Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

 

Yesterday we recorded the Godfather-like meeting, described in the New York Times, held last week in Treasury’s offices, in which the financial rescue’s architects, headed by Secretary Paulson, made the big banks an offer they couldn’t refuse.

 

“Someday, and that day may never come, I’ll call upon you to do a service for me. But, until that day, accept this justice as a gift.”

 

Actually, the terms are incredibly clever in balancing between the government’s desire to see banks visibly strengthened and its equal desire not to get fleeced.  They did with a combination of very cheap equity and equity kickers calibrated to incentivize speed.

 

1.  Preferred stock: the sandwich between debt and equity

 

Preferred equity is the tasty filling sandwiched between debt and equity

 

The preferred stock that each bank will have to issue will pay special dividends, at a 5% interest rate that will be increased to 9% after five years.

 

In today’s environment, five percent fixed is very cheap money.  It gets cheaper because it doesn’t have to be paid immediately. 

 

Preferred stock is a distinct type of capital:

 

§  It’s not debt – it doesn’t have to be paid.

§  It’s not common equity – it earns no share of ongoing profits.

 

Rather, it sits sandwiched behind the debt, ahead of the common equity. 

As explained in a Treasury fact sheet:

 

Ranking

Senior to common stock and pari passu with existing preferred shares other than preferred shares which by their terms rank junior to any existing preferred shares.

 

One of us is preferred, and most of you are common

 

Additionally, because this is equity, not debt, it has the following ranking:

 

Regulatory Capital Status

Tier 1.

 

As the name implies, Tier 1 capital is the bedrock form of capital, whose absence has led all the banks to be frightened of one another.  The money has to stay in the institutions until they build up their Tier 1 capital themselves:

 

Redemption

Senior Preferred may not be redeemed for a period of three years from the date of this investment, except with the proceeds from a Qualified Equity Offering (as defined below) which results in aggregate gross proceeds to the QFI of not less than 25% of the issue price of the Senior Preferred.

“Qualified Equity Offering” shall mean the sale by the QFI after the date of this investment of Tier 1 qualifying perpetual preferred stock or common stock for cash.

 

You’re going to sit there, young man, until you raise your Tier 1 capital

 

In other words, the preferred stays injected until it is replaced by equity that is also Tier 1 capital.  Meanwhile, banks are given numerous reasons to get the preferred paid off:

 

For as long as any Senior Preferred is outstanding, no dividends may be declared or paid on junior preferred shares, preferred shares ranking pari passu with the Senior Preferred, or  common shares (other than in the case of pari passu preferred shares, dividends on a pro rata basis with the Senior Preferred). 

 

The preferred stock thus acts as a complete bar to the stockholders’ dividend-based enrichment – and as we saw yesterday, to the executives’ as well:

 

Executive Compensation

As a condition to the closing of this investment, the QFI and its senior executive officers covered by the EESA shall modify or terminate all benefit plans, arrangements and agreements (including golden parachute agreements) to the extent necessary to be in compliance with, and following the closing and for so long as UST holds any equity or debt securities of the QFI, the QFI shall agree to be bound by, the executive compensation and corporate governance requirements of Section 111 of the EESA and any guidance or regulations issued by the Secretary of the Treasury on or prior to the date of this investment to carry out the provisions of such subsection.

 

Along with the executive compensation waivers comes another little provision, loosely translated as: As for lawyers, guys fuhgeddaboudit.

 

Say goodbye to those bonuses

 

As an additional condition to closing, the QFI and its senior executive officers covered by the EESA shall grant to the UST a waiver releasing the UST from any claims that the QFI and such senior executive officers may otherwise have as a result of the issuance of any regulations which modify the terms of benefits plans, arrangements and agreements to eliminate any provisions that would not be in compliance with the executive compensation and corporate governance requirements of Section 111 of the EESA and any guidance or regulations issued by the Secretary of the Treasury on or prior to the date of this investment to carry out the provisions of such subsection.

 

2.  Warrants: the kicker on the yield

 

Beyond the 5.0% baseline yield, the government gets upside:

 

The government will also receive warrants worth [sic: Ed.] 15% of the face value of the preferred stock.  For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.

 

The sic is because the warrants aren’t ‘worth’ any such amount; they have a face of that amount. 

 

Warrant

The UST will receive warrants to purchase a number of shares of common stock of the QFI having an aggregate market price equal to 15% of the Senior Preferred amount on the date of investment. 

 

When issued, the warrants will be ‘at the money’ – meaning there’s neither inherent discount nor premium:

 

The initial exercise price for the warrants, and the market price for determining the number of shares of common stock subject to the warrants, shall be the market price for the common stock on the date of the Senior Preferred investment (calculated on a 20-trading day trailing average), subject to customary anti-dilution adjustments.

 

Even though the warrants aren’t ‘in the money,’ they have an option value, because they can be exercised, at that same fixed price, any time during the next ten years.  Obviously, most stocks appreciate – from inflation if nothing else – and these should appreciate more than most, since the bank stocks have all taken a pounding of late.

 

I – want – warrants!

 

An option, even if not in the money today, has value – and in this field, complicated formulae are used, of which the most broadly accepted is the Black-Scholes model — for which Myron Scholes was awarded the Nobel Prize in Economics.

 

The Robert Oppenheimer of economics?

 

The program is strewn with incentives for financial institutions to increase their Tier 1 capital, and pay back the preferred, as quickly as they possibly can. 

 

For instance, the options last for ten years.  The longer they’re outstanding, the more they’re likely to be worth.  So the bank would like to cut them down, and there’s one way it can: by a Qualified Entity Offering – basically, raising new common stock – in a material amount.  If it does, then not only can the preferred be paid off sooner (allowing executives their bonuses again), but also:

 

Reduction

In the event that the QFI has received aggregate gross proceeds of not less than 100% of the issue price of the Senior Preferred from one or more Qualified Equity Offerings on or prior to December 31, 2009, the number of shares of common stock underlying the warrants then held by the UST shall be reduced by a number of shares equal to the product of (i) the number of shares originally underlying the warrants (taking into account all adjustments) and (ii) 0.5.

 

If the bank raises as much as the Treasury money – and, presumably, uses it to pay Treasury back – then Treasury will have half as many options.

 

And a bargain at that

 

What it boils down to: you will take the money, and you should pay it off as quickly as you can

 

Once again, the financial rescue team has made a bold, aggressive move that’s used the bully pulpit and extraordinary executive powers to force through sweeping change.  (It has other plans for the GSEs, which I’ll detail in a future post.)  Just as the Treasury is banking on value, it’s forcing banks to raise their value – not necessarily for the banks’ individual interest, but for the country’s – and the world’s – economic health.

 

You’ll agree voluntarily … unless, that is, you’d like me to exercise some more of those powers Congress saw fit to grant …

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