Secretary of the Deal

Posted on January 7, 2009 by David Laidlaw 

Friends used to ask what an investment bank did, back before September 2008 when their operations seemed irrelevant to Main Street. I usually replied that they broker all sorts of deals in order to make money on the transactions.

Investment banks issue and sell equity and bonds for companies and governments to raise money. They advise on mergers and acquisitions. They have investment management divisions which invest money for 3rd parties. They produce research rating companies as buys or sells.They have trading desks.Finally, investment banks create structured products using various derivatives that often promise high returns without additional risk. This division has been in the news lately for its highly publicized mortgaged-backed obligations, which package subprime mortgages (and pay a high return) but come with a triple-A rating (in theory due to the diversity of loans).

An investment bank makes a deal, takes its cut, and moves on to the next revenue generating possibility.This strategy is on display for everyone to see now, but the dealmakers aren’t from Goldman Sachs or Morgan Stanley, but from the United States Treasury.

The United States Treasury Secretary is Henry Paulson, formally CEO of Goldman Sachs.He started at Goldman in 1974 and worked his way up to CEO, eventually leaving in May of 2006 when he was nominated by President George W. Bush. He left Goldman, but kept his deal-making abilities.

Following are examples of Paulson’s deal making prowess:

·On March 17th, Paulson brokered a deal in which Bear Stearns was bought by JP Morgan with the Federal government guaranteeing a portion of Bear Stearns’ loans.

·On September 7th, he took over Fannie Mae and Freddie Mac after first attempting to just take equity stakes in the companies.

·On September 15th, he allowed Lehman to slide into bankruptcy.The next day he backed an $85 billion loan to AIG so it would avoid collapse.

·On October 3rd, the $700 billion bailout was passed in order to buy troubled assets from banks.Eleven days later he announced he would use $250 billion of the bailout package to buy equity stakes in banks. About a month later (November 12th) he officially announced that the Treasury would drop its plans to buy troubled assets.As of December 29th, only $172 billion of the $250 billion had been invested in banks.

·On November 24th, Paulson announced the Citigroup bailout in which $306 billion of Citi’s troubled assets are guaranteed by the Treasury, FDIC and Fed.The Treasury also received warrants in the deal.

·On December 19th, GM and Chrysler were given $17.4 billion of the bailout package after Paulson insisted that no bailout money would be given to the automakers.

·Also on December 19th, coinciding with the auto bailout, Paulson announced that he would ask for the 2nd half of the $700 billion bailout.Back on November 17th Paulson had announced that he wouldn’t need the second half of the $700 billion bailout package.

Paulson has attempted various strategies to fight the financial crisis and keep us out of a long and painful recession.He brokered deals between private companies, took over companies, gave out loans, guaranteed private loans and watched companies declare bankruptcy. Clearly he has no overriding philosophy.

 Originally he wanted to avoid creating a moral hazard by allowing private companies to fail, most famously Lehman. He reversed course in one day, deciding some companies were too big to fail (see AIG).Paulson has handled each case on its own merits, perhaps believing the faster the deal was done, the better.

This course of action has its advantages as square pegs aren’t shoved into round holes.The original bailout plan to buy troubled assets was going to be difficult to manage as the market for the assets disappeared, making it very difficult to gauge an accurate price. But something had to be done or the credit markets would freeze completely, pretty much assuring a depression.

The disadvantages may be greater. Due to the haphazard nature, the public has lost confidence in the bailout.For example, allowing financial institutions to survive (and management to receive huge paydays) has fostered a sentiment that it’s a bailout for the wealthy. Floating statements that mortgage rates are going to be forced down to 4.5% has perhaps delayed homebuyers from purchasing or refinancing existing loans.

The largest problem may be the slippery slope on which we are sliding. Each bailout has become more complicated: the Citigroup bailout involved several government agencies and $306 billion of guarantees where the Bear Stearns deal “only” guaranteed $29 billion. And we’ve extended beyond financials and into auto makers, making one wonder which industry has enough political clout to be next in line.

In the end, no one can say with complete confidence what the best solution was or is. But we know for sure that deals are being made, which should make any investment banker proud.