Kashkari Daydreams While Bailout Teeters

When Treasury Secretary Henry Paulson chose his protégé Neel Kashkari last month to run the Big Bailout, we were led to believe Kashkari was some kind of whiz kid who would use his background in both engineering and finance to stop the meltdown of the financial sector. A month later, Kashkari has succeeded—in his own mind.

Appearing at an event sponsored by the Securities Industry and Financial Markets Association, the Interim Assistant Secretary for Financial Stability gave a speech yesterday with a surprisingly upbeat tone. Kashkari spoke of having made “tremendous progress” and of having “accomplished a great deal in a short period of time.” He bragged that his team is “working around the clock” while “ensuring high quality execution.” The only problem is that, to the outside world, the bailout is looking more and more like a disaster.

As Kashkari was speaking, news was circulating that American International Group, one of the biggest recipients of federal bailout aid, had reported a $25 billion quarterly loss. At the same time, Treasury revealed it was upping its rescue package for AIG to $150 billion in capital infusions and purchases of the company’s toxic assets. Fannie Mae, another ward of the state, reported a $29 billion quarterly loss.

Also while Kashkari was speaking, readers of the Washington Post were learning that amid the initial phase of the bailout in September, the Treasury Department quietly announced a tax code change that gives a huge windfall (estimated by some tax lawyers at $140 billion) to banks that are buying up other financial institutions. The article reports that some tax experts believe the rule change was illegal.

And all this follows several weeks in which it has grown clear that many banks intend to use the capital infusions they are receiving from Treasury for making acquisitions and paying dividends rather than expanding their loan activity. Today the Post is reporting that the feds have concluded they need to draw up rules that will, in effect, coerce banks to use their rescue money to expand lending—something we were led to believe would happen spontaneously.

The only way all this translates into “tremendous progress” is if Kashkari is a financial Walter Mitty caught up in daydreams about financial greatness. Unfortunately for Kashkari—and fortunately for the country—his reveries will soon be brought to an abrupt end as the Paulson team is displaced by the new Administration.

This is not Corporate America’s Moment

The votes are still being counted in some places, but the battle for the soul of the new Administration and Congress has begun. Corporate America wasted no time in launching an effort to warn against any initiatives that would be seen as unfriendly to business. The Wall Street Journal is already predicting that Democrats will give in to the pressure and “go slow on controversial labor and regulatory issues.”

The National Association of Manufacturers (NAM) issued an open letter to Obama pledging to work with the new administration, but that pledge was followed by a dozen pages in which the group outlined its usual agenda of reduced corporate taxes, tort reform, easing of the regulatory “burden,” and so forth . The U.S. Chamber of Commerce was a bit more tactful. Its CEO Thomas Donahue put out a statement vowing to work with Obama and the new Congress “to help quickly restore economic growth,” avoiding for now the more contentious issues.

Not surprisingly, the sharpest battle lines are being drawn on labor law reform. Business has already been mobilizing to fight against proposed legislation—the Employee Free Choice Act (EFCA)—that would make it easier for workers to organize unions free of employer intimidation. Corporate interests targeted various members of Congress over the EFCA issue during the electoral campaign, to little effect, and undoubtedly intend to keep up the effort. Today NAM President John Engler told the Journal: “This is not the time and this is certainly not the issue with which to build a relationship.”

Someone needs to remind the business lobbies that elections have consequences. When George Bush won reelection four years ago, that same John Engler, speaking for the corporate class, declared: “This will be our moment.” Business Week added: “business groups are already busy claiming considerable credit for Bush’s win. Their wish lists are extensive.” Many of those wishes were granted by Bush and Cheney.

Despite the overblown McCain/Palin rhetoric, Obama did not run as a socialist, but he expressed clear disapproval of the deregulatory agenda. And he accepted extensive help from labor union members, many of whom were motivated by his criticism of corporate excesses and his support (albeit muted) for EFCA.

