Convertible Preferred

The Wall Street Journal runs a guest piece by hedge fund hero John Paulson advocating an alternative to the proposed Treasury rescue - have the Treasury mirror what Warren Buffet did with Goldman Sachs by buying convertible preferred stock in troubled firms.

There are major problems with the Treasury plan. First, by buying banks' worst assets at above-market prices, taxpayers take an immediate economic loss -- while transferring wealth to shareholders and executives of the very institutions that brought on the financial crisis.

Second, this plan puts too much discretionary power in the hands of Treasury officials. Who determines what financial assets are purchased and at what prices? Who determines which bank gets to benefit from these taxpayer subsidies? Will bank shareholders continue to receive dividends, and executives continue to get paid huge bonuses?

When financial institutions borrow massive amounts of money to invest in assets that are now found to be illiquid and poorly performing, it is not the responsibility of taxpayers to bear the resulting losses. These losses should be borne by the shareholders.

...

This mechanism -- purchases of senior preferred stock with warrants in troubled institutions -- addresses the problems with the Treasury plan. The financial market is stabilized, companies get recapitalized, failures are avoided, debt securities are supported, and time is gained for illiquid assets to mature.

The institutions continue to function, their cost of funding will decline as equity capital increases, and innocent third parties like bank depositors, broker/dealer clients and insurance-policy holders are all protected. The only difference is that potential losses are kept with the shareholders where they belong.

The Treasury plan would also entail larger outlays than the Preferred plan. By allowing all banks to sell their worst assets to Treasury at inflated prices, taxpayers would be subsidizing healthy banks which have access to private capital (Goldman Sachs, J.P. Morgan, Wells Fargo, and Bank of America, for example) as well as banks that don't have a private alternative. But under a Preferred plan, only banks that don't have a private alternative will be given federal assistance. This would reduce the outlay otherwise required to solve the crisis.

Few people familiar with the issues deny that Treasury action is needed to stabilize the financial markets. However, the question is who should bear the cost?

Under the Treasury plan the taxpayer pays the price. Under a Preferred plan, the shareholders of the firms who created the problems bear the first loss. Who do you think should pay?

I am well aware that this Paulson may be talking his own book, but conceptually he is correct.

Yet another alternative - Treasury could provide the mother of all term-repo facilities by lending against troubled assets rather than buying them.  This would be effective if the problem is liquidity and price discovery rater than solvency.

Under the facility Treasury makes long term (3, 5, 7 years?) recourse loans secured by illiquid, troubled assets at a modestly punitive rate of, for example, Fed Funds plus 2%.  Healthy firms will probably pass and continue to fund themselves in the conventional money markets.  Troubled firms will dump their worst assets into the pot and get cash back, solving their liquidity problem.  And if liquidity is the extent of the problem then over time the value of the assets will improve, troubled firms will raise other capital, the loans to Treasury will be repaid, and all well be well.

If there is also a solvency problem then the use of this longer-term facility should kick the problem down the road.  However, even with secured recourse loans, if the assets are over-valued (i.e., the Treasury over-values them for collateral purposes) and the borrower eventually slides into bankruptcy, the recourse feature will not provide meaningful taxpayer protection.

That said, I am not sure that buying preferred stock in a failing firm will work out well either.

Well - the Fed has already expanded and extended eligible collateral for its repo program.  My thought is simply to take a few giant steps down the same path, accepting more assets for a longer time period.

Lat thought for now - corner solutions are rarely optimal.  Is there some reason that a combination of direct Treasury purchase, direct investment in convertible preferred, and provision of term repo facilitates could not be even more effective than any one of the approaches?

Comments

[Neo]

Frankly, I think this thing is dead.

Wall Street is on it's own.

[Wounded Messenger]

Sebastian Mallaby, another HEDGEFUND HERO...

HANDS OFF THE HEDGE FUNDS

"Summary: The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international financial system. In reality, hedge funds do not increase risk; they manage it -- and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well.

Rather than seeing hedge funds as sources of dangerous financial fires, in fact, it is more accurate to see them as the financial system's benevolent fire fighters -- and to let them have the tools they need to do their jobs well.

Sebastian Mallaby is a Washington Post columnist and the author of The World's Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations."

'Benevolent fire Fighters', indeed.....

http://www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/hands-off-hedge-funds.htm

[Charlie (Colorado)]

Wall Street is on it's own.

Get long guns beans and bacon.

[glasater]

Charlie Gasperina just ripped into Harry Reid. It was good to watch.

[glasater]

McCain is going to the debate!

[Charlie (Colorado)]

Tom, first thoughts, although at least I've had some coffee now.

I still think the biggest issue is that the CDSes are busily turning people's cash into illiquid securities. The B&P plan, unadorned, is to use a big credit line to buy up the illiquid securities, turning them back into cash at a discount, and owning the securities in return, which can be sold, hopefully at a profit, later.

This plan is to buy up convertible preferred stock, thereby adding in cash that turns into equity in the companies, leaving the companies partially nationalized instead of the securities; but on a balance sheet basis it's a wash, because they're still going to need to inject enough cash, and buy enough equity, to free people from the illiquid securities.

