Reflections on TARP, AIG, Citi, and Compensation

TARP

For several reasons, I have never liked TARP, the Troubled Asset Relief Program.

  • It was the wrong medicine for the disease. The disease was that the credit markets were frozen because banks did not trust one another. This could and should have been remedied by the Feds guaranteeing bank-to-bank loans. The Executive branch could have made these guarantees Congressional involvement. The guarantees would have cost American taxpayers nothing unless one of the banks failed.
  • Instead, Paulson made a power grab unprecedented in U.S. history. In the text of his initial four-page Congressional request, he asked for $700 billion to purchase mortgage-related assets defined as “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages.” He asked for this authority with no strings and absolutely no liability for him or his staff if things went wrong: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” And even though the bill ultimately passed Congress ended up being 96 pages, Paulson got what he wanted.
  • The Congressional request/approval process wasted three valuable weeks that caused the credit freeze to worsen and catapult us into a global recession.

So far, TARP has been used for the following:

Systematically Significant Failing Institutions
Date Company (mill. US$)
11/25/08 AIG 40,000
  Automotive Industry Financing Program
12/29/08 GMAC 5,000
12/29/08 GM 1,000
12/31/08 GM1 13,400
1/2/09 Crysler 4,000
1/16/09 Crysler Financial 1,500
Total 24,900
  Targeted Investment Programs
10/28/08 Citigroup 25,000
1/16/09 Bank of America Corporation 20,000
Total 45,000
  Asset Guarantee Program
12/31/08 Citigroup 20,000
  Capital Purchase Program
10/28/08 Bank of America 15,000
1/9/09 Bank of America (for purchase of Merrill Lynch) 10,000
10/28/08 Citigroup 25,000
492 Other Banks 166,903
Total 216,903
  Term Asset-Backed Securities Loan Facility (TALF)
3/3/09 Total Debt Obligation 20,000
Overall Total   366,803

Congress originally authorized Treasury to spend $350 billion and then come back to get approval for spending the other $350 billion. The $366 billion total is a bit misleading inasmuch as TALF and some other items are loan commitments and not actual expenditures. But Treasury is getting close to the limit and the Congressional grilling for the second $350 billion will be tough.

By far, the largest TARP activity has been the Capital Purchase Program under which Treasury purchases equity in financial institutions. Since October 28, Treasury has arranged 495 equity purchases. That has been a lot of work – 26 equity infusions per week. Treasury has had to solicit proposals from the banks, review them, and finalize agreements with each. It is expensive money. As one banker told me recently: “I can get Home Loan Bank funds for less” http://berkshirehomestyle.com/features_how.html. That means the 495 taking the money really needed to shore up their capital bases.

This program will probably make some money for the US taxpayers: In exchange for Federal support, the recipient institutions must provide preferred stock paying a 5% dividend for five years jumping to 9% in the sixth year and forward.

But there is little evidence the TARP bailout has done much to ease the credit freeze. And while Obama has continued it (195 institutions have gotten equity infusions since Obama took office) one does wonder whether it will be featured when Obama asks for the second $350 billion tranche from Congress.

While 500 firms have received TARP money to date, two institutions stand out – A.I.G. and Citigroup.

CITIGROUP

Consider first Citigroup. In late October 2008, Citi was one of the first banks to get money ($25 billion) from the bank equity program. On November 4th, the Treasury, Federal Reserve, and Federal Deposit Insurance Corporation provided loan guarantees that could end up totaling $277 billion. On January 16, it got an additional $20 billion plus $5 billion in additional loan guarantees from TARP. All told, that is $327 billion.

How did Citi get to a point where it needed so much support? Two years ago, just before the credit freeze, I had a discussion with a wealth manager at Citi about the bank’s repackaging and selling of asset-backed securities. The bank made a commission on these sales. It was a good business. In passing, he said that for the bank’s best clients, Citi would guarantee these packages. That seemed odd at the time, but it is worth keeping in mind in trying to understand where the bank is now.

According to the bank’s 10-Q reports on the SEC’s Edgar system, Citi set aside approximately $7 billion for loan losses annually between 2002 and 2006. In 2007, that number jumped to $17 billion. Consequently, the bank’s net income fell from an average of $20 billion for the earlier period to $4 billion in 2007. In 2008, provision for loan losses jumped to $34 billion, and the company lost $28 billion. But note this: without the jump in the provision for loan losses, Citi would have been profitable in 2008.