There may be reasons why the Obama Administration and Congressional Democrats have to proceed carefully on regulatory and labor issues, not the least of which is the apparent absence of a filibuster-proof majority in the Senate. Anti-union executives may not soon find themselves bodily removed from office, as Montgomery Ward President Sewell Avery was in 1944 (photo). Yet neither should business interests expect their wish list to be the current center of attention. This is not their moment.

Kashkari’s Gang of Five

The Bush Administration Treasury Department has been executing the big bailout with a limited amount of transparency, but today an article in the New York Times business section pulls back the curtain and gives a fuller picture of how Henry Paulson’s minions are functioning.

While the country has been preoccupied with the presidential election, a group of five young officials have been meeting to decide which banks will receive federal capital investment funds and which will not. While it originally appeared that Treasury would provide the infusions to any bank that wanted them, the Times describes a very different process. The five officials, led by Interim Assistant Secretary Neel Kashkari, Paulson’s 35-year-old protégé who used to work for him at Goldman Sachs, is unilaterally giving a thumbs up or thumbs down to each institution that applies. Their decisions are said to make use of rankings on a scale of 1-5 determined by each bank’s regulatory agency.

Given that eligibility for the infusions is now being treated by the market as key factor in a bank’s viability, Kashkari’s gang of five is making what the Times calls a “life-or-death decision” for each institution.

It’s amazing how far we have come from the bailout plan approved by Congress, which centered on the federal purchase of “troubled” assets. That scheme, which Paulson insisted be approved immediately to prevent financial doom, has been put on a back burner, while the capital infusion program, which was never debated by Congress, has taken center stage.

It now looks as if the Kashkari group will be remaking not only the banking sector but other portions of the financial world as well. The Wall Street Journal is reporting today that Treasury is considering using some of its investment funds to invest in bond insurers and specialty finance firms such as General Electric’s GE Capital unit and CIT Group.

With remarkably little oversight, Treasury is making wide-ranging decisions about the future of a major sector of the U.S. economy. Even before taking office, the new Administration should put an end to this undemocratic process and replace it with a coherent, transparent plan for economic recovery.

Peer Pressure to Join the Bailout Club

Once upon a time, there was a stigma attached to businesses that had to be bailed out by government. Only ones that desperately needed help—the likes of Lockheed, Chrysler and Continental Illinois—would resort to such a step.

In the upside down world of the current U.S. economic situation, the tainted firms may be those that are not being rescued. That seems to be the growing sentiment among the country’s banks, which are feeling increased pressure to participate in the partial nationalization plan being pursued by Treasury Secretary Henry Paulson. As the Wall Street Journal put it today: “Now institutions across the U.S. worry that if they don’t try for the money, the market will judge them as too unhealthy to qualify, or lacking the savvy to deploy cheap government capital on acquisitions and investments.”

It thus appears, according to the Journal, that thousands of banks will be applying for capital infusions from the federal government, whether they need them or not. For example, US Bancorp, known for its stability and conservative practices, announced today that it will be getting $6.6 billion from the feds. Depository institutions that for decades have proudly displayed their “Member FDIC” sign now feel obliged to advertise that they are also members of Paulson’s bailout club.

One banker already in that club told the Journal: “There’s a perception in the market that the government is actively picking winners and losers…we wanted it well-known in the market that we’re on the list of survivors.”

Those survivors are making sure their status as wards of the state does not cause them to lose much of their autonomy. High-powered banking lobbyists are working hard to thwart any new strings that might come with the federal investment, while financial industry trade groups such as the American Bankers Association are signaling that they would like to remove the modest restrictions on executive compensation that Treasury has already imposed.

Given the mood of the public, the pay rules are not about to be lifted, but neither is Paulson likely to go along with any additional rules. Banks may be largely responsible for the mess we are in today, and they want to use their federal money for acquisitions, bonuses and dividends rather than new loans, yet Paulson continues to treat them with kid gloves. His successor should be a lot less accommodating.

