A Better Bailout Plan

[A DC lawyer of my acquaintance sends the best analysis of the bailout I’ve seen, and a counter-proposal.]

Taxpayers receive preferred stock and collateral from a bank borrowing from the Taxpayers, both in the full amount of the loan sought by the bank.  In other words, stock plus collateral in double the amount of the loan. Taxpayers profit from a bailout before anyone else does.

Thanks to Warren Buffett and Goldman Sachs for the heads-up by disclosing the terms of their deal, which should be the low water mark for any Taxpayer bailout.  A higher water mark would be the terms suggested above, which are not uncommon in private equity deals and chapter 11 bailouts.

Paulson’s plan calls for him to buy assets of an unknown but admittedly low value, at an inflated book value, for cash, from the member institutions of his own industry, with other folks’ money (ours).  He sees his industry and its member institutions as too important to fail.  With all due respect, Paulson cannot claim to be objective or disinterested.

Paulson’s plan pays in cash the price on the bank’s books for the subprime mortgage-based assets.  The book value is probably a high percentage of the total balances owed on the underlying mortgages.

Paulson’s price for the subprime mortgage-based assets is favorable to the banks. If Paulson’s price for the subprime mortgage-based assets was not favorable to the banks, the banks would not sell.

Neither Paulson nor the banks have presented any rationale, much less a convincing argument, for the proposition that the US is on the brink of financial chaos.  They have declared it to be so.  If you believe them, the banks are on the brink of failure without a bailout. If you believe them. One of the benefits of the better plan is to put that proposition to the test.  To accept the terms of the better plan, the banks will have to be on the brink of failure.  Otherwise they will not seek a loan, and a new equity participant, under the terms of the better plan that will enable them to survive.

Does the banks’ condition put the US on the brink?  What, because the banks won’t lend without a bailout?  I don’t believe so.  The banks remind me of the Sheriff in Blazing Saddles who takes himself hostage.  The banks commit suicide by not lending.  The banks won’t lend without a bailout? Fine. Don’t lend, banks. Don’t lend starting now.  You already have?  Huh.  Most banks in the DC area are advertising that they are not holding subprime mortgage-based assets and open for business to make loans.

If the banks won’t lend and there is money to be made lending, someone else will lend, like the banks that are advertising.  That’s the free market, and the creative destruction should start now. If things are so bad that banks won’t lend, the Taxpayers would be stupid to do so without the substantial potential for profit that the better plan provides.  Paulson’s plan provides only certainty, the certainty of losses.  Why would anyone buy high for the certainty of selling low?

Hidden in the courts is another problem.  The banks own securities. The value of the securities is based on subprime mortgages.  The banks do not hold the subprime mortgages, or the notes secured by the subprime mortgages; they hold securities.  A trustee for the issuer or the underwriter holds the notes and the equitable interest in the mortgages.  Independent trustees hold the legal interest in the mortgages and the power to foreclose. The mortgages for any particular issue of securities were assembled — without much forethought — from all over the country.  How many mortgages were bundled to offer one issue of the securities?  Lots.  Securitizing a whole bunch of mortgages at once reduced the relative amount of the soft costs necessary to pay the lawyers, underwriters, accountants and auditors necessary for the issue of the securities. There are many different issues of subprime mortgaged-based securities.

So for each issue of subprime mortgage-based securities, here’s the cast of characters and their problems:  the banks (from all over the country) holding a particular issue of securities, the issuer and the underwriter in say, NY, the issuer’s or underwriter’s trustee in say, DE, and the numerous trustees on the individual mortgages (from all around the country where the individual mortgaged properties are located) are difficult to assemble anywhere, and if assembled might fill the Yale Bowl, especially if the meeting is open to the homeowners.  Many of the trustees for the issuers and underwriters did not receive the original notes at closing, and many of the original notes can’t be found.  Banks have attempted to foreclose on the mortgages and sue homeowners for deficiencies after foreclosure, only to be turned away by the courts for lack of standing because they don’t hold the mortgages and cannot produce the original mortgage notes in court.  The trustees won’t act for lack of clear authority from anyone to tell them what to do.  Courts, banks, issuers, underwriters, holders, trustees, homeowner-mortgagors and mortgagees, oh my.