On February 27th, 2009, the US Treasury and private investors agreed to convert preferred stock valued at $25 billion to common stock. As a result of this transaction, the US government could own up to 36% of Citi. That portion of the now $45 billion preferred not converted would be placed in a preferred trust paying a dividend of 8%. Current stockholders will end up owning somewhere between 42% and 26% of the company.

So why did Citi first need $25 billion from TARP and then an additional $25 billion, and on top of that, government guarantees of up to an additional $277 billion? It probably had something to do with the actual values of its “Trading Account Assets” that have fallen from $539 billion in 2007 to $378 billion at the end of 2008. And probably the package guarantees for the Bank’s best clients mentioned above took a bite out of the Bank’s capital position.

PARIS, March 10 (Reuters) – European stocks rose on Tuesday morning, gaining ground for the first time in four sessions, as a memo from Citigroup’s chief… [indicated that] the bank was profitable in the first two months of 2009….”This certainly fuels hope that the worst could soon be behind them, and behind the sector in general,” one London-based trader said.

As an American taxpayer and consequently a part owner in Citi, I do hope that after all of this, “the worst could soon be behind them.”

AIG

Let us turn now to AIG. Last September AIG got a Fed loan of $85 billion. In November, it got $40 billion more for preferred shares out of TARP’s “Systematically Significant Failing Institutions” window (I wonder who thought that name up? To date, AIG is the only recipient from that window). There have been a few more financial transactions between the Feds and AIG; the net is that the Feds own 80% of the company. The company just reported a quarterly loss of $61 billion, the largest quarterly corporate loss in US history, and that follows a $99 billion loss for 2008.

How did AIG, the largest and arguably the greatest insurance company in the world, get into this mess? As documented by Gretchen Morgenson in an excellent New York Times piece on September 27th of last year, AIG started to insure asset-backed securities out of a London office in 1999. It was a very profitable business: it amounted to more than 17% of AIG’s operating income in 2005. When the global market for asset-backed securities disappeared last year, those institutions that had bought AIG’s insurance for those securities asked AIG to pay up.

Assessment

For both Citi and AIG, virtually all their problems stemmed from there suddenly being no market for asset-backed securities. And now, many are calling for tighter regulations, the end of derivatives trading, etc. AIG has come under particular fire: why would the world’s leading insurance company take on such risks?

For some perspective on this question, let us go back to early 2006 just after the real estate market started down. Suppose you had been a risk assessment manager in a financial institution at that time: would you have developed a scenario in which the real estate downturn led to a freezing up of the global asset backed securities market and the virtual ending of bank-to-bank loans? I put this question to a risk manager of a major bank last November when I was teaching at the University of Palermo in Buenos Aires. He said such a scenario was so unlikely that he would not be taken seriously if he made such a presentation. As Morgenson reported, the head of the AIG unit guaranteeing the securities that went bad said: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

And I ask you, who did correctly anticipate the real estate downturn would result in a credit freeze followed by a massive global recession? Aside from a few regular “gloom and doom” peddlers, nobody did.

Paulson, AIG, and Goldman Sachs

When word of AIG’s problems came out, Treasury Secretary Paulson, the former Chairman and Chief Executive Officer of Goldman Sachs, set up a meeting to discuss the matter. Morgenson reported: “The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs”. Blankfein took Paulson’s position as CEO. AIG just reported the payments it has made with TARP monies (http://www.aig.com/aigweb/internet/en/files/CounterpartyAttachments031509_tcm385-153015.pdf). Goldman Sachs was one of the largest beneficiaries, getting a total of $12.9 billion. At the very least, Paulson should have used better judgment in deciding who to invite to the AIG meeting. It smells.

Compensation

Two observations:

  • The Merrill Lynch bonus payments were far more egregious than the AIG payments. From what I can tell, the AIG bonuses were put in place before the AIG collapse. And Morgenson reported that payments to the workers in AIG’s problem unit had historically been huge – ranging from 33% to 45% over the last seven years. The Merrill payments, amounting to $3.62 billion (versus AIG’s $165 million) were apparently made after the company knew it was going to lose $15.84 billion in the last quarter of 2008. The Merrill actions were really “grab all you can as you run out the door after destroying the firm.”
  • As I indicate in a posted article http://www.morssglobalfinance.com/paying-people-too-much/, the market for business executives is rigged, and nobody needs the sort of money these people take home.

I urge all readers to visit the Treasury web site listing all the completed transactions with financial institutions – just scroll through it to capture the enormity of what is happening – http://www.ustreas.gov/initiatives/eesa/docs/transaction_report_03-16-09.pdf

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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