Fundmastery Blog

Kurt Brouwer January 12th, 2009

I have been saying for some time that the way to bail out the banks was not to have the U.S. Treasury invest directly. Instead, a better plan would have been for the Treasury to create a structured investment with Warren Buffett or Bill Gross or both in charge of structuring the deal.

In this approach, the government would give private investors a significant tax break on any capital invested in approved banks. Then, the government would step aside and let private investors put in capital as they see fit. In this scenario, investors would have gotten a good deal, banks would have gotten the capital they need and the U.S. Treasury would not have been on the hook for anything.

To see why this would have been better, here, is a comparison of how Buffett’s Goldman Sachs deal compares to the Treasury’s Goldman Sachs deal. This chart from Barry Ritholtz’s excellent blog illustrates the points made in a fascinating Bloomberg piece (see below):

Source: Barry Ritholtz

This piece from Bloomberg gives the details on how poorly the U.S. Treasury fared in its bank investments versus Warren Buffett’s investment in Goldman Sachs [emphasis added]:

Paulson Bank Bailout in ‘Great Stress’ Misses Terms Buffett Won (Bloomberg, January 10, 2009, Mark Pittman)

Henry Paulson’s bank bailouts, done under “great stress” during the worst financial crisis since the Great Depression, failed to win for U.S. taxpayers what Warren Buffett received for his shareholders by investing in Goldman Sachs Group Inc.

The Treasury secretary made 174 purchases of banks’ preferred shares that include warrants to buy stock at a later date. While he invested $10 billion in Goldman Sachs in October, twice as much as Buffett did the month before, Paulson gained certificates worth one-fourth as much as the billionaire, according to data compiled by Bloomberg. The Goldman Sachs terms were repeated in most of the other bank bailouts.

Paulson’s decisions to prop up the financial system included purchasing shares in institutions from Goldman Sachs, the most profitable Wall Street firm last year, to Saigon National Bank, a Westminster, California, lender whose market value is $3.8 million.

…Paulson’s warrant deals may give taxpayers less profit from any recovery in financial stocks than shareholders such as Goldman Sachs Chief Executive Officer Lloyd Blankfein and Saudi Arabian Prince Alwaleed bin Talal, owner of 4 percent of Citigroup Inc., said Simon Johnson, former chief economist for the International Monetary Fund.

The transactions are “just egregious,” said Johnson, a fellow at the Peterson Institute for International Economics in Washington. “You want to do it the way Warren does it.”

…The Treasury would have held warrants for 116 million shares of Goldman Sachs under Buffett’s terms, which would be equivalent to a 21 percent stake when added to those currently outstanding. Instead, the dilution is 2.7 percent under the Treasury plan. Blankfein is the company’s biggest individual investor, with 2.08 million shares worth about $178 million today, according to Bloomberg data. His 0.47 percent interest would have declined to 0.36 percent under Buffett’s terms and would be 0.44 percent if the Treasury’s warrants were exercised.

…In advancing the $5 billion, Paulson accepted warrants that reward taxpayers with an additional $250 million, or 5 percent of the stake. That compares with 15 percent on the 174 completed bank rescues as well as the 100 percent Berkshire Hathaway Inc. Chairman Buffett obtained on an investment in Goldman Sachs in September, Bloomberg data show. A warrant is a company-issued certificate that represents an option to buy a certain number of shares at a specific price by a predetermined date.

…”You’d certainly hope that the trend would be in the other direction, for stronger terms,” said Rep. Scott Garrett, a New Jersey Republican on the House Financial Services panel, in a telephone interview Dec. 26. “I don’t buy the methodology that they have to be circumspect to protect the parties involved. Ultimately their position has to be to protect the American taxpayer.”

While the government has pledged to recover its investments, Congress provided little guidance on how to accomplish that. Legislation mandated that the Treasury receive warrants to acquire shares in companies tapping the program to potentially reward taxpayers. The law didn’t specify how many warrants or how they should be priced, factors that will determine how much money, if any, taxpayers get in exchange for their risk.

…The government has received warrants valued at $13.8 billion in the 25 biggest capital injections from TARP, according to Bloomberg data. Under the terms Buffett negotiated for his $5 billion stake in Goldman Sachs, the TARP certificates would have been worth $130.8 billion.

Buffett received 43.5 million Goldman Sachs warrants valued at $82.18 apiece on the date of the transaction, or $3.6 billion, Bloomberg analytics show. Paulson, who served as the New York- based bank’s chief executive officer until 2006, injected twice as much taxpayer money into Goldman Sachs a month later and got 12.2 million warrants worth $72.33 each, or $882 million.

If the Treasury had received the same terms as Buffett, taxpayers would have become the biggest investors in most of the bailed-out banks and existing stakes would have been diluted, Bloomberg data show…

Based on this information, I think it is fair to say that the government is investing huge dollars and getting a much worse deal than private investors obtained. That makes no sense to me at all.

As I pointed out above, I think we would have been better off just giving investors a tax break for investing in banks. Let Warren Buffett or Bill Gross negotiate a deal and then have the banks offer it to all comers, plus a nice tax break from the Feds. If we had done so, I believe the capital would have poured in and, the Treasury would have had none of our taxpayer money at risk.

See also What Are Bill Gross and Pimco Buying?

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