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.

Slow-Motion Socialism

It is a sign of how topsy-turvy capitalism has become that stock markets skyrocketed today on the news that some governments are taking complete or partial control of their major banks. Nationalization, traditionally the anathema of private enterprise, is now welcomed as its savior “amid fears,” as the Financial Times states in today’s edition, “that the global financial system is on the brink of collapse.”

These latest moves in Europe and possibly the United States follow a series of stock market plunges that are now being routinely described as a “slow-motion crash.” By turning to direct government investment or full takeover of financial institutions, the latest rescue efforts are starting to look like slow-motion socialism.

The $700 billion U.S. bailout, which until now was supposed to be the solution to the crisis, was criticized by many on the right as a dangerous move toward socialism, while leftists denounced it as socialism for the rich. That was mostly rhetorical. Public ownership of banks is closer to the real thing.

But what kind of quasi-socialism will this be? Left to their own devices, mainstream policymakers like ex-Wall Streeter Henry Paulson will see to it that public investment in banks does not seriously threaten vested private interests. There’s already discussion in today’s Wall Street Journal of how government investment would be done in a way that protects the banks’ existing shareholders. Protecting pension fund and 401(k) holdings in the financial sector is a good idea, but this does not mean that the federal government needs to be a completely passive investor.

On the contrary, now that the crisis has broken down the taboo against direct federal investment in corporations, we need to be sure this extraordinary intervention does more than help banks get through the immediate credit crunch. Unless there are fundamental changes in the way these institutions operate, we’ll be facing another crisis very soon.

While some of these changes need to come through re-regulation, the federal government should use its position as a major shareholder to bring about changes from the inside as well. This should begin, of course, with ousting the top executives who helped to create the current situation. The next step would be to shake up corporate boards and see to it that all stakeholders, which now include taxpayers, are fully represented. The Federal Reserve is already taking a step in this direction by announcing it will appoint three trustees to oversee the government’s stake in AIG.

The new boards could reconfigure executive compensation formulas and overall bank policies to discourage reckless lending and investing practices. Restructuring subprime mortgages to help homeowners avoid foreclosure and lending to prudent renewable energy projects should be their new priorities.

Government investment in banks may not solve all the ills of capitalism, but if done right it could mean that something good comes out of the current mess.

Paulson’s Small Circle of Friends

While the stock market was swooning on Monday, Henry Paulson’s Treasury Department issued a series of press releases detailing how it will choose asset managers to carry out the $700 billion purchase of “troubled” securities. Any thought that this process would be open to a wide range of participants was shattered by Treasury’s requirement that any applicant already be involved in managing at least $100 billion in dollar-denominated fixed-income assets.

This means that the bailout will be handled exclusively by a small number of firms that are already major players in the money management business. It also means that it is almost inevitable that these firms will have conflicts of interest while working for the feds.

We can identify the tiny universe of these players by looking at a list compiled by Institutional Investor magazine. It shows that as of the end of 2007, there were two dozen firms that managed $100 billion or more in the domestic fixed-income segment. Here are the top ten:

– Allianz Global Investors of America (parent of Pimco) – $424.5 billion
– BlackRock – $423.2 billion
– Legg Mason – $328.2 billion
– Prudential Financial – $245.7 billion
– Vanguard Group – $239.4 billion
– Fidelity Investments – $183.1 billion
– Goldman Sachs Group – $180.0 billion
– Franklin Resources – $158.4 billion
– MetLife – $158.1 billion
– Bank of New York Mellon Corp. – $155.0

The buzz in the financial world is that Pimco and BlackRock have already submitted applications (the deadline was yesterday) and are likely to be chosen. They are among the firms on the list with the biggest potential conflicts of interest.

Pimco has been an aggressive investor in mortgage-backed securities (MBS) over the past year. In September 2007 it announced the creation of a whole fund devoted to distressed debt. In May 2008 it bought a $2.55 billion MBS portfolio from Israel’s Bank Hapoalim. In August 2008 Pimco was reported to be increasing its distressed-debt portfolio by $5 billion. BlackRock purchased a $15 billion portfolio of subprime mortgage securities from UBS last May.

Pimco and BlackRock are not the only fixed-income money managers heavily exposed to MBS and subprime investments. Legg Mason, for example, posted its first quarterly loss ($255 million) in 25 years earlier this year. The deficit came about after it was forced to pump nearly $2 billion into its money market funds to cover MBS-related losses. Legg Mason’s Western Asset Management (WAMCO) unit made some bad MBS bets, prompting several pension funds to terminate its services.

Whether they’ve done well or poorly in their MBS investments for private clients, these money managers should not have the federal bailout put in their hands. They could use their position either to try to make up for their losses or maximize returns from the distressed debt they purchased at bargain-basement prices.

Treasury has announced interim conflict-of-interest guidelines that would not exclude firms such as these from participating in the bailout. More likely is that they would simply disclose their conflicts and then be given a green light to proceed. Whether they end up doing more to benefit their public client or their private ones is an open question.

A Cool Hand at the Tiller of the Bailout?

There is a lot of talk these days, at least from John McCain, about the need for a “cool hand at the tiller” of government. Presumably, that would apply not only to the White House but also to the $700 billion bank bailout that is under way. Yet the man just chosen by Treasury Secretary Henry Paulson to oversee the massive purchase of toxic securities once wrote an anti-Japanese tirade that was published as a letter to the editor in an automotive trade journal.

