On September 26th, I made appearance on Mike Galano’s CNN television program to discuss the public’s fury over the “bailout” of our banking and financial services industry. My point of contention, or warning in regards to the $700 billion plan was not the dollar amount, or any of the other conventional objections being offered, but rather a the point that this “bailout” was nothing but a large asset buy by Uncle Sam, with my biggest worry being that it was going to work too well and the moral hazard that goes in lockstep could be disastrous.
You might be asking yourself, “Why is it a bad thing for the government to make money or succeed on this deal?” Allow me to explain…
Moral Hazard #1
First, I am a firm believer that words have meaning and that language and its usage is important in order to debate issues in a Socratic manner. Webster’s defines the word “bail” as to extricate from a difficult situation. The word extricate is defined as “to free from.” The government has most certainly aided many financial institutions from their precarious situation, but it is most certainly was not free.
Over the past several months there have been frequent instances where sovereign wealth funds, private equity groups, high-quality cash rich hedge funds and other entities such as Berkshire Hathaway have stepped in and made major investments in various companies. Many of these investments involve a cash infusion bearing a high coupon (interest rate) with an equity stake attached that helps to insure the investment. This is what hedge funds, for all intents and purposes, if they were to abide by the definition of their moniker are supposed to do, hedge their investments. It is exactly, what Uncle Sam is doing with the $700 billion TARP (Troubled Asset Recovery Plan) funds. Henry Paulson the head of Hedge Fund USA completely backed away from the original intent of the TARP which was to buy troubled mortgage assets with direct investments in the financial institutions. Two examples…
Citigroup and Hedge Fund USA have identified a pool of about $306 billion in troubled assets. Citigroup will absorb the first $29 billion in losses in that portfolio. After that, Hedge Fund USA through its subsidiaries, the Treasury Department, Federal Reserve and Federal Deposit Insurance Corporation will assume any additional losses. Hedge Fund USA will be insuring a portion of Citigroups’s balance sheet. So Hedge Fund USA will be on the proverbial hook if their massive portfolios of mortgage, credit cards and commercial real-estate and large corporate loans continue to deteriorate. In exchange for that guarantee, Hedge Fund USA will receive warrants to buy shares in the company. In addition Hedge Fund USA injected a fresh $20 billion in capital that bears an 8% coupon rate. This deal is very similar to the investments that Warren Buffet made in both General Electric and Goldman Sachs this past year.
The original plan that the Hedge Fund USA made with AIG back in September was so one sided to the detriment of AIG that they had to rework the deal. The deal was so bad that it was suggested in many circles it would have been much better for AIG to have entered bankruptcy. For example, the original plan offered a credit line of $80 billion to AIG with a coupon of 12%, AIG had to pay on the credit line whether they were using it or not. Imagine having to pay on a home equity line with a zero balance…ouch. The new deal consists of a $60 billion loan, a $40 billion preferred-stock investment and $50 billion in capital to purchase distressed assets which are to be placed into separate entities.
In my opinion, over the past 10 years Wall Street has failed on all fronts. They have become institutions that have failed their clients, shareholders and the public. They became entities that served one master, that master being executive compensation and the bonus pool. In order to serve that master the investment banks created yield-enhanced, subprime mortgage loans securities that they leveraged in some cases at multiples as high as 40 to 1. In order to keep the gravy train moving, the creators of these toxic securities put them on their own balance sheets. The masters of the universe in order to keep their conscience clear, tried to insure themselves from inevitable disaster by purchasing a credit derivative known as credit default swaps from insurance giants like AIG.
When market forces eventually worked and people realized that homes could not go up forever and in fact reverse to the mean, mortgage securities and the derivatives surrounding them were worth a hell of a lot less. Whoops!
The media is focusing on the dollar amount that Hedge Fund USA is using. Numbers in the trillions are being thrown around, with frightful calls of too much debt. Debt has become a dirty word, something to be shunned at all costs. The reality is that in some cases that couldn’t be farther from the truth. The costs of debt, along with the use of the funds, are the underlying variables in determining whether debt is good or bad. Credit card debt ranging sometimes from 18% to 30% used more often than not to purchase consumer goods bad. Caterpillar Corporation issuing commercial paper at 4% to fund a major project that will yield a much higher return than the cost of the money, good.