Is Paulson’s Plan Mysterious or Non-Existent?

Those who regard Treasury Secretary Henry Paulson’s bailout program as a step toward socialism should remember that such a system involves not just government ownership but also some degree of centralized economic planning. With all the twists and turns in Paulson’s actions, it is difficult to determine whether he is indeed trying to guide some aspects of U.S. business but is doing so in a way we mere mortals cannot understand.

Especially puzzling is Treasury’s approach to deciding which banks should receive capital infusions. It was no surprise that the first $125 billion went to nine of the country’s largest financial institutions, since Paulson believes that shoring up the big guys is key to restoring stability to the system. But when he then turned to regional banks for smaller injections, it was unclear why some were on the list and others were not (at least not yet).

As Fortune points out, Paulson seems to have deliberately omitted Cleveland’s National City Bank (which is now being sold to PNC) because of its precarious portfolio of bad home loans, but he included similarly situated ones such as Milwaukee’s Marshall & Isley. Now that Paulson, under pressure, is reportedly planning to extend the capital program to privately held banks, whose finances are less transparent, it will be more difficult to figure out if there is rhyme or reason to Treasury’s picks.

Paulson was so lackadaisical in structuring the bailout that the banks getting the federal investments did not hesitate to signal that they would use the funds not to make loans but rather to finance acquisitions and continue paying out dividends and probably big executive bonuses.  Presumably responding to criticism from other quarters, ranging from members of Congress to the United Steelworkers, some banks are promising that they will take steps to ease the credit crunch. Yet it is unlikely these limited gestures will be enough to shore up a financial system that grows weaker by the day.

So, are things going according to Paulson’s plan—or is there no real plan but simply an ad hoc set of measures that desperately seek to prevent a collapse? Paulson seems to want it both ways. He is willing to push through an unprecedented partial nationalization of banks but is unwilling to use that investment to pressure banks to put the public interest before their selfish objectives (which now means lending as little as possible in a enervated economy). We end up with a bizarre form of socialism in which firms get government investment but continue doing what they damn well please.

While Paulson would like to be seen as the mastermind of a brilliant rescue plan, he may be, like the individual Dorothy and her friends discover is frantically manipulating a bunch of levers behind a curtain in Oz, just not a very good wizard.

Note: Since Treasury has been slow to announce all the banks receiving capital infusions, the investigative website ProPublica is filling the void with its own running list compiled with information from other sources.

Paulson’s Magic Wand

Henry Paulson’s Treasury Department has chosen key private-sector advisors for the Big Bailout (whatever that includes this week) and is apparently getting ready to hire the money managers who would carry out a huge federal purchase of toxic assets from banks. In recent weeks, I’ve been raising questions about the conflicts of interest that exist for many of the firms that have been mentioned as likely choices. Now the Wall Street Journal is reporting that Treasury will soon announce the selection of one of the most conflicted firms of all: Pimco, the big bond trader owned by the German financial conglomerate Allianz.

Paulson and his fellow Goldman Sachs alumni at Treasury apparently don’t read the Journal, which reported last week that Pimco has been raising its holdings of mortgage-backed securities—exactly the sector that the federal purchasing would focus on. This means that Pimco and its clients will have a larger position that could be affected one way or the other depending on how Treasury’s purchase plan proceeds.

Pimco is not the only firm with conflicts. Business Week points out in this week’s issue that Simpson Thacher & Bartlett, the law firm chosen by Treasury to be its legal advisor for the bailout, has done extensive work for banks that will be receiving capital infusions from the federal government. The magazine also notes that “the firm represents private equity kings Kohlberg Kravis Roberts and Blackstone, which may try to profit from the bailout later.” 

Such conflicts of interest used to be a reason for a law firm to decline to take on a client, but Simpson Thacher, like Pimco, is apparently counting on Paulson to wave a magic wand and make the conflicts disappear.

