A Devil in the Details

Although Secretary Paulson's move towards using the $700 billion war chest to add to bank capital (i.e., make equity investments in them) rather than buying "troubled" assets has been widely applauded, the terms are not good, according to Willem Buiter:

Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.

In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.

In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson’s capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.

The terms are not good for the US taxpayer, that is, but they are favorable Paulson's financial sector friends. I would feel much better if Bernanke - or the Obama administration - was running the show.