Show Us the Money
Taxpayers should wake up the politicians and ask them to tell Wall Street: "We want the same deal Warren Buffett got." The Omaha billionaire announced he is playing White Knight to Goldman Sachs by investing $5 billion in the endangered investment house. What a big-hearted guy. Buffett is an old-fashioned capitalist who invests in companies for the long term and I am a big admirer. But Warren Buffett did not get to be a billionaire by committing public-spirited acts of charity. He plays to win.
So his deal with Goldman Sachs is carefully wired to produce gorgeous returns for Buffett's Berkshire Hathaway. Upfront, he gets a 10 percent ownership stake in preferential shares that will pay a 10 percent dividend--even if Goldman's stock price keeps falling. But Buffett also gets the right to buy $5 billion in common shares at below the market price. So if Goldman flourishes in these hard times, Buffett will win big as its stock price soars.
To sweeten his chances, the Omaha sage quickly announced that he endorses the $700 billion bailout plan proposed by Treasury Secretary Paulson. Let's follow the bouncing ball. Buffett puts some of his capital at risk on terms that are smartly protected from loss. Then Buffett urges the taxpayers to put their money on the line too. Only the taxpayers don't have any deal. They are the naked investors in this drama, asked to put up many billions to rescue Wall Street firms with nothing more than a vague promise it will save the Republic. I am reminded of the oldest rule in the financial business: "Get it in writing."
Warren Buffett's intervention provides a clarifying moment because it demonstrates what's wrong with the bipartisan bailout Congress is preparing to authorize. There's nothing illegitimate in what Buffett accomplished. The overlapping terms and contingencies he secured for his capital are standard practice in Wall Street deal-making. Investment bankers work out the fine print and put it in enforceable contracts or the deal doesn't happen.
Hank Paulson was a star in that world. When he left as chief executive to become Treasury Secretary in 2006, Goldman awarded him $110 million in cash to cover remaining stock options and restricted stock, in addition to $51 million to repurchase family shares. These payments were on top of the approximately $500 million in Goldman shares Paulson sold when he joined the government.
Doing hard-nosed deals in the Buffett style is essentially what the federal government should be doing now--bank by bank--as it intervenes to rescue the financial system from ruin. In our situation, the public treasury is the White Knight because private capital is afraid to play. The federal government has all the leverage it needs to demand very stern terms. That includes demanding an equivalent equity stake in banks or brokerages it assists, but also the power to impose explicit commandments and prohibitions on how these rescued firms must behave. The threat that banks will refuse to play is a meaningless whine from the banking industry. If bankers find a better deal from private lenders, they should take it. Otherwise, they are down the tubes.
The underlying power relationship in this crisis has been artfully obscured by the bailout sponsors because they decline to explain clearly what the bailout really is intended to accomplish. First, they said it was to restore calm in markets. Then they said it was the rotten assets centered in mortgage securities. But the problem is more accurately described as the great deflation of Wall Street's illusions--inflated prices, profits, deals, commissions and bonuses. You name it, they ran it up to stratospheric levels. Now the dream is dying and values are falling, but have not yet hit bottom.
To put it more concretely, the banks and investment houses have lost massive amounts of capital--a hole that is real, not psychological. Maybe $1 trillion, possibly twice that. We can't say exactly, because the banks have still not come clean and because assets in bank portfolios continue to lose value as housing prices continue to deflate.
The great capital losses mean Wall Street is sure to get smaller--a lot smaller--with fewer firms, less leveraged deals based on inadequate capital and a general retreat from its domineering role in economic life. Personally, I believe a smaller Wall Street will be good for the country, part of restoring balance to the damaged economy.
In any case, it is folly for Washington to imagine that it can--or should--simply replenish Wall Street's great loss. That essentially is what Paulson's blanket bailout attempts to do--restore conditions to "normal" by buying up the bad assets from banks at inflated prices. In other words, supply the missing capital that private lenders won't provide. Good luck with that.
"Normal" is not in the cards. Trying to accomplish this, given present realities is not in the country's interest. It also resembles King Canute trying to command the tides.
The real goal for government intervention should be to manage Wall Street's inescapble downward adjustments in ways as peaceable as possible. Stabilize the shrinking financial system so it will keep the the real economy going, that is, insure that credit and capital flows continue, while Wall Street is gradually cut down to normal size. There is real pain in that for everyone, but the objective is concrete and manageable.
Washington would exercise an activist supervisory role and offer deals in exchange for cooperative, compliant behavior. Bank regulatory agencies, including the Federal Reserve, already do this with troubled banks; now they have to step up with a more forceful hand. Banking watchdogs estimate at least 100 (maybe 200) banks are already doomed to fail. But another 1,000 banks are still solvent but on the edge. These can be managed to safe ground with tougher regulatory controls and some aid. Subsidiary financial markets need similar treatment and liquidity injections if they seize up.
At center stage are the big, bad players--the mega-banks and some others--who took the extreme risks and are now conveniently described as"too big to fail." If that's so, then one goal of government should be to make them get smaller, either through market forces or by lawful edict. The public likewise needs a new federal agency to manage the deal-making--something like the Reconstruction Finance Corporation during the New Deal--and determine which major banks can be cleaned up and stabilized, which ones cannot. The objective is not to save everyone--that is not what the nation needs--but to wind up with a broadly balanced financial system, chastened by new rules and ready to serve the rest of us, rather than eat us alive.
Only the federal government can do this. But I am suggesting government should mimic the hard-headed assumptions and practices that are commonplace in Wall Street. Don't take wishful promises in exchange for your money. Insist on hedges to protect the broad public interest. And get it in writing.
Maybe Warren Buffett and some other trustworthy capitalists would come to Washington during this emergency and show government officials how to make real deals. These are savvy people. Many are genuinely interested in helping the country get out of this mess. We could offer them a dollar a year.
After I filed the above, the New York Times reported that Bill Gross, managing partner of Pimco, the giant bond investment house, is offering to serve as expert advisor to help Treasury sort through the rotten bank assets. "If the Treasury wanted to use our help, it would come, you know, free and clear," Gross said. Like Warren Buffett, Gross is a brilliant capitalist who plays to win. I happen to know him and I trust him. He has an enlightened understanding of global capitalism, not just financial markets and monetary economics but the deeper tides of history. In fact, Gross should be the next president's pick for chairman of the Federal Reserve. I don't know his politics, though I assume he is Republican.