Dirt Diggers Digest

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.

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.

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.

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.

Buried inside the Big Bailout bill that the Senate just approved and the House will vote on tomorrow is a section that has received insufficient attention. Titled “Preventing Unjust Enrichment,” Section 101(e) states that the Treasury Secretary, when spending his $700 billion bank roll, “shall take such steps as may be necessary to prevent unjust enrichment of financial institutions.”

This is one of the numerous safeguards added to the original bare-bones proposal submitted to Congress by Secretary Paulson. But what exactly does it mean? One might argue that the whole bailout is a way of unjustly enriching Wall Street and the big banks.

The language of the bill provides a very narrow definition: The Treasury is not supposed to pay more for an asset than the financial institution paid for it in the first place.

Isn’t this superfluous? The point of the bailout is to allow banks and others to unload “troubled” assets – in other words, ones that have been sinking in value. Unless Paulson intends to spend like a drunken sailor, there would no reason to pay more than the original price. The real issue is whether the feds will pay the depressed market price for those assets or something a bit higher.

It’s not unusual for legislation to have redundant safeguards, but if you keep on reading in the bill you will see that there is a big exception to the seemingly unnecessary provision: It “does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings.”

As E. Scott Reckard pointed out in the Los Angeles Times earlier this week, this seems to open the door for banks that have bought weaker competitors during the crisis – such as JPMorgan Chase, which swallowed Washington Mutual last week – to sell the toxic assets they inherited in those deals to the federal government at a big profit. Is the sky the limit in how much Paulson can pay for their junk?

Much was made of the fact that the shotgun marriage meant that the Federal Deposit Insurance Corporation did not have to pay out anything to WaMu depositors, but JPMorgan may make out like a bandit when it comes time to play “let’s make a deal” with Treasury’s asset managers.