Tuesday, December 16, 2008

"2008-Breaking Out the Bailouts"

Looking back on a historic year for financial markets and capitalism.

Bear Stearns

Date- March 14, 2008

Structure- Initially, Federal Reserve backed 28-day emergency loan to Bear Stearns. Subsequently, firm sold to JPM for $2 per share in conjunction with a $29billion non-recourse loan for illiquid mortgage assets. Offer later raised to $10 a share by JPM.

Logic- Since this was the first bailout the logic was that the fed needed to intervene to preserve the orderly functioning of financial markets. The initial loan was provided to stem the run on Bear as counterparties were pulling assets. It would then appear that the fed being concerned with a “moral hazard” argument pressured Bear management to find a buyer or face bankruptcy. Though when you consider the non-recourse loan JPM got, I have to believe the fed was not planning on letting bear go under and would have extended them more time had JPM not balked.

Message to Private Capital- Mixed. Initially, somewhat harsh as fed’s focused on moral hazard issue. But the raised JPM offer tempered this. As this was the first bailout, regulators believed that focusing on systemic risk was their top priority and thus very little attention was given to a potential banking sector panic.

Date- Sep 7, 2008

Structure- Placed into a conservatorship by FHFA. Treasury was then issued senior preferred stock and warrants that represented 79.9% stake in the equity of both entities. Treasury announced that they were willing to commit up to $100 billion in capital to each entity. Common and preferred dividends suspended. This bailout came on the heels of a failed backstop attempt by Treasury in early July.

Logic- After failing to restore confidence with a backstop guarantee, the government was forced to address the systemic risk posed to the housing market by a potential GSE failure. With outstanding obligations of almost $5 trillion the main concern was maintaining the orderly functioning of the agency debt market, and Fannie and Freddie’s ability to provide housing credit. The massive capital commitment was designed to instill confidence in anyone holding agency debt or GSE backed paper. As far as this is concerned, the government achieved their objective.

Message to Private Capital- Very harsh. Common equity was effectively wiped out by massive dilution, and the preferred stock was crushed by the subordination and suspension of dividends. Many critics have pointed (see GaveKal’s “Unintended Consequences of Mr. Paulson”) out that terms of the GSE bailout provided the catalyst for a mass-exodus of private capital from the financial sector. A move that would result in the bankruptcy of Lehman, the BAC/Merrill merger, several bank failures, and the conversion of all remaining investment banks into bank holding companies.

Date- September 16, 2008

Structure- Federal Reserve Credit Facility of $85 billion in exchange for warrants amounting to79.9% of total equity. Subsequently modified to include additional $37.8 billion facility from the NY FED, and then a $40 billion preferred investment via TARP. The TARP investment reduced the initial central bank facility to $60 billion. Term of credit facility was initially LIBOR +850 BPS. TARP modification reduced this to LIBOR+300 bps for borrowed funds.

Logic- AIG failure posed massive systemic risk to financial markets. Outstanding Credit default swaps sold by AIG on cdo’s meant there was tremendous counterparty risk in the event of an AIG default. Bankruptcy could cripple the financial system, and thus was not an option. Lack of liquidity triggered by loss of AAA rating meant AIG needed immediate cash infusion to post margin requirements. FED took initiative.

Message to Private Capital- Initially very punitive. Equity holders effectively diluted to almost zero by government warrants. Though subsequent modifications and TARP investment have somewhat blunted this move, message is still quite harsh. This bailout was about avoiding market disruptions and not about preserving confidence in financials. (That is if you believe the two can be effectively separated)

Date-September 25, 2008

Structure- FDIC led secret auction. Bulk of banks assets including branch network, secured debt, and all deposits sold to JP Morgan for $1.9billion.

Logic-Unsecured senior creditors were subordinated to depositors to protect FDIC Insurance Fund from taking a potential crippling hit. Clearly, the focus here was on protecting depositors and stopping the 1907 style run on bank deposits.

Message to Private Capital- Punitive. Equity Stakeholders pretty much wiped out as surviving holding company filed for CH11. Also, WAMU board had no say in sale as regulators held auction without their approval.