Your Tax Dollars at Work: Creating Megabanks

It’s now clear that Treasury Secretary Henry Paulson is seeking to use the Big Bailout not only to resolve the credit crunch but also to remake the banking sector of the U.S. economy. Going on the dubious theory that bigger means better and stronger, Paulson is encouraging giant banks to use federal money to take over their smaller counterparts. In an interview with Charlie Rose last night, Paulson said: “There will be some situations where it’s best for the economy and for the banking system for there to be a consolidation.”

The big players are getting the message. The Wall Street Journal and the Washington Post have pointed out that executives at major banks such as J.P. Morgan Chase and BB&T are openly considering using capital infusions from the feds not to make more loans but to purchase competitors.

It’s odd there is not more of an uproar over this development, the way there has been in response to reports that the big banks have been stepping up their federal lobbying activities at the same time they are taking public money.

What Paulson conveniently ignores is that the crisis gripping the country was brought on primarily by major financial institutions through their reckless lending and investing practices. We’ve already had years of consolidation both among commercial banks and between commercial and investment banks, resulting in the likes of Citigroup, with assets of more than $2 trillion. Rather than being rocks of Gibraltar, many of the big boys have been both causes of economic distress and victims of it. Moreover, if the reports of widespread federal fraud investigations are accurate, many executives at the megabanks may soon be too preoccupied with indictments to focus on business.

Instead of creating more Frankenstein-monster megabanks that would be “too big to fail,” we should be considering, as economist Joseph Stiglitz told a House committee yesterday, breaking up the leviathans into smaller institutions that focus on making prudent loans and investments rather than gambling in exotic financial casinos. But that’s not the kind of policy we’re likely to get as long as a veteran Wall Streeter such as Paulson is running the show.

Goldman Sachs’s Dirty Little Secret

Last week the American News Project put a human face on the economic crisis with a moving video report about a woman named Jocelyn Voltaire facing foreclosure on her home in Queens, New York after she fell victim to a predatory lending scheme. The report mentioned that the foreclosure was being pursued by Litton Loan Servicing, a company tied to Goldman Sachs. Given that much of the economic policy of the United States is being carried out these days by former Goldman executives, including Treasury Secretary Henry Paulson, I was curious to find out more about this firm.

It turns out that Houston-based Litton is a leading player in a field known as subprime servicing. These firms specialize in the handling of subprime (frequently predatory) mortgages in which the homeowner has fallen behind in payments and is at risk of foreclosure. In other words, they are a type of collection agency dealing with those in the most vulnerable and most desperate financial circumstances. Litton services some $54 billion in such loans.

Subprime servicers such as Litton claim their mission is to help homeowners put their mortgage back in good standing. Yet, Litton has frequently been accused of engaging in abusive practices. According to the Justia database, the company has been sued more than 100 times in federal court since the beginning of 2004. In 2007 a federal judge in California granted class-action status to a group of plaintiffs who charged that the company’s late-fee practices violated the Real Estate Settlement Procedures Act. The case is pending. Meanwhile, individual suits continue to be filed. For example, in June homeowner James J. Portley Sr. sued Litton in federal court in Philadelphia for using “false, deceptive, misleading and evasive practices” in violation of the Fair Debt Collection Practices Act (case 08-CV-02799).

Litton has also been accused of being overly aggressive in pressing for foreclosure when a homeowner has difficulty catching up. Last year the Houston Press described the controversies surrounding the company by focusing on one of Litton’s own employees who alleged that the firm had unfairly forced her into foreclosure.

Litton was founded in 1988 by Larry B. Litton Sr., who still runs the firm despite several changes in ownership. In December 2007 Goldman Sachs bought the company for $428 million, plus repayment of $916 million of outstanding Litton debt obligations. The deal was covered in the mortgage trade press, though Goldman, which may not have wanted the wider world to know of its investment, never issued even a routine press release.

