Treasury Discounting TARP Advances to Small Banks

On May 4, I posted a blog that discussed the fact that the United States government…us…will probably have problems getting TARP money back from smaller commercial banks.  In that post I reported the following:

“’Most small banks bailed out by US taxpayers during the financial crisis are unlikely to be able to repay the Treasury department, the Obama administration says.’ (FT.com)

This came out in a blog post on the Treasury’s website yesterday. See “Winding  Down TARP’s Bank Program,” by Timothy Massad, assistant Treasury secretary for financial stability. The Treasury does not expect “the majority of the nearly 350 lenders still partially owned by US taxpayers to repurchase in the next 12-18 months the preferred stock that Treasury received in exchange for bailing them out.”
The “smaller” banks are defined as those with less that $10 billion in assets.”

Well, currently the Treasury Department is trying to speed things up in an attempt to bring the TARP to an end for the commercial banking system.  The word on the “street” is “The current administration is very motivated to unwind its crisis-related investments.”  This from Compass Point Research and Trading, a broker dealer that has been analyzing recent TARP auctions.

The translation of this from Jesse Eisinger of the New York Times is: “The world has moved on, and the Obama administration seems to be counting on being able to run down the program as quickly as possible without too much scrutiny.”

But, this is nothing new.  As reported in my last post, when the government gets involved in the private sector, the list of objectives on the government’s “to-do” list is not always the same as the list of objectives of a private institution…or of taxpayers. 

In this post I discussed the bailout of the General Motors Corporation, which resulted in the US government becoming roughly 75 percent owners of Ally Financial, formerly known as General Motors Acceptance Corporation (GMAC).  For more on this case go to my blog, because the only important point from that blog for today’s discussion is the quote that, “The government apparently believes that it cannot wait because the outcome…is uncertain and working out’ the (problem) would take an extended period of time. ‘When the government is your lender, paying back the money is your first goal.’”

In other words, the Obama administration wants to get the financial crisis behind it as soon as it can regardless of what the cost of an early exit might be.

The outcomes discussed in the article relating to the commercial banking situation and in the article relating to Ally Financial are that the government is leaving cash on the table as it seeks the exit door.

In the case of the commercial banks, the Treasury Department is not getting back 100 percent of each dollar advanced to the banks.  And, this includes banks that have “strong profits and strong capital positions.”  That is, even healthy banks are not paying back 100 cents on the dollar.

The New York Times article cites four specific cases: “When the government sold its holdings in MetroCorp Bancshares of Houston this month, the bank itself bought back most of it—at 98 cents on the dollar.  Wilshire Bankcorp of Los Angeles bought back its paper at 94 cents on the dollar.  The Treasury Department sold preferred shares of Ohio-based First Defiance at 96 cents, and Peoples Bancorp of North Carolina at 93 cents.  All of these are regarded as healthy.”

The big banks paid back 100 cents on the dollar.

But, the question still outstanding is the discount the government will have to take on the banks that are less than healthy.

The issue is not so much that the bank bailout program is going to cost the government money.  So far the bank portion of TARP has been profitable with the Treasury estimating that it will make almost $22 billion from the bank support programs.  Even if the money coming back into the Treasury is not 100 cents on the dollar, the shortfall will not use up all that has been already received. 

The primary issue is that the discounts are going to reduce the final amount that will have been returned to the Treasury and the faster officials try and bring this part of the program to a close, the less taxpayers will have to show for the government’s effort. 

But, as my previous post discussed, this is one of the problems with many government programs.  The ultimate objectives of the programs run by the government are not the same as the objectives that a private organization would seek.  As a consequence, these government programs tend to leave something “on the table” for the well positioned, the well informed, and those with the resources to walk away with.

Nothing illegal here…it is just the way governments work.

And, who seems to be “walking away from the table” with icing in this case?

Note that the examples given above all relate to “healthy” banks…those that have “strong profits and strong capital positions.”  But, time is money and the government apparently is willing to give up money in order to get paid back sooner rather than later.

Still, this leaves a big question open.  What about the banks that are not healthy?

In the earlier Treasury report, the author stated that there were 350 banks that remained “partially owned” by the federal government.  In the current New York Times article, Mr. Eisinger states that the discounts that may have to be taken could result in further taxpayer losses “in the hundreds of millions.” 

But, take off a dozen or so healthy banks from the 350 number and you still have a substantial number of banks partially owned by the government that are in various stages of “not very good health.”  What is our problem here?  How many of these banks are seriously impaired? 

There are still a lot of commercial banks in the banking system that are not in very good health.  As of March 31 there were 772 FDIC insured banks on the list of problem banks. (We will get the number for June 30 this week as the FDIC releases these numbers 55 days after June 30.)  How many of the banks that owe the government TARP money are on the problem list?

There have only been 40 banks closed this year through last Friday.  It appears that many more banks are merging out of existence than are closing outright.  In the first quarter alone the number of banks in the country dropped by 50 units even though there were only 16 bank closures. 

The point is, the banking system is still not back to “good health” yet and the TARP numbers, the bank closure numbers, the fact that the Fed still has injected over $1.5 trillion in excess reserves into the banking system just confirm this fact.  Things continue to get better, but I believe that the system is still somewhat fragile.  This is one reason why many banks are not growing their loan portfolios.  We just continue to hold on and hope things will continue to improve.    

Does Warren Buffett have an Ally?