From a "financial engineering" standpoint, it really seems like the only advantage is that it adds enough smoke and mirrors to be more politically palatable.

[Steve Diamond]

How ironic, the WSJ is to the left of Hank Paulson.

[Charlie (Colorado)]

On your loan scheme, wouldn't they be vulnerable to another run via mark to market?

[Charlie (Colorado)]

How ironic, the WSJ is to the left of Hank Paulson.

Steve, aren't you more or less defining "left" here via "the enemy of my enemy"?

[Barney Frank]

There are usually, if not always, theoretically better ways to do things, but there are seldom very many practical ways to do anything, especially in a crisis.

The RTC was certainly not the preferred nor the most elegant way to clean up the S&Ls, but it was simple, it worked and it smashed the problem.

The problem we now face, again, is bad debt. Larry Lindsey and the House Republicans and Martin Feldstein and numerous others have many sensible, even elegant proposals to rid the system of it eventually or at least rid the system of the worst effects of it. But I tend to think that the direct route of buying it and reselling it is the simple brute force needed and most sure route to fixing it and the most easily understood and sold.

I don't think there's going to be a second chance to get it right and avoid a massive economic dislocation, so some variation of what we found to be effective twenty years ago would seem to me the wisest course.

There are many differences between the two situations but there is one overwhelming similarity; the assumption by the government of the impaired assets in a locked market and their resale over time. It worked before so why walk a tightrope looking for elegant alternatives when it's suspended over a volcano? Get a bulldozer and build a road around the volcano. It's blunt force and it's dirty but it gets you to the other side without burning your arse off.

[Rick Ballard]

I can't quite see how this (loan in exchange for convertible preferred) creates a 'new, improved balance sheet'. The Poland China takes on a slightly different appearance but the oink and squeal give the game away.

I'll go with Barney on this one - a reverse auction will clarify the situation very quickly and the market "floor" created will allow companies to make rational decisions about what assets to hold or sell.

[independent pendant]

"Steve, aren't you more or less defining "left" here via "the enemy of my enemy"?"

If you are defining the 'left' as those who
support the bail-out, Republicans are the enemy.

[Sue]

I don't think there's going to be a second chance to get it right and avoid a massive economic dislocation, so some variation of what we found to be effective twenty years ago would seem to me the wisest course.

I know I sound like a parrot, but wasn't that Paulson's 3 pager? The 40 pager, democratic plan should be dumped if republicans are going to be required to sign onto Paulson's plan.

[Barney Frank]

I know I sound like a parrot, but wasn't that Paulson's 3 pager?

Absolutely, Sue. Bulldozers are fairly simple machines. Add on bells and whistles and all they do is breakdown.

[SlimGuy]

Well for my dime with what Dodd & co are trying to add into the bill the short form is hey we screwed up and passed laws and blocked oversight for years causing this train wreck.

How by rewarding us for such a fine job by giving in to us on things we want for us and our friends as a way of saying thank you.

[SlimGuy]

Chuck Schumer tells McCain to get out of town, meanwhile nobody is sure if The One is there and what he did while he was there.

[Joseph Somsel]

If we go for the buyout of bad (or locked up) paper, we the taxpayers should at least get warrants for our trouble.

That's like convertible preferreds but without the dividends. Either way it adds enough pain to keep solid players from gaming the government. When the dust settles and the time is right, the Treasury sells and recoups some cash (by diluting the existing shareholders) to balance the expected losses.

But if Barney Franks supports a proposal, my first impulse is to oppose it.

[Tom Maguire]

On your loan scheme, wouldn't they be vulnerable to another run via mark to market?

In a word, yes. But in a lot of words, maybe not.

I see the collateralized loan as being long term, so the government can't pull the plug on it overnight. However, I also think that these loans would need to be made public (surely they would be picked up in standard accounting statements anyway, but the Treasury can report activity from its end too.)

People could see who the big borrowers were, look at the collateral, and form their own judgments as to the long term solvency of the firm. And the loan facility ought to have a creeping mark-to-market so more collateral is required if the initial pledge is inadequate (shades of AIG!)

But if the firms using this have time and disclosure, I think (hope? pray?) that other firms will also give them time to raise new capital or take other steps.

Frankly, if I were trying to avoid a Great depression I would just but the damn stuff, which is where Paulson is coming from - the idea that Wall Street's suffering can be compartmentalized may be accurate but if the experts focusing on that are wrong the price will be staggering.

As to taking equity in the firms - that helps, too, obviously, but they still hold risky, illiquid assets, which drives up their capital requirement. Getting rid of the risk gets rid of the need for new capital in many cases. It also exposes the insolvent, which may be a good thing if there is a Step 3 to bail them out/prop them up.

However, libs are terrified that somewhere some Wall Streeter will sell to the Feds and make money. Too high a price to pay for saving America!

[Thomas Esmond Knox]

"sell their worst assets"?

Where did this meme come from? I haven't heard Bernanke or Paulson specify the asset class they might buy.

My understanding is that the banks can't sell the good stuff now, and that's the problem.

[sophy]

I do not know how to use the rs gold ; my friend tells me how to use.