When was the last time you invested in something that you knew wouldn’t make money? In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager on Tuesday to park money in the world’s safest investment, United States government debt, that they agreed to accept a zero percent rate of return. The Wall Street Journal December 10, 2008
The Federal government is borrowing money for 90 day periods at 0%. It is paying less than 3% on funds borrowed for 10 years. How much money would you borrow if you could get the rates the Uncle Sam Hedge Fund is getting? Talk about a no brainer, the government is borrowing money at 2.7% and lending it out to Citibank at 8%. Talk about a great business model. Arbitrage alive and well at Hedge Fund USA.
Andy Kessler, a former hedge fund manager described in a Wall Street Journal op-ed piece reiterates what we have been preaching over the past several months, “The piling on started. Hedge funds could short financial stocks and then bid down the prices of CDO’s stuck on Wall Street’s balance sheets. This was pretty easy to do in an illiquid market. Because of the Federal Accounting Standards Board’s mark-to-market 157 rule, Wall Street had to write off the lower value of these securities and raise more capital, diluting shareholders. So the stock prices would drop, which is what the shorts wanted in the first place.”
There is an old saying on Wall Street that goes; the market can stay irrational longer than you can stay solvent. Hedge Fund USA is doing what all intelligent investors do when they see opportunity in irrational behavior, they are taking advantage. Henry Paulson is stepping into financial institutions and getting once in a lifetime deals. Fortunately for Hedge Fund USA, and unfortunately for the free market (the rest of us) they also get to cheat.
Uncle Sam writes the tax laws, securities laws, Uncle Sam can print money, and they can do under difficult and current circumstances whatever they want. This scares the hell out of me. I could care less about the price tag, mark my words Hedge Fund USA is going to make some serious coin on this misnomer everyone is calling a bailout, I will discuss those scary implications in a bit. For all intents and purposes; I am now competing against Uncle Sam. Uncle Sam is a major shareholder in Smith Barney, Goldman Sachs, and Merrill Lynch/Bank of America etc. Talk about an unfair competitive advantage.
Fortunately there are some bigger names than myself that are beginning to see the enormous moral hazard coming down the turnpike. FDIC chairwoman Sheila Bair has stated her desire for a pre-determined exit strategy for Uncle Sam. She stated, “I’m a capitalist. I believe in markets.” Securities and Exchange chairman Christopher Cox stated very eloquently, “The U.S. government is now a major shareholder in banking and financial institutions and other private firms across the United States. Recipients of federal funding and guarantees are naturally coming under scrutiny by Congress, which rightfully believes it should control the purse strings in our government. As a result, there will be demands for compliance with congressional investment preferences and corporate governance policies, which will grow in direct proportion to the length of time that the federal investments and guarantees remain outstanding.
For all these reasons, it is incumbent upon federal policy makers to ensure that the extraordinary actions of the past months are understood to be temporary, and constructed so that they are self-liquidating. Since government programs do not on their own go away, there has to be a deliberate design to eliminate them, and a relentless adherence to execution of that plan. Anything short of this will almost certainly guarantee eternal life for these vast new federal roles. Focusing on exit strategies now is of vital importance to ensure that we do not stumble along a dangerous path of confusion that may end in far greater financial exposure for the American people.”
Moral Hazard #2
Hedge Fund USA is now the largest fund in the world, and will be one of the most successful. The trillion dollar question that I have been asking is “What will happen with all that money that Hedge Fund USA will end up making?” According to the TARP rules half of the profits are destined to pay down national debt, the other half…well, let’s just say that it’s unspecified. Neel Kashkari, the director of the Treasury’s office of financial stability has made it clear that the taxpayers will make money from the TARP program.
Raise your hand if you think you will be getting a dividend check in the mail.
When it comes time for Hedge Fund USA to cash in, whatever party is in power is going to have a hefty slush fund that could buy many votes and entrench power for a long time. Not to mention the fact that once government programs start, they never end. The last thing government ever does is save money for a rainy day. There was a great Simpson’s episode where the town of Springfield came upon a windfall and fell victim to charlatan who convinced them to build a monorail.
Trust me when I tell you we will have, monorails, amphibious garbage trucks, and Al Gore approved cow-fart collection systems in place if Nancy and Harry get their hands on trillion dollar slush fund.
The American people need to be focused on Hedge Fund USA and the repercussions and hazards ahead of us. If I end up in Guantanamo for hammering Smith Barney, Bank of America/Merrill
Lynch or any of the usual suspects, you will know why.