Brad Setser

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Sharing upside and downside risk …

by Brad Setser
September 23, 2008

Sovereign wealth funds have invested about $35b in US financial institutions. Adding in Qatar’s investment in Barclays and Singapore’s investment (through the GIC) in UBS brings the total up sovereign funds have invested in firms with a large US presence to around $55b.*

The US taxpayer is now being asked to invest $700b to help recapitalize the global financial system – a sum that is more than 10 times as much as the world’s sovereign funds put in.

But, at least as I read Paulson’s initial proposal, the US taxpayer would not get any equity in the world’s large financial institutions in exchange for this help.

Now the US isn’t making a pure equity investment, though some – like Doug Elmendorf and Sebastian Mallaby– think it should.

It is buying the banks’ illiquid assets.

But there is at least the possibility that it will “overpay” for those assets, and in the process effectively contribute equity capital to the US and global banking system. Indeed, there is a real probability it will overpay by more than the $55b sovereign funds have put into the global financial system.

There are broadly speaking two ways a government can recapitalize a banking system.

One is to put in a lot of equity. That equity can be put in to allow the banks to write down (and eventually sell) their bad assets – or it can be put after the banks’ have down the write down, providing the funds both to make the banks’ creditors whole and to supply the banks with new equity. It works out to the same thing. Such an equity infusion is good for the holders of the financial systems debts (depositors, money market funds, bond holders) and bad for the holders of the banks’ equity.

The other is to buy the banks bad debt. That clearly generates a bit of liquidity for the banks – they have more cash on hand, and thus more capacity to make new loans. But it also is risks providing a large gift to the banks equity investors – as they get to move an illiquid asset off the banks books at what may well prove to be an above market price.

Most bank recapitalizations have elements of both. The FT – in its usual sensible way – suggests that the US recapitalization should too. I agree.

To give a concrete example, the Chinese recapitalized their state banks earlier this decade both by buying bad assets off the banks books (usually by exchanging bad assets for the bond of an asset management company, with bad assets shifted to various asset management companies at book value) and by injecting new public funds (whether new funds from the Finance Ministry or some of the PBoC’s foreign exchange reserves) in exchange for the banks’ equity. Now the state banks were already owned by the government, so it didn’t matter too much – apart from internal accounting — exactly how the system was recapitalized: Chinese taxpayers stood to gain on their “equity” in the state banks if China’s taxpayers overpaid for the banks bad assets. But the Chinese example still illustrates the range of choices available to the government.

Some banks still seem to have faith in the illiquid assets they hold and worry that the government might be getting too good a deal on their MBS and complex securities; it will buy distressed assets at a discount from illiquid institutions, and could end up with a significant financial gain if it holds those assets to maturity. Maybe. The mysterious knzn at least initially believed that this scenario wasn’t entirely unrealistic. The obvious solution to this concern is to give the banks a bit of the government’s upside: if the taxpayers make a profit, some of it could be “given back” to the banks.

On the other hand, the government might end up overpaying – perhaps significantly – on the banks’ assets. That helps the banks and hurts the government. The fairly obvious solution here is to give the taxpayers some of the banks upside.

Apparently one objection to an “equity” component of a recapitalization is “a gut Congressional reaction against the government taking equity stakes in a broad array of American corporations.

Alas, that cart has already left the barn.

The Fed effectively bought AIG last Wednesday – and the Treasury took over Fannie and Freddie the previous weekend.

And unless foreign governments’ do not count, governments (though not the government) already have an equity stake in a lot of US financial firms. The governments of Singapore, Abu Dhabi, China, Korea, Kuwait and Qatar (through Barclay’s investment in Lehman) all hold equity stakes in the US financial system.

Is it really better to reward the banks’ existing equity investors — remember, they own the financial institutions that made the bad bets that led the financial system to seize up – to avoid a US government equity stake?

* My accounting is as follows:

Morgan Stanley: $5.6b (CIC)
Citi: $17.4b ( $7.5b from ADIA, $6.88b from the GIC, $3 from the KIA)
Merill: $12.5b ($5.9b from Temasek and, per Craig Karmin and Carolyn Cui of the Wall Street Journal, $6.6b from KIA and the KIC)

Total: $35.5b

UBS: $9.54b from the GIC and $1.8 from an unnamed investor in the Gulf widely thought to be a member of one of the region’s royal families.
Barclays: around $9b from a rights issue with substantial participation from both the QIA and Sheik Hamad’s private “Challenger” fund (Sheik Hamad also runs the QIA)

Combined total: $55.84b

This leaves out some pre-crisis investments – like the CDB’s investment in Barclay’s. And I am not totally confident of the accounting for the increased stake various funds took in Merrill when the initial deal was reopened, or for the Barclay’s rights issue. It is an approximation.

Sovereign funds may have provided additional funds through private equity funds or participation in public rights/ convertible issues. I have no way of tracking those investments.

104 Comments

  • Posted by pseudorandom

    Twofish: The guarantees only worked because there was cash on the table. The government guarantee of money markets came out of a $50 billion fund. Freddie and Fannie bailouts came with a cash injection of $1 billion with more to come. AIG came with a $85 billion loan. The trouble with all of this is out of cash, and the FAN/FRE/AIG bailout is just a minor prelude to what is about to happen.

    I am not sure what you are getting at. Of course a government guarantee means putting cash on the table. When did I ever suggest otherwise? This discussion started when I suggested that government money could be provided to the FDIC to directly insure depositors instead of to the banks. You claimed that it won’t work because government guarantees were pointless.

    Twofish: Anyone the number for one billion for lawyers comes from the fact that JPMorgan set aside $2 billion for the purchase of Bear Stearns and $6 billion for settling lawsuits from the purchase.

