The executives and staffs of the nine largest financial firms in the US should be wary of their new minority partner. In retrospect, they will find that recapitalization by black-market cartels would have been much less violent and personally damaging.
The new minority partner, the US Treasury, has publicly stated that it has no wish to run these companies however, that lie is betrayed immediately by the restrictions and caveats that were given to the heads of these banks as an offer they could not refuse. These are the “not running” directives we know about so far:
- creation of a new class of senior preferred stock that pays automatic 5% dividends for 5 years and 9% after that
- compensation limits on the top five execs at each bank
- issuance of warrants on common stock worth 15% of the “investment”
- no repurchase allowed for three years unless the capital is raised through additional offerings
These are, on their face, reasonable measures to protect the Treasury's “investment”. As we shall see, however, they will not (indeed, can not) be the last instances of “not running” these companies.
No Basis for Value
Before the problems start, let me be the first to note (reiterate, actually) that the Treasury has no basis for valuation of their newly-acquired shares. That is, the US Treasury is taking a buy-and-hold position where the value of the security is irrelevant in hopes of long-term appreciation. As far as the Treasury is concerned, there is no price target or exit signal, nor can there be.
While the preferred shares taken by the Treasury are marketable, they exist in a class by themselves. Any price, then, is purely arbitrary (think negotiating with your dive buddy for his extra air at a depth of 130 feet). Please keep that in mind when Paulson pontificates that his program will generate a profit.
The Treasury's premise is that, by injecting this capital, the common stock of these firms will attract additional capital from other sources, pushing the price of common stock up and giving value to the warrants the Treasury demanded as well as a 5% dividend. In other words, the Treasury is taking a contra-market position that all these firms are lacking is some extra cash.
On its face, this premise is absurd. If all these firms needed was cash, they could easily get it. After all, the Treasury had to go out and borrow cash to make these purchases. All these purchases can, and will, do is divert cash from worthier investments as if the Treasury has some super-secret, can't miss, back-tested valuation formula that the rest of the financial world doesn't possess.
But even if the Treasury has such a mind-blowing formula, why put it to use within the US? After all, if the Treasury is correct, the profits on these purchases will come directly from the capital of US firms. The Treasury should use its omniscience in foreign markets, thus profiting off foreign companies; those profits should certainly replace taxation, and indeed, the need for anyone to work in the US. We could all just live off the dividend checks that Hank Paulson provided.
Other Government Institutions
To the extent that the Treasury takes equity stakes in these firms, it is pitting itself against other government regulators. Any government regulation that is beneficial to the Treasury's position will be self-evident and, thus, not require the regulation. Conversely, then, any regulation that is required must be (at least on its face) harmful to the Treasury's position.
Ignoring politics, this is a very real dilemma. If the Treasury takes no steps to protect its “investment”, we must ask again about the point of taking equity stakes in these firms. If, however, the Treasury goes against its word and assumes the role of managing partner, Treasury officials will be directing actions of these firms contrary to law. While Treasury employees enjoy qualified immunity, the executives and employees of these firms have no such protection from criminal penalties.
That is the next problem these firms will face. Where before they faced civil liability for their actions and omissions, since the Treasury has an equity stake mistakes and fraud are now crimes against the state (ask any number of Siberian residents). This is certainly not unprecedented or trivial; Elliot Spitzer and other prosecutors have gained standing against publicly-traded companies in the past specifically because the state pension plans were invested in these companies.
Executives, employees, and shareholders of participating firms take heed: there will be scapegoats and jail time involved with this program. Perhaps hari kari will come into fashion on Wall Street.
Tightening the Noose
As with all interventions, the government is not creating opportunity (or jobs, or liquidity, or ...) it is diverting resources from what the market has determined are worthier investments. Although the stated goal is for financial institutions to loan out the newly-injected capital, the fact is these firms cannot loan this money. Any loans made from this new capital will upset their risk exposure even more.
Since it is unclear who holds how much of what debt, and firms are unwilling or unable to discover prices, shares of common stock have a built-in risk discount. Any additional loans will merely add to that discount, depressing price per share (which is already depressed by the creation of new government warrants). The only thing these firms can do with the money is prop up their own balance sheets, thereby reducing the risk discount.
In other words, the new capital is nothing but a price subsidy for common stock. As we have seen with commodity price supports, these subsidies lead to nothing but an ever-abnormal granary.
As long as the Treasury holds stakes in these companies, the market will (rightly) view the stakes as liabilities: dividends that must be paid, warrants and preferred stock that must be repurchased. These companies must raise capital to un-yoke themselves from the government, but will be hard-pressed to raise the capital as long as they are yoked to the government. Until, that is, the government stakes in these companies are viewed as permanent.
As if that's not enough to heap on these firms, we cannot avoid the all-but-certain probability that these firms will become even more of a political football than they already are. Come January, with the election a fading memory, these firms will be mercilessly kicked around capital hill. I don't think it's too far of a stretch to imagine many, if not all, of these firms being wholly-owned subsidiaries of the Federal government by the end of 2009.
Then again, perhaps this program will turn out unlike every other government program in history. Maybe, just maybe, we'll all get unicorns for Christmas, too.