King's Bench)  that one may find in a first year contracts case book -- frustration of purpose and impossibility defenses (add, perhaps a void as a matter of public policy based on irreparable harm).  At issue is an intriguing question for a judge.  When is a contract "too tight" to be enforced?   Is there some limit to using judges to enforce contracts that, due to events, rip the soul out of one party and put the other party in paradise?