Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion
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The government’s response, as awesome as it was, would be criticized as haphazard and seemingly hesitant. At first, the government ignored the credit crisis, structuring the bailout of Bear Stearns and then proceeding to later bailouts on a one-off basis. Then, in the wake of Lehman Brothers’ and AIG’s collapse, the government changed course and obtained congressional blessing for the $700 billion TARP program. This programmed, systematic response would be short-lived. The government would soon revert back to form, structuring bailouts on a unique, one-off basis, in the case of Bank of America and Citigroup.
The government’s apparently inconsistent response left many puzzled as to what the government’s plan was. Some even speculated that there was no plan. But there is an explanation for the government’s conduct first revealed in the Bear Stearns transaction. Professor David Zaring and I have written a separate paper, Regulation by Deal: The Government’s Response to the Financial Crisis, in which we theorize that the government, led by a team of ex-investment bankers, was doing deals. These deals showed all the good and the bad of dealmaking and the deal machine. The government structured bailouts as dealmakers do, preferring private solutions to government ones. The government dealmakers and their lawyers used the enormous power of the government to structure some truly novel deals that stretched the law to the breaking point at times.
Other times, as in the sad case of Lehman Brothers, the government did what dealmakers do: walk away from the table to show authority or otherwise because the law or politics constrained their action. As dealmakers, the government concluded its deals and moved on; conclude it and forget it is the dealmaking term. Precedent was important for structuring the next deal, but as dealmakers, the government was not looking for consistency but rather a completed transaction structured to its political and other interests. The government’s dealmaking showed the mistakes, the resort to loopholes, and the overreliance on precedent that all too frequently characterizes private dealmaking.
More telling, though, government by deal exposed a fallacy of the government’s program. Financial panics are a product of asymmetric information and fear. People, lacking the information to value financial institutions or their assets, move their own assets to other institutions in a mad rush for safety. The key to restoring equilibrium is to defeat this panic by inspiring confidence in suspect institutions and the financial system generally.1 The government’s haphazard strategy, though, worked against confidence building. Instead, the government left a wake of deals that made the government appear to be lurching, struggling to respond to the crisis instead of controlling it. The government saved the financial system, but its approach may have hindered a fuller recovery from the panic of fall 2008.
However, this criticism must be leavened by the cold reality that the government lacked the statutory power in many cases to take more holistic action. The federal government lacked the ability to seize non-bank financial institutions in a quasi-bankruptcy process. The government also lacked a broad “lender of last resort” power that could provide it wholesale ability to salvage these institutions. Instead, the government was forced to work among the laws that existed at the time, mainly statutes dating from the 1930s. This partially explains why the government adopted a “government by deal” approach. It lacked the ability to otherwise save the financial system and in the fall of 2008 it choose not to go to Congress for wider authority other than the TARP Bill. Dealmaking thus became the government’s only real choice.
In the government’s actions are also lessons for dealmaking and deals. It is an incredible illustration of the potential of dealmaking. In pushing the limits of the law, the government has created precedent for extreme dealmaking situations. This is precedent not only for future government action to stem systemic panic, but also for private dealmakers structuring deals.
Table 10.1 Significant Government Financial Institution Investments Sept. 2008-March 2009
The Nationalization of Fannie Mae and Freddie Mac
It began the summer of 2008.
On July 11, 2008, the Office of Thrift Supervision ominously closed the IndyMac Bank and placed it into conservatorship with the Federal Deposit Insurance Corporation (FDIC). This was the second largest bank failure in the history of the United States. Particularly troubling for the government was that even after the bank was seized, people lined up in the thousands to withdraw their money, despite the existence of federal insurance for their deposits.2
After Indy Mac, attention turned to Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) responsible for the bulk of securitized mortgage lending in the United States. Going into August 2008, these two GSEs were battered by the housing downturn. The government urged the two institutions to recapitalize, but their stockholders resisted the dilution, and investors, wary perhaps of an equity-destroying Bear Stearns-like bailout, stayed away.3
In late August, the ratings agencies downgraded the preferred stock of Fannie Mae and Freddie Mac because of their continuing inability to raise capital.4 Capital was still not forthcoming. Instead, the downward market pressure on Fannie Mae and Freddie Mac stock produced by the rating agency downgrades ironically made raising capital more difficult, as the market lost confidence in the two entities. Meanwhile, investors in the debt securities of both institutions were beginning to back away from them and the spread on their debt over U.S. treasuries began to widen.
