Business Law Prof Blog

Lessons on Markets from the Chinese

China announced a $560B stimulus plan and our market went up 200 points on the Dow.  When President Obama passed a $780 B plan our market dropped like a rock.  We need, apparently, to take some lessons on capitalism from the Chinese.

The Fed's TALF Program: Another Surprise in the Details

The Fed announced the details of its new $1T TALF lending program yesterday.  It was another unpleasant surprise.  The Fed is acting as a prime broker (investment banker) for private investment funds (hedge funds), in essence, for free.  Here is how it works.  The Fed loans money to hedge funds who use the money to leverage purchases of the AAA tranche of asset backed securities from SPV pools of assets.  The backing will encourage other investors to buy other tranches, will give SPVs money to buy income producing assets (loans) from originators who will then be encouraged to place loans with consumers who will then buy on credit from American manufacturers. Several problems: 1) Who will buy the "junk" tranches? 2) Consumers are credit wary. 3) The Fed is, very quietly, backing securitization, leverage, and hedge funds, three of the primary targets of Congress and the media. Moreover, hedge funds will make a killing in profits and not share them with the Fed.  4) Obama, in his budge bill, is attempting to impose higher taxes on hedge fund manager's share of the profits ("carried interest"), however.  Good golly Miss Molly.

New AIG Bailout: A Complex Mess

AIG has lost $61B in the 4th Quarter and the government has responded with another bailout plan. The new plan does two things: First, it corrects a horrible first plan and, second, it dumps in more cash.  The new problem is that the new plan is a complex mess.  The plan lowers the interest rate AIG must pay on the government's line of credit, offers lines of credit to a variety of AIG subs, and gives up cumulative dividends on the preferred stock the government holds. In exchange the government takes a substantial ownership interest in two of AIGs more profitable subs (and continues to hold a potential 77.9% ownership interest in AIG itself with outstanding warrants).  The ownership interest is held in a "trust" with trustees appointed by the Treasury.  The government exchanges its Series D Preferred for two new issues of preferred, Series E and Series F and new out of the money warrants ($2.50 strike price).   Why the complexity??  To hide the true extent of the bailout (for how much cash are we in??) and to hide the true extent of AIG's problems (will this hold??).  In many ways, the AIG bailout is the government's worst of its worst efforts.  And it will get worse yet.

Obama the "Gambler": Read, "Speculator"

With yesterday's budget proposal for next year, even the New York Times has labeled Obama a "gambler."  Gambling is in: Poker players are on television and romanticized in Westerns.  Speculators are out:  They caused our economic crisis and are vilified by Oliver Stone. But gamblers are speculators. I prefer another word entirely: Obama is "Confused."  He wants a stable housing market but is willing to cut back the interest deduction on mortgages; he wants not for profits to flourish but is willing to cut back on deductions for charitable donations; he wants private investors to get back in the market but is willing to up the tax significantly on the returns on new private investments.  He goal of economic recovery is conflicting with his social redistribution goals. Either he is confused or intentionally sacrificing economic recovery for social goals (a deceit).  I prefer "confused." 

RIP GM

GM lost $10B in the last quarter and $31B for the last fiscal year.  The $4 B government loan went in and out immediately to pay creditors and salary.  The current quarter will be worse, with sales declining further.  GM has a deficit of $13B in its pension plan. With a cash reserve of $14B at the end of its fiscal year, this means that the company has probably (given how accounting works) already eaten through its reserve.   The company has to be on the verge of not having the cash to met payroll. Any more government loans will go in and out immediately to creditors and workers.  RIP GM.

