Bloomberg News summarizes Dodd's alternative plan; the text is at The Politico (and a hat tip to blogger P Krugman, who writes: "Very preliminary, no details — but this sounds like a big step in the right direction." Wait until he sees the fine print (although he will still back it, as explained below) - what Bloomberg characterizes as an equity stake is really a random loss recapture provision that dilutes the equity stake of current shareholders and will probably scare off prospective new equity investors; it does not represent new capital at all.
A baffler is here, from Bloomberg:
Sept. 22 (Bloomberg) -- Senate Banking Committee Chairman Chris Dodd offered an alternative today to the Bush administration's financial rescue plan aimed at giving the U.S. Treasury an equity stake when it helps companies burdened by debt.
The legislation requires Treasury to take an equity stake equal to the purchase price of the assets being bought. If the company isn't publicly traded, the government would take senior debt instead, placing it in the front of the line of debt holders for repayment in the event of a bankruptcy.
Among my many questions [and see UPDATE - the Bloomberg summary oversimplifies the equity stake]:
1. IF the problem is an absence of capital in the financial services industry, how does issuing *senior* debt to the US Government solve that, and why is that a plausible alternative to equity? Surely the US ought to be taking subordinated debt. Answer - the point of this provision is to protect taxpayers in the event of a future loss, not to add capital to the system and enhance stability. Let's note that the future loss requires a decision by Treasury to sell and realize a loss. Let's also note that, since asset prices move as market conditions change, these losses may not reflect an "overpayment" by Treasury at the time of purchase - even a price that is free, fair, transparent and "correct" at the time can be overtaken by subsequent events.
The text of the bill is this:
(ii) DEBT INSTRUMENTS.—In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares, which shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to 125 per cent of the dollar amount of the difference between the amount the Secretary paid for the troubled assets and the disposition price of such assets. The Secretary may demand payment of such contingent debt instrument under such terms and conditions as determined appropriate by the Secretary.
Well. First, clearly a mechanism would be needed to track funding costs and cash receipts of instruments that were held for a while and then re-sold.
By my simple reckoning, suppose the Treasury buys an asset for $10 million dollars, tracks the funding costs and cash flows correctly, and then sells the asset for a net price of $10 million dollars. Does this mean the senior debt vests at the difference between $10 million and $10 million, namely zero? Well, yes. In which case, what was the senior liability prior to sale and how were other investors supposed to evaluate it? And I'm afraid to ask what the interest rate was on this senior debt. This mechanism is not intended to put capital into non-traded firms *or* provide reassurance to investors - the goal is to protect the taxpayer.
So here is a new example - suppose instead of a final sale price of $10 million the asset is flipped for $8 million. The difference is $2 million; 125% of that is $2.5 million.
So for costing the government $2 million the private firm now has a senior debt obligation equal to $2.5 million. I see how that helped the government, but how did this help the firm or reassure investors?
If the firm is exposed to losses on the assets it has "sold" during their remaining life, in what sense have they sold it?
OK, in some fantasy I suppose someone could argue that the firm's payment of $2.5 million represents their loss plus some share of the interest ostensibly due on the senior debt. But I smell "half-baked" even at my great distance from Washington.
For the conventional equity my question is different - why do we think the financial sector needs $700 billion in new capital as well as an opportunity to shed $700 billion in troubled assets? Or, if Paulson is limited to writing $700 billion in checks, why do we think that a mix of $350 of new capital and $350 of asset purchases is the right answer? [See UPDATE; I made the mistake of relying on the Bloomberg summary instead of reading the bill. Apparently, this "equity stake" vests at 125% of any losses on the asset in a manner similar to the senior debt described above, which is hardly equity as we normally think of it. Instead, *if* Treasury chooses to recognize a loss on an asset, current equity holders are diluted by the issuance of new shares intended to compensate Treasury].
The general rule from the bill is this:
(1) IN GENERAL.—The Secretary may not purchase, or make any commitment to purchase, any troubled asset unless the Secretary receives contingent shares in the financial institution from which such assets are to be purchased equal in value to the purchase price of the assets to be purchased.
The UPDATE continues this train of thought but my key insight is this - a firm which sells assets to the government will experience equity dilution at a future date *if* the government sells the assets at a loss; if the government chooses to buy and hold or can sell at a profit, the firm is in the clear. So how will a firm in that situation attract new equity investors? The prospect of possibly dramatic dilution based on a Treasury decision to sell or hold a complicated, troubled asset based on prevailing market conditions (which may move against the asset even if the original price was fair) will probably deter many people.
This next bit is just goofy:
(B) MULTIPLE CLASS OF SHARES.—If the financial institution from which troubled assets are to be purchased has more than 1 class of shares, the contingent shares to be received by the Secretary shall be that class of shares with the highest trading price during the 14 business days prior to the date of the purchase of such assets.
So if one set of preferred shares were issued at 100 and are trading at 105 and another preferred class was issued at 50 and is trading at 40, the Treasury will be obliged to buy the shares trading at 105. Why? Because 105 is a bigger number? Surely they want the government to purchase the class trading at the greatest discount from par (or the greatest premium to par, or something more logical than simply buying the class with the highest absolute dollar price).
