Dirt Diggers Digest

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.

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.

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.

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.

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. 

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.