Goldman is not the only major bank with direct involvement in subprime servicing (Bank of America’s Countrywide Financial is at the top of the rankings), but the movement of its executives into top federal policymaking positions raises serious questions. Is Hank Paulson’s resistance to measures that would directly help struggling homeowners a conscious or unconscious effort to help Goldman’s Litton operation?

Sunday’s New York Times business section reported that the role of Goldman alumni in handling the current economic crisis has prompted a new nickname for the firm: Government Sachs. Its involvement in the dubious business of subprime servicing suggests that another sobriquet may be in order: Bloodsucker Sachs.

The Rescue Plan Needs to be Rescued

Twice in the past month, the Bush Administration has sounded the alarm about the economy and pushed through unprecedented measures: a $700 billion buyout of toxic assets from financial institutions and now a $250 billion plan for the federal government to take ownership interests in banks. Neither of these schemes has been fully implemented, but already there are signs that they are not having the desired effrect of calming financial markets. Stocks, in particular, remain incredibly volatile, swinging wildly from day to day.

There are also voices suggesting that by focusing on bailing out the banks, Treasury Secretary Henry Paulson and his cohorts made a serious miscalculation. As the New York Times put it today in its account of Wednesday’s 733 point plunge in the Dow: “Investors are recognizing that the financial crisis is not the fundamental problem. It has merely amplified economic ailments that are now intensifying: vanishing paychecks, falling home prices and diminished spending. And there is no relief in sight.”

A blunt attack on the Paulson Doctrine also came today from the Chairman of the Federal Deposit Insurance Corporation, Sheila Bair. In an interview with the Wall Street Journal, she expressed frustration at the failure of the bailout measures to provide direct help to struggling homeowners. Mortgage defaults are “what’s causing the distress at the institution level,” Bair says, “so why not tackle the borrower problem?” The Journal notes that Bair has long been pushing the idea of using federal resources to restructure mortgages to avoid foreclosures, but she was apparently thwarted by Bush Administration figures such as White House Chief of Staff Joshua Bolten.

Not only is the bailout not providing aid to homeowners, it is making things worse. One of the side effects of the plan has been to push mortgage interest rates higher. Rates on 30-year fixed mortgages have jumped to 6.38 percent from 5.87 percent last week. This makes it more difficult for those with predatory mortgages to refinance, and it also drives down home values. All of this will exacerbate the foreclosure problem and make the mortgage-backed securities held by banks even more worthless.

Paulson & Company seem more clueless every day. The so-called rescue plan needs its own rescue. 

Paulson is No Warren Buffett

News accounts of the Treasury Department’s meeting with major bank executives have suggested that Henry Paulson had to pressure the financiers to go along with his plan to have the federal government purchase substantial holdings in their institutions. But for someone who was supposedly throwing his weight around, Paulson did not exactly drive a hard bargain.

On some key points, Paulson’s deal with the banks looks much worse than the terms Warren Buffett was able to extract from General Electric and Goldman Sachs when he provided them with comparable capital infusions. Paulson (left in photo) is requiring the banks to pay a dividend of only 5 percent to the feds. Buffett (right), by contrast, will receive a 10 percent dividend both on his $3 billion investment in GE and his $5 billion investment in Goldman.

In addition, the Treasury’s preferred shares are callable after three years with no premium. Buffett’s shares in GE are callable after three years with a 10 percent premium. At Goldman the shares are callable at any time with the same premium applied.

It is true that Buffett is not imposing the same limits on executive compensation Treasury is applying, but given that Paulson is representing the power of the federal government at a time when there is intense public anger at the big banks, he could have forced them to make a lot more concessions, beginning with an insistence on voting rights for the shares (even though this is not typical for preferred stock).

Paulson seems to want to have it both ways. He is carrying out an extraordinary intervention into the private sector, but aside from placating public sentiment about overpaid executives, he is not demanding that these institutions change their core practices in a way that might benefit their victims (subprime mortgage holders et al.) and reduce the chances of future financial crisis.

The banks are not innocent parties in this crisis. They need not be treated with such deference.