Friday, January 9, 2009

Motley Fops Part 1

Jan. 9 (Bloomberg)
By Mark Pittman
Last Updated: January 9, 2009 00:01 EST

Henry Paulson may be the most powerful manager of money in the world and he still couldn’t do for taxpayers with the $700 billion bailout of American banks what Warren Buffett did for his shareholders in investing in Goldman Sachs Group Inc.

The Treasury secretary has made 174 purchases of banks’ preferred shares that include certificates to buy stock at a later date. He invested $10 billion in Goldman Sachs in October, twice as much as Buffett did the month before, yet gained warrants 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 warrant deals may give U.S. taxpayers, who are funding the bailouts, 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.”

Paulson’s decisions mark the first time in the nation’s 236- year history that the U.S. government has had to prop up the financial system by purchasing shares in institutions from Goldman Sachs, the most profitable Wall Street firm last year, to Saigon National Bank, a Westminster, California, lender with a market value of $3.8 million.

“Paulson said he had to make it attractive to banks, which is code for ‘I’m going to give money away,’”
said Joseph Stiglitz, who won a Nobel Prize in 2001 for his work on the economic value of information.

“The worst aspect of this is that they were designed not to do what they were supposed to do,” he said in a telephone interview from Paris Jan. 7. “In many ways, it’s not only a giveaway, but a giveaway that was designed not to work.”

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.

Treasury spokeswoman Brookly McLaughlin wouldn’t say how the bailout conditions were set.

“Obviously, the government is going to have different objectives than a private investor,” McLaughlin said in an e- mail.

“We believe the public has a right to know the value of the investments being made with the TARP funds and whether the terms Treasury receives for investing taxpayer dollars are as good as those that private individuals like Warren Buffett receive for similar investments,” said Elizabeth Warren, chairwoman of the TARP Congressional Oversight Panel, in an e-mail. “This is a question we will continue to ask until we get a complete answer.”

Stiglitz said finance professionals at Treasury possessed expertise on warrant pricing that members of Congress didn’t. As a result, Paulson gave lip service to the lawmakers’ intent on TARP without gaining much value for taxpayers, said Stiglitz, a Columbia University professor who described the pricing mechanism as “a gimmick to make sure that they were giving away something worth nothing.”

“If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired,” he said.

Paulson declined to comment, McLaughlin said.

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.

“I halfway believed that the taxpayers would make money in September, but I really don’t believe it now,” Rep. Brad Miller, a North Carolina Democrat on the House Financial Services committee, said in a telephone interview last month.

“We have to have confidence in Treasury to run the program in a way that protects taxpayers, and there’s very little in the way they’ve run it that inspires confidence,” he said.

Congress left it to Paulson and his staff to decide how warrants would be priced and how many the U.S. would receive under the TARP, according to Caleb Weaver, a spokesman for the program’s oversight board. Treasury imposed identical terms for 140 capital injections. Thirty-four closely held lenders issued certificates to the government for preferred stock instead of common shares and one community development institution wasn’t required to issue warrants, according to the Jan. 6 Treasury report on TARP.

Paulson left money on the table in three ways, according to economist Johnson: accepting fewer warrants than Buffett did; setting the certificates’ price trigger, or strike, above market values; and receiving an annual yield on the preferred shares that is half of what Buffett will get for the first five years.

The government will forgo almost $48 billion over the next five years in preferred stock dividend payments from the 25 biggest TARP infusions, as compared with Buffett, according to the terms of the deals.

Buffett’s five-year warrants for 43.5 million shares of Goldman Sachs were valued at $82.18 each using the Black-Scholes option pricing model developed by Fischer Black and Myron Scholes to estimate the fair market value of such contracts. The model uses, among other data, the implied price volatility of the underlying security. The Treasury received 10-year warrants for 12.2 million Goldman shares priced at $72.33 on Oct. 28 using the same method.

The taxpayers’ certificates were set at the 20-day trailing average of the share price, which for Goldman Sachs was $122.90 on Oct. 28, when the company closed almost $30 cheaper at $93.57. The trailing average ensured a higher strike price, and lower value for the warrants, because bank stocks were plummeting.

By contrast, Buffett received an 8 percent discount to the market price at $115 a share on Sept. 23, when the stock closed at $125.05.

Taxpayers also acquired preferred shares as part of the bailout. These securities, which can’t vote unless the issue at hand is the creation of a more senior preferred stake, carry an interest payment of 5 percent that increases to 9 percent in five years. Buffett’s preferred shares in Goldman Sachs pay a 10 percent yield.

If Goldman Sachs rises to its five-year average price of $147, Buffett will be able to profit by $1.4 billion from exercising his warrants. The government warrants will be in the money for $294 million, or about a fifth as much for twice the investment.

Under Buffett’s terms, the Treasury’s investment in Citigroup would also have brought greater potential for profit to taxpayers. The two cash infusions totaling $45 billion would have resulted in warrants for about 5.6 billion shares, which would more than double the 5.4 billion of existing shares. The Treasury’s warrants call for 464 million shares, or 8 percent of the number under Buffett’s terms.

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