[Peace-discuss] A better bailout plan

[C. G. Estabrook]

[Here's the best analysis and counter-proposal to Paulson's plan that I've seen. 
   It comes from a DC-area lawyer of my acquaintance.  --CGE]


A Better Bailout Plan ~~ Taxpayers receive preferred stock and collateral from a 
bank borrowing from the Taxpayers, both in the full amount of the loan sought by 
the bank.  In other words, stock plus collateral in double the amount of the 
loan. Taxpayers profit from a bailout before anyone else does.

Thanks to Warren Buffett and Goldman Sachs for the heads-up by disclosing the 
terms of their deal, which should be the low water mark for any Taxpayer 
bailout.  A higher water mark would be the terms suggested above, which are not 
uncommon in private equity deals and chapter 11 bailouts.

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Explanation ~~ Paulson's plan calls for him to buy assets of an unknown but 
admittedly low value, at an inflated book value, for cash, from the member 
institutions of his own industry, with other folks' money (ours).  He sees his 
industry and its member institutions as too important to fail.  With all due 
respect, Paulson cannot claim to be objective or disinterested.

Paulson's plan pays in cash the price on the bank's books for the subprime 
mortgage-based assets.  The book value is probably a high percentage of the 
total balances owed on the underlying mortgages.

Paulson's price for the subprime mortgage-based assets is favorable to the 
banks. If Paulson's price for the subprime mortgage-based assets was not 
favorable to the banks, the banks would not sell.

Neither Paulson nor the banks have presented any rationale, much less a 
convincing argument, for the proposition that the US is on the brink of 
financial chaos.  They have declared it to be so.  If you believe them, the 
banks are on the brink of failure without a bailout. If you believe them. One of 
the benefits of the better plan is to put that proposition to the test.  To 
accept the terms of the better plan, the banks will have to be on the brink of 
failure.  Otherwise they will not seek a loan, and a new equity participant, 
under the terms of the better plan that will enable them to survive.

Does the banks' condition put the US on the brink?  What, because the banks 
won't lend without a bailout?  I don't believe so.  The banks remind me of the 
Sheriff in Blazing Saddles who takes himself hostage.  The banks commit suicide 
by not lending.  The banks won't lend without a bailout? Fine. Don't lend, 
banks. Don't lend starting now.  You already have?  Huh.  Most banks in the DC 
area are advertising that they are not holding subprime mortgage-based assets 
and open for business to make loans.

If the banks won't lend and there is money to be made lending, someone else will 
lend, like the banks that are advertising.  That's the free market, and the 
creative destruction should start now. If things are so bad that banks won't 
lend, the Taxpayers would be stupid to do so without the substantial potential 
for profit that the better plan provides.  Paulson's plan provides only 
certainty, the certainty of losses.  Why would anyone buy high for the certainty 
of selling low?

Hidden in the courts is another problem.  The banks own securities. The value of 
the securities is based on subprime mortgages.  The banks do not hold the 
subprime mortgages, or the notes secured by the subprime mortgages; they hold 
securities.  A trustee for the issuer or the underwriter holds the notes and the 
equitable interest in the mortgages.  Independent trustees hold the legal 
interest in the mortgages and the power to foreclose. The mortgages for any 
particular issue of securities were assembled -- without much forethought -- 
from all over the country.  How many mortgages were bundled to offer one issue 
of the securities?  Lots.  Securitizing a whole bunch of mortgages at once 
reduced the relative amount of the soft costs necessary to pay the lawyers, 
underwriters, accountants and auditors necessary for the issue of the 
securities. There are many different issues of subprime mortgaged-based securities.

So for each issue of subprime mortgage-based securities, here's the cast of 
characters and their problems:  the banks (from all over the country) holding a 
particular issue of securities, the issuer and the underwriter in say, NY, the 
issuer's or underwriter's trustee in say, DE, and the numerous trustees on the 
individual mortgages (from all around the country where the individual mortgaged 
properties are located) are difficult to assemble anywhere, and if assembled 
might fill the Yale Bowl, especially if the meeting is open to the homeowners. 
Many of the trustees for the issuers and underwriters did not receive the 
original notes at closing, and many of the original notes can't be found.  Banks 
have attempted to foreclose on the mortgages and sue homeowners for deficiencies 
after foreclosure, only to be turned away by the courts for lack of standing 
because they don't hold the mortgages and cannot produce the original mortgage 
notes in court.  The trustees won't act for lack of clear authority from anyone 
to tell them what to do.  Courts, banks, issuers, underwriters, holders, 
trustees, homeowner-mortgagors and mortgagees, oh my.

