Paulson’s Gift

The U.S. government's response to the financial crisis in the fall of 2008 created enormous value for banks and saved a few that were on the brink of bankruptcy.

On Monday, October 13, 2008, the chief executive officers of the country's largest banks were summoned to a meeting in Washington DC. The call came just days after the worst weekly decline in U.S. stock market history. At the meeting, then U.S. Treasury Secretary Henry Paulson announced a plan that reportedly took the CEOs by surprise. The plan was to inject a massive $125 billion in preferred equity investment in the country's top banks and provide them with various guarantees — an unprecedented move that would hopefully restore stability to a tumultuous financial market.

Much controversy followed on whether this was the right thing to do and whether the U.S. government should have stepped in at all. From an economic point of view, government involvement may be warranted only if it achieves something that the market cannot do on its own. For this to be true, government intervention would have to create value rather than merely redistribute money from taxpayers to banks.

A recent paper titled "Paulson's Gift" by Chicago Booth professors Pietro Veronesi and Luigi Zingales finds that the financial rescue plan announced by Paulson on October 13, 2008, indeed created value. The plan affected the country's 10 largest commercial banks, including Wachovia, which was purchased by Wells Fargo, and three former investment banks: Goldman Sachs, Morgan Stanley, and Merrill Lynch. In particular, Paulson's plan increased the value of banks' financial claims—debt, equity, and derivative liabilities—by $130 billion. Accounting for what the government spent for the rescue plan, which was between $21 billion and $44 billion, the authors find that the plan produced a net gain of $86 billion to $109 billion.

The likely reason why Paulson's plan appeared to have created value is that it prevented a disastrous run on the banking system that, according to the paper's estimate, would have destroyed 22 percent of a bank's enterprise value. Unlike a traditional run on deposits, a bank's short-term creditors can run on a bank by refusing to roll over loans if they fear other creditors will do the same, which can quickly make a bank insolvent. The fear of a run can be self-fulfilling. Thus, successfully stopping a run on banks can create significant value.

In spite of its success, the plan ended up being very expensive for taxpayers. "The terms of the deal were very friendly to banks," says Zingales. Moreover, the authors think that a bankruptcy procedure that allows banks to restructure their debt would have been a better strategy to repair insolvent banks. In the long run, the success of Paulson's plan underscores how tempting it is for the government to intervene, which encourages banks to take on more risk. “The results exacerbate the perception that banks are too big to fail,” Zingales says.

Evaluating the Gift

The financial rescue plan that Paulson presented to bank CEOs on October 13, 2008, had three parts.

The first was a $125 billion preferred equity investment in the 10 largest U.S. commercial banks. In exchange for this capital infusion, the government would get preferred stock with a nominal value equal to the amount invested and which would pay a dividend of five percent for the first five years and nine percent thereafter. In addition, the government would receive a warrant equal to 15 percent of the value of preferred stock with a strike price equal to the average stock price 20 working days before the money is invested. The second part of the plan was a three-year Federal Deposit Insurance Corporation (FDIC) guarantee for all new issues of unsecured bank debt until June 30, 2009. The third part provided full FDIC insurance coverage on all non-interest-bearing deposits.

The study analyzes the impact of Paulson's plan by looking at the change in the market value of banks' equity, debt, and derivative liabilities before and after the announcement. The technique of looking at the impact of a news event on equity prices was invented many years ago by Chicago Booth professor Eugene Fama. But while this standard technique has been applied in many ways it has mostly eluded bonds. When a company is very highly leveraged, as is the case with a bank, bond prices tend to be very sensitive to the value of the underlying assets. However, corporate bonds are not very liquid so price changes are very difficult to measure.

Veronesi and Zingales are the first to undertake a proper event study on bonds using credit default swaps (CDS). A CDS is insurance against the risk that the company that issued a bond will default. The party that buys this insurance has to pay a premium called a CDS rate. A CDS becomes more valuable as the risk of default rises and vice versa. Thanks to an increasing trading volume of CDS in recent years, daily movements in the CDS rates can provide a reliable measure of changes in the value of the underlying bonds. Thus, the authors were able to analyze the impact of the plan on the banks’ total financial claims, not just equity. This is important because debt holders are expected to gain the most from Paulson’s plan.

Looking at the changes in bank CDS rates between October 10 and October 14, 2008, and at the same time controlling for movements in the CDS rate of the largest financial firm that was not involved in the intervention (GE Capital), the study finds that bond holders of the 10 participating banks gained $120.5 billion from the announcement of the Paulson plan. Citigroup and the three former investment banks gained the most.