Date- September 29, 2008

Structure- FDIC ordered sale to Citigroup. Wachovia was ordered to sell itself to Citigroup for $2.1 billion. Deal was backed by Treasury and the FED and in exchange for the purchase Citi losses over $42 billion on Wachovia’s loan book would have been absorbed by the FED. In exchange for this backing, the FED would receive $12 billion in preferred stock. Retail brokerage arm and asset management unit were not part of the deal and would remain independent.
Subsequently, sold to Wells Fargo for $15.1 billion on Oct 3 in a board approved deal. No federal assistance required.

Logic- It would appear regulators panicked once Wachovia’s deposits started to fall fast as the financial crisis spread and thus took the forced sale initiative as a step before receivership. What happened afterwards is still murky, but it would appear that the situation wasn’t as bad as initially thought and that the Wells Fargo deal for the whole company could not be ignored. Though it is perplexing how this deal even happened with Citi receiving govt approval for the initial purchase.

Message to Private Capital- Mixed. Shareholders would have been left with about 1$ but the brokerage business would have remained separate so the deal was not as nasty as WAMU. However, when you consider that the board was allowed to pursue an alternative solution, even after the govt forced bailout, that ultimately added shareholder value has to viewed as a positive, as wamu’s board was left completely in the dark and ultimately rendered useless.


Date- October 14, 2008

Structure- The Treasury Asset Relief Program was born out of the Emergency Economic Stabilization Act of 2008 which was initially passed by Congress(Oct 3) as a means for Treasury to provide economic relief via the direct purchase of distressed assets that were infecting the US banking sector. The program was modified before it was implemented into a direct equity purchase vehicle by which the Treasury has taken stakes in the US financial sector through the purchase of senior preferred shares. The shares pay 5% cumulative dividend for 5 years at which point they reset to 9%. The treasury receives warrants for common stock amounting to 15% of senior preferred stake at a 20day trailing strike price.

Logic- US Financial Stocks started imploding despite the Congressional approval of the TARP bailout. Treasury was basically forced into a corner as European governments took the lead by taking direct equity stakes in their banks. U.S. had no choice but to abandon their proposed toxic asset relief program. This moved was designed to stop a banking sector panic. It worked temporarily, however, within a few days financials resumed their painful slide and more federal intervention would end up being required.

Message to Private Capital- Supportive and encouraging. Govt is willing to step in and shoulder some of the de-levg pain. Treasuries stakes were at very low costs to the banks and current stakeholders and potentially high costs to the US taxpayer. These deals could have been much more punitive, but considering the state of affairs the government was trying to avoid an all out collapse of the financial sector. Thus, TARP was turned into a stock market support program as systemic risk had turned into systemic failure. Treasury probably hoped this move would put a floor on bank stocks and bank runs.


Date- November 24, 2008
Employees- 300,000

Structure- $306 Billion Asset Guarantee to be split between TARP, FDIC, and Federal Reserve Non-recourse loan in exchange for $7billion in preferred stock. Also, US Govt ups preferred stake via TARP to $45 billion by agreeing to purchase $20 billion more. Citigroup agrees to exec compensation restrictions and dividend restrictions and provides the US Govt with $2.7 billion in warrants with a $10.6 exercise price.

Logic- Citigroup shares were free-falling for five straight days despite the initial $25 billion TARP investment and thus the government was forced to act. Investor confidence was at critical levels, and thus something needed to be done to resolve the too big to fail question regarding Citi and their massive balance sheet.

Message to Private Capital- Extremely equity supportive. Treasury and Fed broke from past practice of punishing private capital at the expense of tax payer funds. The city deal was set up in such a way to make the actual equity recover as the government ownership stake was kept very small and also set at a much higher valuation then the prevailing market price. It would appear the goal here was to throw free money at anyone willing to get back into financial stocks with the hope that the sentiment impact would ultimately offset any taxpayer costs. Could be argued as an attempt to correct the Lehman blunder or the GSE/AIG precedent.

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