Who Will Be Left Holding The Bag?

Unless I’m mistaken, it was only seven months ago that Lehman Brothers slipped beneath the waves and others of this

Unless I’m mistaken, it was only seven months ago that Lehman Brothers slipped beneath the waves and others of this great republic’s signature financial institutions were poised to follow—unless upwards of a trillion dollars in Public Capital were quickly transfused onto their balance sheets.

Now, suddenly, banks are talking about robust and satisfactory first-quarter profits (largely, I suspect, by shoving the bad stuff below the line, as we bankers say) and complaining that the premium Uncle Sam requested for the use of his stakeholders’ money—mainly warrants to buy varying percentages of afflicted banks’ equity—was extortionate. Some want the feds just to tear up the warrants—presumably to make confetti to shower over the heads of the bankers who have so miraculously turned things around and deserve a parade up Broadway.

Here, for instance, from last week’s New York Times: 

“Douglas Leech, the founder and chief executive of Centra Bank, a small West Virginia bank that participated in the capital assistance program but returned the money after the government imposed new conditions, said he complained strongly about the Treasury Department’s decision to demand repayment of the warrants. That effectively raised the interest rate he paid on a $15 million loan to an annual rate of about 60 percent, he said.

“‘What they did is wrong and fundamentally un-American,’ he said. ‘Even though the government told us to take this money to increase our lending, the extra charge meant we had less money to lend. It was the equivalent of a penalty for early withdrawal.’”

There are two aspects here that merit scrutiny. Anyone over the age of 60 should be familiar with the argument that now that the damage is undone, at least in theory, the warrants should be canceled. It happened with Chrysler back around 1979. The government bailed out the automaker, and—just as any private-sector financier would have done—took back a stake in the form of warrants. When Chrysler recovered—at a time when Cerberus was but the merest mote in Mammon’s eye—down to Washington went Iacocca and his colleagues to argue that these warrants should be eliminated. Uncle Sam and his advisers—principally, as I recall, Jim Wolfensohn—stood firm and the warrants were cashed, earning a nice but hardly exorbitant return for the taxpayer. We should do no less today.

As for the “un-American” effective interest rate, I think Mr. Leech is mistaken on two counts. If gouging is “un-American,” then I expect that the patriotism of most credit-card-holding Americans is being sorely tried. Actually, sharp-dealing and welshing on contracts are entirely in the American vein, as is beating up on the little guy. The first definitive history of the American currency and banking system was written (in 1833) by a chap named Gouge, which I have always thought was Providence’s way of telling us something about ourselves.

As for Mr. Leech’s argument about the high effective interest rate that results from the inclusion of warrants in first-round TARP financing, let me quote, in its entirety, an email from a friend who—take it from me—knows his way around high finance up close and personal:

“In case you are wondering about the ‘exciting’ profits of Wells Fargo and some other banking institutions? It goes like this:

“The Federal Reserve Bank supplies almost all new monies to the banks as loans at a rate of 0.25% per annum. That is to say, separate from TARP, taxpayers are lending to banks an undisclosed but extraordinary amount of money at 0.25%.

“The banks then turn around and lend that money out to the taxpayers at an approximate average of 6.0%, a profit of 5.75% or, in other terms, a mark-up of 24 times cost. As the average equity capital requirement is approximately 10% (5% in the case of mortgages) the banks are able to earn at least 57.5% per annum on equity. At the same time the equity of the banks is augmented by taxpayers, courtesy of TARP and 9 trillion other dollars of guarantees grants, investments, etc., guided by our economic team in Washington.

“When will there be some real relief for the middle and poorer classes which will actually help to reverse the downward spiral in the economy rather than the continued subsidies to incompetence?”

My correspondent’s last point ties neatly to an assertion made in a recent Wall Street Journal piece, “From Bubble to Depression?” by Steven Gjerstad and Vernon L. Smith: “Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.”

I can only say that this makes perfect sense to me. And it suggests that, when it comes to securing a cheery economic future for ourselves and our posterity, top-down solutions, at least as they are going right now, are only going to drive the real problem child—the overstretched, overcharged, over-indebted, insecurity-stricken consumer—deeper and deeper into the hole his friendly neighborhood “all-American” financiers have been only too pleased to help him dig for himself.

I think we have entered a very tricky period here, one of great confusion about what it all means, about right and wrong, about distinguishing cabbages from kings. The high-finance blogosphere is sizzling with the statistically replete argument at the blog Zero Hedge (http://zerohedge.blogspot.com/2009/04/incredibly-shrinking-market-liquidity.html) that there is “… a high likelihood of substantial market dislocations” resulting from big liquidity shifts, and that the little guy, the marginal plain-vanilla investor, is likely to be the one left holding the empty popcorn bag.

In this scenario, the Lohengrin riding the black swan is none other than our old friend Goldman Sachs. Indeed, with all due respect to GS CEO Lloyd Blankfein’s nostra culpa the other day, it is Goldman that is the paradigm-setting paragon of our era, with its eminently sensible rationale that the best path to total success and riches is to be on every side of every deal, which includes being closest—in approved Iago style—to the ear of a bewhiskered old boy in a star-spangled topper whenever he takes a seat at the table and stumps up a trillion-dollar buy-in.

I don’t like to see this. Not now. At a time when we are beset with so many questions that yield contradictory and confusing answers, with so many mixed signals, the last thing we needed stirred into this witches’ brew is moral and ethical ambiguity.

Which brings me to the matter of Larry Summers. But I guess I’ll have to save that for next week.



Who Will Be Left Holding The Bag?