Fannie Mae and Freddie Mac had lost the market’s support, and the weekend of September 5, 2008, they also lost the government’s confidence. Government auditors discovered that the accounting records of Fannie Mae and Freddie Mac significantly overstated their capital. According to these accounting reevaluations, the GSEs, thinly capitalized in the best of times, were technically insolvent. The government then concluded that whatever efforts the GSEs were making to recapitalize were failing. In a meeting that weekend with Secretary Paulson, Fannie Mae CEO Daniel H. Mudd and Freddie Mac CEO Richard Syron pleaded not to be nationalized. Paulson rejected the petition, and the government seized the enterprises, placing them into conservatorship. 5 The CEOs of the GSEs were each fired and replaced. In addition, the Federal Housing Finance Agency (FHFA), the GSEs’ regulator, would later cut the exit packages of Mudd by $8 million and Syron by $15.5 million.6 This last act would be the sole example thus far of the government acting to claw back executive pay in connection with a bailout.
To increase the GSE’s capital, the Treasury also entered into senior preferred share purchase agreements with Fannie Mae and Freddie Mac for each of them to issue up to $100 billion of senior preferred stock to the Treasury Department.7 The GSEs initially issued only $1 billion of preferred stock but were permitted to each draw greater amounts, up to this $100 billion limit, as needed. The issued preferred shares were ranked senior to Fannie Mae’s and Freddie Mac’s existing preferred shares and paid the Treasury a 10 percent yield if paid in cash and 12 percent if paid in kind. This yield was below the approximate 15 percent yield on the GSEs’ other outstanding preferred. The terms of the preferred prevented each GSE from paying any dividend on the GSE’s equity securities while any part of the government’s preferred interest remained outstanding.8
The Treasury also received a warrant to purchase 79.9 percent of the outstanding common stock of each of Fannie Mae and Freddie Mac.The warrant was exercisable for a 20-year period and had a nominal exercise price.9 Through this mechanism, the government effected a transaction to significantly, but not completely, dilute the holders of these securities and significantly reduce their value. But the government did not place its ownership interest higher into the capital structures of each GSE in order to penalize or otherwise wipe out the secured or subordinated debt of these entities.
This was probably done for both political and economic reasons. The secured debt was issued by Fannie Mae and Freddie Mac to finance mortgage lending and had historically been viewed as having an implicit (now effectively explicit) government guarantee. The amount outst
anding was more than $5.14 trillion in mortgage-backed securities and guarantees, and the Treasury could not eliminate it or otherwise impair this debt without risking significant, if not catastrophic, disruption to the mortgage market.10
The subordinated debt was generally thought not to have the same government guarantee. This debt was utilized by Fannie Mae and Freddie Mac to finance their riskier, nonconforming loans and for trading capital. However, the subordinated debt, like much of the secured debt, was held by foreign financial institutions and sovereigns. It was privately viewed that if this debt was impaired, it would drive away foreign lenders from U.S. debt at a time when the U.S. required this money to service the federal deficit.11 Thus, the government limited its actions to impairing the value of the GSEs’ preferred and common stock.
