Corporate Welfare for Bank Investors: Paulson's Gift

The current week's stock market meltdown took me back to October 13th, 2008 when then Treasury Secretary Henry Paulson summoned the CEO's of ten leading banks to an emergency meeting in Washington, D.C. The worst weekly decline in stock market history, to that time, precipitated the meeting.

Pietro Veronesi and Luigi Zingales of the U of Chicago Booth School of Business wrote a paper, "Paulson's Gift," which is a well reasoned analysis of the net benefits to society of the plan to inject $125 billion of preferred equity into the nation's top banks, as well as providing them with extremely valuable financial guarantees.

The lack of a rapid resolution authority for these SIFIs (Strategically Important Financial Institutions) and the desperate condition of Citigroup and the former investment banks, including Paulson's own Goldman Sachs forced an emergency plan that was "very expensive for taxpayers."

In a creative use of CDS rates, the authors generated a Fama analysis of the news events disclosing the investment and its impact on the value of the investment claims for the ten bank holding companies. For the intervention to have social value, it had to accomplish something which the market could not do, while providing a net social benefit to taxpayers.

Bank bond holders made out the best from the taxpayer handouts. The value of their holdings, the authors estimate, increased by $120.5 billion between October 10-October 14, 2008. Bank equity holders overall lost $2.8 billion, with JP Morgan Chase stock holders losing $34 billion, while shareholders of Citigroup and Goldman Sachs gained $8 billion each from taxpayer largess.

Preferred equity value rose by $6.7 billion. The value of derivative contracts increased by $5.3 billion.

Taxpayers might have made a small, risk unadjusted gain on the preferred equity investment and attached warrants, but the granting of a three year FDIC guarantee on all new, unsecured bank debt issued by the ten banks before June 2009 and an extension of FDIC insurance to all non-interest bearing deposits, swung a small benefit to a cost of $21 to $44 billion, according to the paper. Champagne corks must have been popping on Wall Street.

The authors, Charles Calomiris and others have proposed various automatic mechanisms for debt-equity swaps which economically dominate the Paulson plan. However, we've done nothing with the bankruptcy laws, nor have we created any special resolution authority for SIFI's that might avoid similar problems in the future.

As the authors point out, "the pressure for governments to intervene is irresistible," and now banks know that they are permanently backstopped for injudicious risk taking. Let's hope that we don't have any similar, daffy ideas coming out of this week's stock market decline.