TARP II Terms: The New Bank Bailout Program

Treasury today issued the terms for its new Capital Assistance Program (CAP) for handing out TARP funds.  There are some very interesting wrinkles.  First, the government will purchase funny convertible preferred stock instead of preferred stock and warrants (on common).  The conversion ratio is based on a 10% discount from the price of the common stock on Feb. 9th.  Second, the preferred pays 9% for seven years rather than 5% for five and 10% for the second five (that some banks received).  On the seventh year the government can force redemption of the new convertible preferred.  Third, the preferred is convertible into voting common at the option of the issuer (not the holder, the government) with the approval of the government. Previously the warrants were for non-voting common only.  Fourth, banks are encouraged to exchange the new convertible preferred for the old TARP preferred.  The wrinkles are designed to allow banks to convert preferred into common to aid with TCE ratios (Total Common Equity ratios) that are the rage now for assessing bank health.  But to get the issuer conversion flexibility an issuer must sacrifice some short term dividends and give up, potentially, voting stock to the government.  Banks that need the more have no choice but to sell the convertible preferred but should hold on to the old non-convertible preferred issued under TARP I unless pressured by the government to exchange it to the new convertible preferred.  Then there are the new executive compensation caps that apply retroactively.  The stock market rose a bit on the terms and then tanked again after the President appeared on television at about 4:00 to warn of "heavy oversight."  This new cash is going to come with plenty of strings.  At some point bank boards should think about whether they will get more money to shareholders by voluntarily winding up than accepting government cash and government "oversight."  Indeed, the boards have a fiduciary duty to make the calculation and wind the bank up if the calculation favors the process.

Citigroup, of course, is getting a special deal. The government with exchange up to $25B of the old preferred for new convertible preferred (with an 8% rate) if the private shareholders also participate for the same amount. If it works out the government would have potential voting rights on close to 40% of Citigroups common.  The offer hit the markets hard as Citigroup shares broke trading volume records and fell close to 40% on the announcement.   

Bernanke's Reassurance Scare

To reassure the market that the federal government would not nationalization Bank of American and Citigroup the Chairman of the Federal Reserve said "We do not need majority ownership to work with the banks... We have very strong supervisory oversight. We can work with them now to get whatever's necessary."  In other words, "we run the banks without majority control of voting stock."  This to me is worse than the reverse, "we need majority control of voting stock to run the banks."  Couple this with the front page WSJ story that miscellaneous government officials from four or five departments are running around Citigroup issuing orders and making demands, some contradictory.  What a mess; what a scare.

Government Into Car Companies Too Deep to Get Out?

The principals in the auto companies are negotiating in light of a government bailout.  This makes their negotiations difficult and less than satisfactory; everyone is encourage to hold out.  We now find that even if an auto company takes a traditional Chapter 11, we may have the same problem -- the government financing will determine the winners and losers.  Even in a Chapter 11 then the private parties will negotiate in anticipation of government funding.  In or out of bankruptcy, the government will call the shots -- it has owns the problems.

An Intriquing Legal Issue

Some banks who took TARP I money did so under a clause that allows the government to unilaterally change the terms of the deal.  What is the legal effect of such a clause.  Assume the government now wants to cap salaries and bonuses and demands that the bank do so; the bank does not take any new TARP money.  Must the bank comply?  I would say not. Either the clause is unenforceable (no standards for evaluating whether the government is in breach) or there is no contract at all (no mutual agreement on significant terms).  The bank could refuse and the government cannot vote its non-voting preferred (or common, if it exercises its warrants) stock to force compliance.  In the extreme case, there is no contract and the bank can even ignore the terms of TARP I's deal and force the government to sue for restitution and rescission of the funds (with the result no obvious).  In any event, none of this will happen as the government has the banks running scared of its other regulatory authority. 

Who Is the Sucker??

Now that the new Administration's economic proposals are trickling out we can add them all up and see who is taking it on the chin, who is getting played for the sucker.  The old advice for players at the poker table holds: If you do not know who the sucker at the table is, it is you.  Our economic system runs on voluntary compliance linked to cultural norms, not fear of getting caught and prosecuted.  The cultural norms, in pre-PC days, used to be called the Protestant Work Ethic or the like.  People who put themselves in position to find work and earn some income, did not over-spend their budget, bought and paid for a home they could afford, saved a bit for their children are the suckers.  They will pay for others who did over-spend and saved nothing.  They will pay in increased taxes, both in income and estate taxes (and their social security repayments will be means tested), and in inflation (their savings will be eaten up by inflation).  Those who voluntarily complied with the rules and lived within their means are the suckers.