The government also did not completely wipe out the preferred and common shareholders of the GSEs. Rather, the government limited its interest to the 79.9 percent figure. The exact reasons for this limitation have yet to be disclosed, but it does not appear that this issuance was structured to maintain value for the security holders. Rather, it was probably done to comply with tax laws and accounting rules and maintain an argument that the GSEs were not nationalized but rather were still corporate entities distinct from the federal government and that their debt was not on the government’s balance sheet.12
Whatever the reason, the government felt that it could not completely eliminate these security holders’ interests. The government’s desire, as in Bear Stearns, to seemingly act within the law had allowed the Fannie Mae and Freddie Mac preferred and common shareholders to retain a meaningful interest in the companies. Moreover, to the extent the government was fighting moral hazard, it would have presumably wanted to also impair Fannie Mae’s $11.1 billion and Freddie Mac’s $4.5 billion outstanding subordinated debt, which had no implicit government guarantee.13 This did not happen. Instead, the government was acting as a dealmaker structuring a bailout using the law, but also acting within and to the limits of its political interests. This led the Treasury and the Federal Reserve to impair the preferred and common shareholders and led the FHFA to limit the severance packages of these CEOs, but it did not go so far as allowing the government to act purely in pursuit of its stated purposes. Even assuming that it had any bearing in a financial action of this enormity, moral hazard seemed a shaky principle to rely on to justify the government’s structuring actions.
In connection with the conservatorship of Fannie Mae and Freddie Mac, the federal government had now become the owner or guarantor of approximately 42 percent of American mortgages, and the extent of the guarantees was only growing in size and scope.14 Secretary Paulson announced that these entities’ retained mortgage and mortgage-backed securities portfolio would be shrunk to a smaller size of approximately $850 billion in assets by December 31, 2009, and would continue to decline by 10 percent per year until each reached an asset portfolio size of $250 billion.15 However, this would occur only in later years. Instead, Secretary Paulson announced that the government intended to grow these institutions over the next 15 months to provide assistance to the housing market.16
The Week the Investment Bank Died
In the wake of the partial nationalization of Fannie Mae and Freddie Mac, the already troubled credit markets began to completely freeze up. The government still did not directly act. Indeed, when the Federal Reserve met on September 16, it did not lower interest rates again; instead, it focused on the problem of commodity inflation, particularly high oil prices, to justify keeping rates at the then current level.17 Still, it was apparent that the credit market remained disrupted. This was a very different animal than the equity declines that had typified the financial crises of the past century. Unlike equity crises, the credit crisis was something that was harder for the public and regulators to see. But it was all about to burst into the open.
The Bankruptcy of Lehman Brothers and the Sale of Merrill Lynch
During the weekend of September 13, 2008, Lehman Brothers suffered from the same self-fulfilling feedback loops as Bear Stearns. On September 10, 2008, Lehman Brothers had preannounced quarterly earnings, with a loss of $3.9 billion for that quarter and gross asset write-downs of $7.8 billion. Lehman Brothers also announced on that day plans to hive off its troubled commercial real estate-related and other assets into a separate “bad” bank.18 The plan had been criticized as insufficient by many analysts.19 Rumors began to again circulate of Lehman Brothers’ inability to survive. These rumors quickly created their own feedback loop, as customers became concerned for Lehman Brothers’ survival.They began to pull assets from, demand collateral on counterparty trades from, and refuse to provide short-term repo lending to Lehman Brothers. By the weekend of September 13, Lehman Brothers’ liquidity position had significantly deteriorated to approximately $1 billion, and the company was facing a loan call by JPMorgan.20 Lehman Brothers was the next financial institution faced with insolvency if it could not find a buyer or obtain government backing. Initially, Bank of America and Barclays were interested buyers.
But Merrill Lynch had its own problems emerging at this time. After Lehman Brothers, Merrill Lynch was perceived as the next institution at risk of the five investment banks. Merrill Lynch’s CEO John Thain would later assert that if Lehman Brothers did not survive, his bank would be viewed as the weakest of the investment banks and subject to the same viral self-fulfilling feedback loops.21 The perception of the viability of the investment bank model was now in question. In light of the market turmoil and higher leverage ratios of these investment banks than more regulated bank holding companies, market participants were fearful of doing business with, investing in, or lending to these institutions. Market investors aware of this wariness began selling their stock in the investment banks, once again making it harder for them to raise capital and assuage investors.This led to further concern about the survival of these institutions.The feedback loop was whirring.