    It is not a comparable situation. BSC was at that times being sued by investors in its hedge fund and by others and had potentially huge civil judgement liabilities. The Treasury has no such problems. Of course they will need lawyers and accountants to examine assets etc, but why would they be setting money aside for damages which is why JPM needed that $6B.

  • Posted by Twofish

    pseudo: This discussion started when I suggested that government money could be provided to the FDIC to directly insure depositors instead of to the banks. You claimed that it won’t work because government guarantees were pointless.

    I’m saying that government guarantees without cash are pointless. If you want a government guarantee with cash, it will cost you about ohhhh $700 billion, which brings us back to the current situation.

    The problem with with paying depositors directly through FDIC is that for FDIC to pay out, a bank has to fail. The minor problem is that if you have dozens of banks suddenly fail at once, you freeze the money markets, and this causes spillover affects. The major problem is that if you have a bank fail, then any credit default swaps on that bank will suddenly get triggered and you start having dominoes fall.

    Those CDS are really turning into explosive devices, and trying to figure out how to keep them from exploding is really tricky. If you pass legislation that invalidates CDS’s, then all of the people that are holding CDS’s have to mark to market and you might end up with major insurance companies going under.

    OK so you pay depositors before the banks fail. At this point, you basically have what Paulson is suggesting.

    pseudo: It is not a comparable situation. BSC was at that times being sued by investors in its hedge fund and by others and had potentially huge civil judgement liabilities.

    That’s not how securities lawsuits work. Every time there is a corporate restructuring, the lawyers show up and threaten to derail it. It doesn’t matter if they have a good lawsuit or not, throwing the deal into a courtroom will slow things down.

    So what will happen is that the lawyer comes in. You ask how much it will cost to drop the suit. They give you a number. If it isn’t too high, you write the check. No one cares what the final ruling of the judge is.

    pseudo: The Treasury has no such problems.

    Yes they will. Congress is likely to throw out Paulson’s original language and make Treasury’s actions reviewable under the APA standard of “arbitrary and capricious”. Under those standards, any competent administrative law firm can take any decision that Treasury makes, and then have the Court tie up that decision for months. So if the Secretary of Treasury wants to do something quickly, he now has to call up the law firm that is making the lawsuit, ask them how much they want, and if the price isn’t too high, he writes out a check to the law firm to drop the suit.

    pseudo: Of course they will need lawyers and accountants to examine assets etc, but why would they be setting money aside for damages which is why JPM needed that $6B.

    Because Congress has just changed the law so that law firms will be able to shake down Treasury for cash. That’s how the game is played, and the lawyers just made about a billion. I’ll be very curious to go through the final bill to see how ended up with the real payoffs.

  • Posted by Twofish

    You don’t think that the bill is going to have a real impact on CEO salaries do you? It’s not that the legislators are crooked, it’s that to have a watertight bill you need about six months to a year and we don’t have time. So what is likely to happen is that there is going to be very strong language in the bill against CEO salaries. This will give the senators and congressmen political cover to go home, and in three months when some clever accountant finds a loophole, people would have forgotten about all of this. This means that the accountants get about a billion.

    Part of the issues is that people really don’t want to save money or really care about how much it costs them. They want a human sacrifice and they will get one, not that I’m against it. For that matter most CEO’s aren’t against it since they know that the rules will have lots of holes in them. This isn’t because the congressman are crooked. It’s because to make something watertight you need to spent a year and maybe fifty pages of legislation.

    One consequence is that the CEO’s that were competent are the ones that are going to get hit hardest by restrictions on CEO pay. The incompetent one’s aren’t CEO’s anymore.

  • Posted by pseudorandom

    Twofish: So what is likely to happen is that there is going to be very strong language in the bill against CEO salaries. This will give the senators and congressmen political cover to go home, and in three months when some clever accountant finds a loophole, people would have forgotten about all of this. This means that the accountants get about a billion.

    We can sit here and make up assumptions to justify some pre-determined conclusion. Or we can start from objective facts and evidence, and allow them to lead us to a conclusion.

    You don’t know what is going to happen in the future. All your arguments are based on hypothetical scenarios based on highly questionable premises. If you want to just assume that some clever accountant will find a billion dollar loophole, if you just assume that some clever banker will figure out a $10B arbitrage, if you just assume that some clever lawyer will find a way to shake the Treasury down for $10B etc… then anything can be justified. What objective reason do we have to assume any of this?

    Twofish: The incompetent one’s aren’t CEO’s anymore.

    Once again sweeping assertions unsupported by fact. Last I heard the CEOs of WaMu, Morgan Stanley, Wachovia were all still around..

  • Posted by RetroactiveDownsideRiskRequired

    The Mortgage Forgiveness Debt Relief Act of 2007 removed the last incentive for borrowers to remain in “their” homes. This law must be rewritten and retitled the Patriotic Mortgage Repayment Act of 2008.

    The Patriotic Mortgage Repayment Act of 2008 – If a borrower defaults on a mortgage and the market value of the collateral is insufficient to repay the money borrowed, the Treasury will recover 105% of the residual borrowed but unpaid amount using IRS collection methods and interest schedules. Such a law would prevent the general population from bailing out the speculators that purchased more house than they could reasonably afford. These wannabee flippers took grandma’s life savings out of the bank, now the bank has collapsed and the FDIC is having to pay off grandmas. The least these deadbeats should do is repay 100% of grandmas’ money to the treasury plus 5% as a handling fee.

    It should be trivial for the borrower to meet his obligation. After the foreclosure sale recovers 60% of the original loan, the payments on the remaining 40% loss should be well within the budget of even the biggest speculative wannabe flipper real estate genius that bought at the top of the market using grandma’s money.