Neel Kashkari (photo) has received lavish praise for his intelligence and his character since Paulson announced his selection earlier this week. While some observers are surprised that so much responsibility is being given to someone who is only 35 years old and only six years out of business school, that seems to be outweighed by the gee-whiz descriptions of a career that has included stints as an engineer for a NASA contractor and a vice president under Paulson at Goldman Sachs as well as his current position as Assistant Treasury Secretary for International Economics and Development. His immediate boss at Treasury told the Associated Press that Kashkari, who describes himself as a “free-market Republican,” is “very analytic…very fact-based…very unemotional.”

Perhaps now, but the December 26, 1988 issue of AutoWeek published a letter from Kashkari (available in the Nexis archive of that publication) that read as follows:

I’m sick of it! Japanese corporations are always taking credit, or in some way relating their pathetic attempts at quality or success, to that of some American or European accomplishment. For years, the Japanese have been stealing computer secrets from IBM and other American computer firms and have tried to build computers with that stolen technology. Now they’re copying others’ cars. Nissan built that car which looks like an out-of-proportion Ferrari Testarossa. The real Testarossa is a fabulous display of Italian craftsmanship. But no, Nissan had to build a copy cat. As far as I’m concerned, the so called “great” Mazda 929 is an out-of-proportion Lincoln Continental. And now this new Lexus is said to be so great. But the Japanese cannot be original at anything. Their cars fail, but someone else’s car is a winner. Then they decide to make a body style change — and suddenly they have a winner, which looks exactly like the other person’s car! I am really sick of it.

Now, with their new Honda CRX ad they are, in some odd way, comparing the CRX to the world’s most advanced nuclear bomber, which is an example of American technology, not Japanese. I can stand no more!

The editor of the magazine felt compelled to insert the following note after the letter: “We do not concur with Mr. Kashkari’s views nor the racial animosity that is apparent in his letter.”

It is true that Kashkari, whose parents are from Kashmir, was only 15 years old when he wrote the letter, but if the Senate gets around to holding a confirmation hearing on his new post, it might be worth asking him how much his views have changed.

Meanwhile, the Treasury Department is moving ahead with the process of hiring outside asset managers to carry out the Troubled Asset Relief Program. The close of business of Wednesday was the deadline for asset managers to submit applications to participate in the Treasury’s big buy-up. That was only two days after the solicitation was announced.

The impression that the managers will be chosen from a small group of players was reinforced by the requirement that an applicant already be involved in managing “at least $100 billion in dollar-denominated fixed-income assets.” According to a ranking published last May in Pensions & Investments, there may be only a handful of firms, mainly Legg Mason and Pimco, that would meet the requirement. The winners are supposed to be announced next week.

Paulson’s solicitation also addresses the question of conflict of interest, which he had been ignoring before being pressured by Congress. The interim guidelines require that applicants disclose potential conflicts, but there is no indication that firms will necessarily be disqualified because of them. In fact, the guidelines come right out and say that conflicts may be waived. The bailout is open for business.

CORRECTION: I belatedly realized that the Pensions & Investment ranking cited above refers only to assets managed for pension funds. A fuller list that appeared in Institutional Investor magazine shows that there were 24 firms managing $100 billion or more in domestic fixed-income assets as of the end of 2007. More than a handful but still not a very large group. Goldman Sachs, the alma mater of both Paulson and Kashkari, is number seven on the list.

State Attorneys General to the Rescue

Jerry Brown, once derided as Governor Moonbeam because of his unorthodox ideas while serving as the chief executive of California, today showed that he is much more in touch with reality than the U.S. Congress and the Bush Administration. Brown, currently California’s attorney general, announced a settlement under which one of the worst predatory lenders will be compelled to spend more than $8 billion to assist borrowers who are confronting foreclosure.

Congress, at the behest of the Administration, approved a misguided bill that bails out major banks to the tune of $700 billion and provides little direct assistance for struggling homeowners—and still may not solve the credit crunch. Brown (photo)  and the attorneys general of ten other states went to the real heart of the problem. Earlier this year, they sued subprime lender Countrywide Financial (now owned by Bank of America) and have now gotten the company to disgorge some of its ill-gotten gains tied to the subprime mortgages it was peddling.

Today’s settlement with Countrywide – which Brown’s office played a central role in bringing about – is by far the largest recovery from a predatory lender. Bank of America, downplaying the disgrace of its subsidiary, put out a press release announcing “the creation of a proactive home retention program that will systematically modify troubled mortgages” for nearly 400,000 Countrywide customers. The release manages to avoid any use of the terms “predatory,” “lawsuit” or “litigation” – as if B of A just came up with the idea in informal discussions with the attorneys general.

What’s more important than the spin is the substance of the settlement, which includes options such as interest rate and principal reductions as well as complete Federal Housing Administration refinancing under the HOPE for Homeowners Program. There is also financial assistance for those whose homes have already been foreclosed.

This settlement by itself seems to do more to help homeowners than the whole ballyhooed federal bailout. Bravo to the AGs, who should continue using the power of crusading litigation to go after all the culprits in the crisis.

And what was it conservatives were saying about curbing “frivolous” lawsuits?