My post of Monday August 20 closed with the following comment: “as one reads a book like ‘More Money Than God’ by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes. The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these "tools" are not available to most people. Maybe that is why the distribution of wealth in the United States has become so skewed.”

Well, Steven Davidoff of the New York Times gives us a perfect example of this type of situation as he discusses the evolving consequences of the government bailout of General Motors.

Let me just say before we get started that “government mistakes” can be split into two categories.  The first relates to overt government mistakes like the British government trying to maintain an un-maintainable price for the British Pound in the 1990s.  The result was the classic case of George Soros laughing all the way to the bank with billions of dollars.

The other type of mistake has to do with “unintended consequences,” the result of government action that may occur because the government either does not have the incentive to totally examine the results of what it is doing or the government does not have the same goals and objectives of the private investor. 

An “unintended consequence” gets this story started.  Davidoff sets the scene. “G.M.A.C (General Motors Acceptance Corporation) was the financial arm of General Motors.  In the years leading up to the financial crisis, it was also G.M.'s most profitable unit, which tells you something about the auto industry at the time. The company earned more profit from lending money to customers than in selling cars.”

Why did G. M. A. C. become “G. M.’s most profitable unit”?

Well, in the 1960s, the US government was very concerned with rising unemployment.  In an attempt to keep unemployment as low as possible, the government established a policy of credit inflation to keep workers employed.  The justification was something economists called “the Phillips Curve.”  The Phillips Curve encouraged the government to inflate the economy because there was a tradeoff between inflation and unemployment.  A little more inflation could buy the government a little more employment thereby keeping the unemployment rate down.

Milton Friedman showed this argument to be a fallacy because a little more inflation got built into inflationary expectations and this worked in the opposite direction of lowering unemployment.   However, politicians got stuck on the first point and, in order to get elected or get re-elected, they (both Republicans and Democrats) they continued on with a policy of credit inflation into the 21^st century.

Inflation, however, changes incentives.  As I have written many times before, inflation results in people and businesses taking on more risk, taking on more financial leverage, mismatching the maturities of assets and liabilities, and introducing more and more financial innovation.  And, people make lots and lots of money off of betting with inflation!

General Motors did this through G. M. A. C. and the subsidiary became “G. M.’s most profitable unit.”  But, General Electric also did this and more than half the profits GE earned came from its financial wing.  And, this was true of other “major” US corporation.

Yes, people were kept employed but General Motors did not have to focus on productivity or labor skills or “selling” cars, could focus on keeping its labor unions happy with “good” labor contracts, and, as an unintended consequence GM became uncompetitive.  But, GM executives benefitted greatly from the profits now coming from the financial side of the business.

I won’t go deeply into the situation described by Mr. Davidoff because he does an very good job at explaining what is going on.  What is important is that what is going on is a result of another “unintended consequence.”  The government’s objective in resolving the bailout as the Treasury Department stated was “to exit in in a manner that balances speed of recovery with maximizing returns for taxpayers.”

And, as Mr. Davidoff goes on to explain, “That’s the problem with companies being bailed out.  They’re no longer as entrepreneurial or risk-taking as they might be, and instead have to balance gains against a need to pay back the government.” 

The situation: G. M. A. C. became Ally Financial.  But G. M. A. C. was not just about financing automobiles  “The company was also one of the largest subprime housing lenders through its ResCap subsidiary.”   ResCap is the fifth-largest mortgaging service and origination unit in the nation. Thank you, credit inflation!

ResCap has lost billions during the Great Recession and Ally has subsidized this loss lending ResCap $1.2 billion and also infusing $10.2 billion into the subsidiary since January 1, 2007.

That is, until recently.  Ally Financial put ResCap into bankruptcy.

And, here we get to Mr. Buffett.

In the bankruptcy of ResCap, the company was to split up into two parts, one part consisted of the mortgage servicing and the other part was a legacy portfolio of mortgages with $5.2 billion in loan principal.  Ally initially “announced its intention to serve as a stalking horse bid for the legacy portfolio, bidding from $1.4 to $1.6 billion.” 

Ally has now dropped out.  Guess who showed up?  Berkshire Hathaway…which, by-the-way is one of Ally’s biggest creditors.  Berkshire has now replaced Ally as the “stalking bidder” for the loan portfolio. 

Although the outcome of this bidding will come in bankruptcy court auction, Ally will not be a part of the bidding: Ally, which has lost billions of dollars in the portfolio.  And, they leave just at a time when there is some indication that the housing market might be getting stronger so that there seems to be a growing possibility of getting something more back from the loans.

And, the government apparently believes that it cannot wait because the outcome of acquiring the loans is uncertain and “working out” the loans would take an extended period of time.  “When the government is your lender, paying back the money is your first goal.”

So someone in the private sector stands to gain a lot of money from this transaction.  And, that “someone” is not the “small person”.

As I stated in the August 20 post, “generally the people that make the money off of these (government) mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these ‘tools’ are not available to most people.”

As Mallaby suggests in his book, these returns are “alpha” returns, returns that are not dependent upon the movement of the whole market.  Governments, acting on the best of intentions, seem to create a relatively large number of these “alpha” opportunities.  And, they are not kept a secret and they are legal.  Our job is to look at what the government is doing and determine what are the “unintended consequences” of the government’s action and then take advantage of it.   

Mr. Buffet and Mr. Soros seem to be good role models for us to follow.