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TARP (Troubled Asset Relief Program) = Giveaway

Bloomberg recently analyzed and compared a deal that Warren Buffett negotiated for the purchase of portion Goldman Sachs to the deal that Treasury Secretary Paulson gave to financial institutions who received TARP money.  The analysis concluded that Buffet’s deal was way better.  Economists quoted in the story used the word “giveaway” more than once.  It is not surprising that President-elect Obama and Congress (second chance to get it right) want change how the second $350 billion installment is used.

What are we receiving in return for giving (investing) $350 billion and possible more to (in) a select group of financial institutions?  The source for this post comes from the U.S. Treasury Department’s public document entitled “TARP Capital Purchase Program: Summary of Senior Preferred Terms.”  We were at the mercy of U.S. Treasury Department and Treasury Secretary Paulson in terms of what we got in return for our money thanks to the overwhelming level of control giving to them by congress.

TARP Bailout Money was a great deal for financial institutions.  They get cheap capital/cash to do whatever they want with it and with no strings attached.

Preferred Stock

The mainstay of this TARP Capital Purchase Program was Treasury Department’s purchase of senior preferred stock of the TARP recipients.  Preferred stock generally pays dividends at a specified rate.  Preferred stock ranks higher than common stock in terms of receiving dividends and liquidation of assets in the event of bankruptcy.  Preferred stock usually does not have any voting rights and in our case that characteristic holds.

In the case of TARP Capital Purchase Program, the preferred stock purchased by Treasury, on our behalf, pays a preferred stock dividend in the amount of 5% per annum which increases to 9% in five years and is paid quarterly.  Think of the preferred stock dividend as interest on a loan – the dividend is fixed at 5% per year.  Preferred stock dividend is paid before any common stock dividend is paid meaning we will get our dividends before a common stockholder.

Warrants

Most of the TARP transactions/giveaways included warrants.  Warrants are a contractual right, often represented by a certificate, to purchase a certain amount of common stock at a specified price by certain date.  As an investor you want the specified price, known as the strike price, to be set as lower than higher because that will increase the difference between strike price and current market price.  For instance, assuming we have a warrant to buy Acme Bank at $10/share, the current market price is $25/share, which means that the warrant is “in the money” (finance lingo) by $15/share (25 minus 10).  An investor in this case can exercise her warrant and purchase Acme Bank shares for $10/share but the current market value for the shares is $25/share so there is a gain by exercising the warrants which can be turned into a real profit/gain if she chooses to sell the Acme Bank stock in the stock market.

Bloomberg’s analysis showed that Warren Buffett negotiated a much better deal than what Paulson structured on our behalf.  Paulson did not maximize taxpayers’ investment opportunity.

Paulson left money on the table in three ways, according to economist [Simon] 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.

But Paulson argues that he had to structure the TARP deals in a way that was attractive to the financial institutions.  Paulson said:

The market was under great stress and the private sector was extracting very, very severe terms. What we were attempting to do, which I think we did successfully, was design a program that would be accepted by a large group of healthy banks with terms that would replicate what you would get in normal market conditions.

Who is determining “normal market conditions”?  If you peruse Bank of America’s recent Annual Statements you would be hard pressed to find preferred stock issued at a divided lower than 6.25%.  So, the 5% Paulson was offering may have been well below “normal market conditions.”

Joseph Stiglitz, a noble prize winning economist said:

Paulson said “he had to make it attractive to banks, which is code for ‘I’m going to give money away,’”

A $279 billion giveaway with no strings attached.  Thank you Mr. Paulson.

President-elect Obama recognized the problems with the Paulson giveaway.  Today, he promised to change the use of the bailout money.  President-elect Obama said:

“I think many of us have been disappointed with the absence of clarity, the lack of transparency.” He said some of the money should have been spent on helping people avoid foreclosure.

Let’s hope we can get this bailout right with second $350 billion.