Paulson's plan, with Taxpayers' money, makes a fool's bet, "Heads you win tales 
I lose," with no upside for the foolish Taxpayers.  No one is guaranteeing that 
any recovery can be made on the subprime mortgage-based assets (in excess of the 
cost of collection), no one is guaranteeing that the banks will lend after a 
bailout, and nobody is even suggesting that this bailout, the one currently 
proposed, is the only one that will be necessary.  The precedent for others will 
be set by this one.  What about the securitized commercial mortgages of say, 
shopping centers in neighborhoods decimated by foreclosures?  What about the 
securitized asset-based lending of say, department stores' inventories that 
can't be sold because consumers are paying their variable rate mortgages instead 
of buying new washing machines?  What about the securitized credit cards that 
consumers are not paying to pay their mortgages instead, after maxing out their 
credit cards to pay the mortgage? Tune into call-in shows on radio or TV and 
hear the financial experts tell consumers to not pay credit cards and mortgages 
in order to feed their families.  I have.  The owners of securitized variable 
rate secured debt in any form (guess who?) are all out there, awaiting the 
denouement of the current drama and preparing their own play for the same 
treatment.  The banks will be back again for more bailouts after this one.  By 
definition, Paulson's plan creates a moral hazard, and the speculative trading 
of the subprime mortgage-based assets and securitized variable rate secured debt 
has already begun.

The better plan calls for the Taxpayers to receive a first priority lien on 
fairly appraised collateral, along with an equity kicker.  After the Taxpayers 
receive the preferred stock interest valued at their investment, the subprime 
mortgage-based assets could be the collateral at their appraised value for the 
loan.   The value of the subprime mortgage-based assets as collateral is their 
appraised value, which may be ten or twenty times the total balances remaining 
on the underlying mortgages and is not likely to be the value of the assets 
carried on the bank's books.   Understand that the loan and the investment are 
the same money in the better plan, and if the bank is able to repay the loan, 
the Taxpayers could double their money because they will still own the equity 
kicker. If the bank can't repay the loan, Taxpayers recover on their collateral 
and share, as the most favored shareholder, in the liquidating dividend.  BTW, 
where are the government's bank examiners requiring the write-down of the value 
of the banks' books of the subprime mortgage-based assets? I think they work for 
Paulson.  Seriously, I do.

No more private profit at Taxpayers' risk.  Under Paulson's plan, we are about 
to nationalize the almost certain losses incurred in running the banks badly, 
and at the same time we leave the banks, without their losses, with more money, 
in the hands of the folks who ran them badly.  The only thing we have socialized 
in this country, after the bailout, will be the (mostly) unrecoverable losses of 
banks, acquired for cash at book value.  Somebody else already got the profit 
and the fees from making the subprime mortgage loans and from issuing the 
securities.  After the bailout, the banks will have shed their private losses, 
and received a premium of public cash for doing so. Private profit, public 
losses, all around.
A bank seeking the Taxpayers' loan is not an admitting bankruptcy; the terms are 
merely a recognition of the risk in the loan that requires a private equity 
kicker to attract the lender (us).  Private equity is not bankruptcy.  The terms 
would be appropriate, for example, if I approached you to purchase an apartment 
building, me being broke.  You would put up the money for a first trust and a 
preferred ownership position for receipt of income, get paid in full first with 
interest, and end up with 50% of the apartment building and its appreciation, 
all your money paid back with interest, and half the income stream.  I would 
have 50% of the apartment building and its appreciation and share in the income 
stream once you are paid off in full with interest.  I have represented clients 
in similar leveraged deals where the financier (you, in my example) gets first 
payout on cash loaned (not contributed) and 50% of the equity in the deal.

For example, the financier in one deal (which involved a third party 80% first 
mortgage for the purchase of a real estate portfolio appraised at $70M) put up 
$14M, was paid back in full with interest in five (5) years, and retained a 50% 
interest in a real estate portfolio and its appreciation and income stream.  14M 
up, 14M with interest back plus 35M with appreciation and half the income stream 
off 70M.  At ten percent interest on the loan and a market appreciation of 1% on 
the portfolio, my client's deal paid the financier, on a $14M loan (in 
simplistic terms), $1.4M per year in interest, $350K per year in appreciation, 
and $14M on the fifth anniversary, a total payout of $22,750,000 in five years, 
with an equity kicker of a $35M interest in a real estate portfolio, the income 
stream it creates and its appreciation.    The bank does not have to borrow from 
the Taxpayers if they don't like our terms.

Buffett is not paying book value in cash for subprime mortgage-based assets, 
with no equity kicker or even a loan structure.  Buffett is buying into value. 
Goldman Sachs has an international name with the best talent to run a highly 
leveraged portfolio and assets to match his buy-in twelve times over.  GS is 
poised to convert to a money center bank, among other options open to it, and 
would likely survive were there no bailout and no Buffett.  Buffett is not 
buying subprime mortgage-based assets, or even lending money. He is buying a 
preferred class of stock issued for him, which has first priority above all 
other owners.  In other words, Buffett is secured by all of GS assets, including 
the money he is paying in, if anything goes wrong, before any other owner gets 
paid.  If things go right, he receives a 10% annual dividend before anyone else 
on the equity side gets paid plus the value of his preferred stock. If the 
Taxpayers have a chance to take Buffett's deal with Goldman Sachs they should 
take it.  Investing in Goldman Sachs preferred stock is not the same as 
investing in or lending to a bank with subprime mortgage based assets, much less 
buying the subprime mortgage-based assets at book value without an interest in 
the bank or a note from the bank to pay the money back.

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