This is being drafted by tired and confused lawyers who don't understand finance, and we are going to pass it this week?
MORE: Per the WSJ, there will be equity kickers in some fashion:
WASHINGTON -- The Bush administration has conceded several changes to its rescue plan for the troubled banking industry, including agreeing to compensation limits for bank chief executives taking part in the plan and the need for more help for homeowners facing foreclosure, a leading House Democrat said Monday.
Chairman of the House Financial Services Committee Rep. Barney Frank said the Treasury also agreed to Democrats' idea that the federal government should receive warrants to take an equity stake in financial firms in exchange for the government purchasing toxic assets from them.
That is a difference in reporting, but the story does not explain whether the Dodd bill has been revised.
UPDATE: I should have read on! Here is the bill describing the vesting of the equity investment:
(3) VESTING OF SHARES.—If, after the purchase of troubled assets from a financial institution, the amount the Secretary receives in disposing of such assets is less than the amount that the Secretary paid for such assets, the contingent shares received by the Secretary under paragraph (1) shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to— (A) 125 percent of the dollar amount of the difference between the amount that the Secretary paid for the troubled assets and the disposition price of such assets; divided by (B) the amount of the average share price of the financial institution from which such assets were purchased during the 14 business days prior to the date of such purchase.
[Note - "14 days" is simply evidence of fatigue and haste; it should be 10 business days or 14 calendar days].
Let's work through a new example.
1. "Troubled" sells $50 billion of dubious assets to the Treasury.
2. At some later date the assets are sold for $40 billion; I have no idea whether the $40 billion figure tracks cash receipts and funding costs but it ought to.
3. The Treasury loss of $10 billion results in a contingent claim for $12.5 billion. To satisfy this claim "Troubled" does not write a check or simply say "Sorry". Instead, they issue new shares to the Treasury. How many? Well, let's assume that the average share price for the two weeks prior to the Treasury purchase was $10/share. In that case, "Troubled" needs to issue 1.25 billion new shares at $10 each, to the Treasury, thereby satisfying their $12.5 billion obligation.
And what are those shares worth when the Treasury gets them? That depends on the prevailing share price. If "Troubled" is on the brink of bankruptcy, they are essentially worthless; if "Troubled" stock has soared, they could be worth quite a bit.
At first blush this approach does nothing to address Krugman's assertion that the Treasury must inject new capital into the system. On day one, "Troubled" had $50 billion in bad assets. On day two, they had a check from the Treasury for $50 billion, which presumably was used to retire short term debt. And on Day Three "Troubled" showed $50 billion less in bad assets, $50 billion less in short term debt, and 1.25 billion new shares outstanding. The upshot - current holders were diluted in exchange for an opportunity to sell their bad assets at a negotiated price with Treasury. When did new capital come into the system? Not ever. However, the asset-to-capital ratio was reduced by the asset sale, as I argued here, so the capitalization of the industry was impoved even without more capital.
Now, one might argue that this equity make-whole provision gives a firm an incentive to be sure it is not overpaid for the assets it sells - assets sold at a premium are more likely to result in equity dilution down the road.
However, economic conditions change and markets change with them - even if the original selling price of $50 billion was absolutely and inarguably fair, subsequent changes might knock the value of those assets down to $40 billion. In that scenario, the seller is still penalized through a forced sale of equity. Why do we want to do that? Yes, it protects the taxpayer but does that add to stability of make the raising of new capital easier?
Or if the Treasury chooses to simply play a buy and hold strategy with a particular bum asset, that particular seller will never be penalized since the asset will never be sold. Does that make sense? From a different perspective, it actually might make profit-maximizing sense for the Treasury to sell the worst-performing assets in order to scoop up equity stakes in the sellers. Whether Treasury would act on that incentive and whether that contributes to financial stability I can't guess.
Well, let's acknowledge that the goal is not to inject new capital or increase stability but simply to recoup losses for assets for which the Treasury "overpaid" (regardless of whether the initial price was fair). The shares the Treasury receives will be worth something even in near-bankruptcy, but the direct connection to the "loss" will be slight - if, for example, the seller's shares have doubled, Treasury gets a windfall on bum assets on which it realized a loss, regardless of the fairness of the original purchase price. If the firm is near bankruptcy then Treasury gets virtually no compensation for its "overpayment".
Krugman asserted that direct equity investment by the government made more sense as a way to stabilize the system and deter gamesmanship and bad behavior. I argued that his objections ignored the fact that selling assets is another way to improve capital ratios. But although I assume he will support this Dodd proposal, I can't wait to see how he contorts himself to square it with his previous call for direct equity investment to stabilize the system.
Dodd is calling, in effect, for random equity issuance with no underlying cash in order to dilute some owners if the Treasury chooses to sell assets at a loss, regardless of why or when that loss may have occurred. This does not bring new government equity into the system but may create enough uncertainty to deter private investors from joining in. That is stabilizing? How in the world will any of these firms attract new capital investors (if that is what is needed) with that random cloud over their heads? How will a prospective new investor in a firm evaluate the joint probability that (a) the assets sold by the firm a few years ago have depreciated and (b) the Treasury will actually sell them rather than ride it out?
Krugman will support this because it looks punitive and onerous to Wall Street. But this is daft.