Paulson’s plan, with Taxpayers’ money, makes a fool’s bet, “Heads you win tales I lose,” with no upside for the foolish Taxpayers.  No one is guaranteeing that any recovery can be made on the subprime mortgage-based assets (in excess of the cost of collection), no one is guaranteeing that the banks will lend after a bailout, and nobody is even suggesting that this bailout, the one currently proposed, is the only one that will be necessary.  The precedent for others will be set by this one.  What about the securitized commercial mortgages of say, shopping centers in neighborhoods decimated by foreclosures?  What about the securitized asset-based lending of say, department stores’ inventories that can’t be sold because consumers are paying their variable rate mortgages instead of buying new washing machines?  What about the securitized credit cards that consumers are not paying to pay their mortgages instead, after maxing out their credit cards to pay the mortgage? Tune into call-in shows on radio or TV and hear the financial experts tell consumers to not pay credit cards and mortgages in order to feed their families.  I have.  The owners of securitized variable rate secured debt in any form (guess who?) are all out there, awaiting the denouement of the current drama and preparing their own play for the same treatment.  The banks will be back again for more bailouts after this one.  By definition, Paulson’s plan creates a moral hazard, and the speculative trading of the subprime mortgage-based assets and securitized variable rate secured debt has already begun.

The better plan calls for the Taxpayers to receive a first priority lien on fairly appraised collateral, along with an equity kicker.  After the Taxpayers receive the preferred stock interest valued at their investment, the subprime mortgage-based assets could be the collateral at their appraised value for the loan.   The value of the subprime mortgage-based assets as collateral is their appraised value, which may be ten or twenty times the total balances remaining on the underlying mortgages and is not likely to be the value of the assets carried on the bank’s books.   Understand that the loan and the investment are the same money in the better plan, and if the bank is able to repay the loan, the Taxpayers could double their money because they will still own the equity kicker. If the bank can’t repay the loan, Taxpayers recover on their collateral and share, as the most favored shareholder, in the liquidating dividend.  BTW, where are the government’s bank examiners requiring the write-down of the value of the banks’ books of the subprime mortgage-based assets? I think they work for Paulson.  Seriously, I do.

No more private profit at Taxpayers’ risk.  Under Paulson’s plan, we are about to nationalize the almost certain losses incurred in running the banks badly, and at the same time we leave the banks, without their losses, with more money, in the hands of the folks who ran them badly.  The only thing we have socialized in this country, after the bailout, will be the (mostly) unrecoverable losses of banks, acquired for cash at book value.  Somebody else already got the profit and the fees from making the subprime mortgage loans and from issuing the securities.  After the bailout, the banks will have shed their private losses, and received a premium of public cash for doing so. Private profit, public losses, all around.

A bank seeking the Taxpayers’ loan is not an admitting bankruptcy; the terms are merely a recognition of the risk in the loan that requires a private equity kicker to attract the lender (us).  Private equity is not bankruptcy.  The terms would be appropriate, for example, if I approached you to purchase an apartment building, me being broke.  You would put up the money for a first trust and a preferred ownership position for receipt of income, get paid in full first with interest, and end up with 50% of the apartment building and its appreciation, all your money paid back with interest, and half the income stream.  I would have 50% of the apartment building and its appreciation and share in the income stream once you are paid off in full with interest.  I have represented clients in similar leveraged deals where the financier (you, in my example) gets first payout on cash loaned (not contributed) and 50% of the equity in the deal.

For example, the financier in one deal (which involved a third party 80% first mortgage for the purchase of a real estate portfolio appraised at $70M) put up $14M, was paid back in full with interest in five (5) years, and retained a 50% interest in a real estate portfolio and its appreciation and income stream.  14M up, 14M with interest back plus 35M with appreciation and half the income stream off 70M.  At ten percent interest on the loan and a market appreciation of 1% on the portfolio, my client’s deal paid the financier, on a $14M loan (in simplistic terms), $1.4M per year in interest, $350K per year in appreciation, and $14M on the fifth anniversary, a total payout of $22,750,000 in five years, with an equity kicker of a $35M interest in a real estate portfolio, the income stream it creates and its appreciation.    The bank does not have to borrow from the Taxpayers if they don’t like our terms.

Buffett is not paying book value in cash for subprime mortgage-based assets, with no equity kicker or even a loan structure.  Buffett is buying into value.  Goldman Sachs has an international name with the best talent to run a highly leveraged portfolio and assets to match his buy-in twelve times over.  GS is poised to convert to a money center bank, among other options open to it, and would likely survive were there no bailout and no Buffett.  Buffett is not buying subprime mortgage-based assets, or even lending money. He is buying a preferred class of stock issued for him, which has first priority above all other owners.  In other words, Buffett is secured by all of GS assets, including the money he is paying in, if anything goes wrong, before any other owner gets paid.  If things go right, he receives a 10% annual dividend before anyone else on the equity side gets paid plus the value of his preferred stock. If the Taxpayers have a chance to take Buffett’s deal with Goldman Sachs they should take it.  Investing in Goldman Sachs preferred stock is not the same as investing in or lending to a bank with subprime mortgage based assets, much less buying the subprime mortgage-based assets at book value without an interest in the bank or a note from the bank to pay the money back.


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“Either you repeat the same conventional doctrines everybody is saying, or else you say something true, and it will sound like it’s from Neptune.” –Noam Chomsky