Did Hank Paulson Give Away the Store -- To Himself?

There is a lot to like about the US Government recapitalizing banks with direct government investment in equities.

First, it is fast. Several economists have pointed out that Treasury Secretary Hank Paulson destroyed a lot of value by dithering with government repurchases of toxic mortgage securities -- a process that would take too long, even if you could figure out how to price the stuff.

Second, if you price the securities right, it is cheap. Paulson made the most optimistic case for directly investing in banks last week when he ventured that the deal would not cost taxpayers anything at all because the investment would be recovered at cost or higher.

Taxpayers can be forgiven for hating the idea of giving any money to the same, too-clever-by-half, anti-regulation clowns that caused the crisis. Love to see them drown, except that they would take the rest of us down with them.

Finally, direct investment in bank equities was politically entertaining, so long as you ignore all of the collateral damage. Suddenly the free-market Bushies were sounding like washed up British socialists and washed up British socialists, namely the hapless British Prime Minister Gordon Brown, became the unlikely savior of global capitalism for advocating the approach. Brown is known for his reverse Midas -- things he touches are uncommonly likely to turn to shit. But forcing British banks to accept investments in preferred stock on terms that required them to increase their lending, although cribbed directly from the Swedish banking crisis of a few years back, turned out to be a smart idea.

But the devil, as a good overview in The Economist noted this week, is very much in the details. In particular, it assumes that the government pays a market price for its preferred stock. Overpaying steals money from taxpayers; underpaying steals it from shareholders. Getting it right is necessary, but not that hard.

Did Paulson get the pricing right? Today the United Steelworkers released an interesting analysis -- and we need to take it seriously.

The Steelworkers? Well, most unions don't make the analysis of financial securities their core competence -- but most unions don't hire Ron Bloom, friend and ex Lazard Freres investment banker. Ron's analysis of the deal is available as a document here for those who want to follow the math closely. The essence of his findings however, are easy to understand and very disturbing.

Ron compares the terms under which Warren Buffett purchased preferred stock in Goldman Sachs with the terms under which the US Treasury bought the same securities three weeks later. In both cases, Goldman sold investors preferred stock (equity that is senior to common stock but junior to most debt and usually earns a dividend) with warrants (the right to buy additional common stock at a set price). Not all of the terms were identical, but the math of adjusting securities for different strike prices, dividend yields, and maturities is something Ron is good at and I do only under duress. I know from working with him however -- he gets these things right.

His conclusion: Buffett got twice as much for his money as the US Treasury did three weeks later. If you assume that Goldman Sachs did not lose half of its value in three weeks, then ex-Goldman boss (and presumed Goldman shareholder) Hank Paulson paid twice as much as he needed to for a share of Goldman stock. Paulson prices securities like this in his sleep --this was no accident.

A letter to Paulson from Steelworker's President Leo Gerard puts the conclusion in plain and scathing terms. Like most labor leaders, Leo is not a bashful man, nor above the occasional rhetorical slight of hand -- but  the thrust of his wrath seems well-placed.

Now I know that you have a lot on your plate, but I am sure that someone at Treasury saw the terms of Buffett’s investment.  In fact, my suspicion is that you studied it pretty closely and knew exactly what you were doing.  The 50-50 deal – 50% invested and 50% as a gift – is quite consistent with the Republican version of the “spread-the-wealth-around” philosophy that seems so much in vogue.

If the result of our analysis is applied to the deals that you made at the other eight institutions – which on average most would view as being less well positioned than Goldman and therefore requiring an even greater rate of return – you paid $125 billion for securities for which a disinterested party would have paid $62.5 billion.  This means that you gifted the other $62.5 billion to the shareholders of these nine institutions.   

This is no different than if you paid me $10,000 for a car for which no one else would pay more than $5,000.  You bought it for $5,000 and gifted me the other $5,000.  In my world such gifts are rarely offered to working people.   

Gerard blasts Paulsen for possible self dealing: "you have surrounded yourself with former Goldman employees.. yet it has never been revealed whether in fact you and they have fully divested yourselves of your Wall Street holdings." He blasts investments that "do nothing to deal with the causes of the current crisis" (it does nothing to deal with a badly broken market for home mortgages, but it may help revive interbank lending to the extent that banks once again trust each others' balance sheets).

He references the New York Times report that banks will not lend the new capital: "It has been reported in the media that these firms have no intention of using this money for its intended purpose.  Don’t we deserve a commitment that the money will in fact be used for either loans to the companies which are groaning under the weight of the credit crisis and being forced to shed tens of thousands of more jobs or to help the millions of Americans struggling with their troubled mortgages?". Ideally this is not a call for banks that have been lending foolishly to resume the practice. On the other hand, it is foolish to invest billions of public dollars on the public's behalf without requiring that the capital be deployed for the public good. (Gordon Brown, like the Swedes before him, got this bit right).

Good for the Steelworker's for doing the math. Congress needs to check Paulson's numbers and renegotiate terms if the deals turn out to be as either as self-serving or as financially lame as their analysis suggests. My money is on Ron Bloom.