Fearful of Merrill Lynch’s survival and being stuck in such a loop, Thain, after heavy prodding by his own board, contacted Bank of America about an acquisition. Bank of America’s Ken Lewis quickly turned his attention from Lehman to Merrill, a much bigger catch. That weekend Merrill Lynch agreed to be acquired in an approximately $50 billion transaction by Bank of America.22 The acquisition agreement for Merrill Lynch, struck in this perilous time, was strangely normal and fairly typical of a deal struck in more normal times. Of course, the one thing that was probably different was the disclosure schedules. These are Merrill’s own disclosures, which qualify the representations and warranties in the agreement.The events included on the disclosure schedules are deemed not to be a material adverse change. The disclosure schedules are also not made public. Merrill had probably thrown everything and the kitchen sink onto these schedules to assure that there was full disclosure and a complete deal with little room for Bank of America to escape its obligation to acquire Merrill.
This left Lehman CEO Dick Fuld without a choice. Ken Lewis was refusing to return his calls, and Barclays was now the only willing buyer of Lehman Brothers. Barclays refused to acquire Lehman Brothers without government assistance. However, Secretary Paulson did not want the government to serve as a backstop for all financial institutions. Likely due to political reality, personal preference, and legal limitations on the government’s power, Paulson insisted that the private market find a solution to Lehman Brothers. Barclays was definitively thrown out of the race when its own British regulator, the Financial Services Authority, refused to approve an acquisition. Meanwhile, the major financial institutions refused (or were unable themselves) to assist Lehman Brothers directly.
Early Monday morning, September 15, 2008, Lehman Brothers’ holding company filed for Chapter 11 bankruptcy.23 Notably, most of Lehman Brothers’ subsidiaries did not file for bankruptcy, and on that Tuesday, Lehman Brothers agreed to sell its U.S. investment banking operations minus certain troubled commercial real estate-related assets to Barclays for a fire
sale price of $250 million.24 Still-aggrieved Bear Stearns shareholders no doubt felt a bit better about the low price they received for their sale. At least they had gotten something.
Many observers would accuse the government of making a mistake in failing to bail out Lehman Brothers, leaving its bondholders without recourse, the credit insurance that it had underwritten meaningless, and its significant issued commercial paper worthless. It was estimated that the “unplanned and chaotic” bankruptcy of Lehman destroyed up to $75 billion in value within Lehman alone.25 Lehman’s failure also caused the oldest and largest money market fund Reserve Primary Fund to break the buck, setting off a stampede as investors raced to withdraw funds from money market funds. This triggered a chain reaction that almost shut down the entire capital markets. In short, the collapse of Lehman led to a near implosion of the commercial paper market, a sharp decline in the stock market, and a financial panic. Regardless of whether Lehman Brothers should have been allowed to fail, it is still unclear that the government realized the extent of Lehman Brothers’ obligations. On the other hand, the drastic market reactions that flowed from Lehman Brothers’ failure ultimately drove the government to attempt to adopt a more comprehensive approach to the crisis.
But that approach had to wait. Secretary Paulson would later publicly state that the reason the government did not bail out Lehman Brothers was that it “did not have the power,” because Lehman Brothers lacked enough assets to provide sufficient collateral for a Federal Reserve loan.26 The government was clearly hamstrung here by the failure to have the power to simply seize Lehman. However, given the broad reach the Federal Reserve had previously interpreted its statutory authority to make loans in the context of the Bear Stearns matter, and would later interpret it to be, this explanation is not creditable.The government may not have been able to seize Lehman but the Federal Reserve could loan it money. Instead, it appears that Paulson was restricted from acting politically and wanted to make a statement about his willingness to bail out all financial institutions.