The banks' equity holders lost $2.8 billion, but there is a wide variation within the group. JP Morgan Chase's shareholders lost $34 billion while shareholders of Citigroup and Goldman Sachs gained roughly $8 billion each. The value of preferred equity rose by $6.7 billion. Because the majority of derivative contracts are traded between the top banks and these transactions are highly collateralized, the increase in the value of derivative liabilities was a modest $5.3 billion.

Overall, Paulson's plan boosted the value of banks' financial claims by about $130 billion, with most of the gains accruing to debt holders. This is not surprising since banks are highly leveraged and carry only a very small share of equity. Long-term debt holders, in particular, stand to gain the most from an intervention because they tend to receive very little in the event of a run.

The bulk of the cost to taxpayers of this plan is the difference between the $125 billion capital infusion and the value of the preferred equity and warrants that the government gets in exchange for the deal. The expense of guaranteeing new unsecured debt for three years also is substantial, which is equivalent to what the banks save by not having to insure their own debt. There is a relatively small cost to extending the FDIC deposit insurance to all non-interest-bearing accounts. On the other hand, the intervention itself makes deposits somewhat safer and the FDIC insurance a little less costly. Altogether, the authors estimate that the cost to taxpayers was between $21 billion and $44 billion.

Adding up all the gains and costs, the authors find that the net benefit of Paulson's plan was about $86 billion to $109 billion.

A Run on Short-Term Debt

The announcement of a government intervention increased the value of banks' financial claims by an amount far greater than the cost of the subsidy. Veronesi and Zingales believe this is because some banks were at risk of a run, and therefore benefited enormously from Paulson's plan.

To measure the risk of a run the authors developed an index based on the difference in the probability of default embedded in the one-year and two-year CDS rates. The likelihood of a bankruptcy usually increases over time because there is more uncertainty in the value of assets far in the future. However, if an otherwise healthy bank faces the risk of a run, then the probability of bankruptcy in the near term would be higher than in the future, assuming that the bank survives. In this case, the bank run index would be positive.

Indeed, the study finds that on the three days before the announcement of Paulson's plan, Citigroup's and the three former investment banks' bank run indexes were positive, suggesting that these four institutions were at risk of a run. Interestingly, the banks that were more at risk as measured by this index also gained the most value from the intervention. "The biggest beneficiaries of the plan were the banks that were in bad shape at that time," Zingales says.

The Price of Success

Although Paulson's plan successfully prevented a bank run, the taxpayers did not capture any benefit. In fact, they paid between $21 billion and $44 billion to help the top 10 banks.

Just three weeks before the intervention was announced, Warren Buffet invested in Goldman Sachs but obtained better terms: a 10 percent coupon on preferred equity and a strike price on a warrant that is 8 percent below the closing price before the announcement, compared with the government's 5 percent coupon and a strike price at market price after the announcement of the intervention. Had it asked for the same terms as Buffet, the government would have walked away with 30 to 40 percent of the value created by the plan without having to pay a single dollar. However, because it was important to the government to get all banks on board it may not have had room to negotiate for more favorable terms.

Paulson's plan was superior to the original intention of buying banks' distressed assets, according to the authors' estimates. In fact, it would have been necessary to spend between $3.1 trillion and $4.6 trillion to buy those assets to achieve the same effect, that is, the same drop in CDS rates. While the expected cost to taxpayers of this alternative is zero because the transactions would have been done at fair value, it is a much riskier strategy. The government could lose up to half a trillion dollars. A pure equity infusion also is riskier and more expensive, and the government would end up owning 40 percent of the banks.

On the other hand, a debt-for-equity swap along the lines proposed by Zingales in previous papers clearly dominates Paulson's plan. If an otherwise healthy company goes into bankruptcy because it has too much debt, then converting debt into equity can be a viable solution. The same could be done for banks. However, this would require a change in bankruptcy law to allow and expedite such a process for financial institutions, something which Zingales feels would have been justified given the extraordinary scale of the crisis.

The long-run consequence of the success of Paulson's plan is that banks know, perhaps more than ever, that it is almost impossible to tie the government's hands in the future. "The pressure for government to intervene is irresistible," Zingales says. Banks will have an incentive to take on more risk if they know that the government will not let them fail, which makes it even more important to find the most effective ways to curb those incentives in order to prevent a future crisis.