Richard Bernstein of Bank of America-Merrill Lynch Says: Sell Financial Stocks

Richard Bernstein, the Chief Investment Strategist of Bank of America Securities-Merrill Lynch has some pretty eye-catching advice. He urges investors to take profits from today's 12-point rally in the financial sector.

Treasury Secretary Tim Geithner's plan for public/private collaboration in the purchase of mortgage-related investments from banks and other financial institutions sent the market soaring. Bernstein, however, says that the surge will not last, and that consolidation in the sector is the only way of stabilizing it and ensuring a recovery:

Removing devalued loans and securities from banks’ balance sheets is a short-term solution that will delay the problem’s ultimate solution, which is bank takeovers, Bernstein said. The government won’t be able to inflate the prices banks receive for selling bad assets indefinitely, he added.

“The history of bubbles shows quite well that financial sector consolidation is inevitable,” Bernstein, Bank of America’s chief investment strategist, wrote in a research note. “Financial stocks will be attractive when the government tries to speed up that inevitable process. However, to the contrary, the government continues to attempt to stymie that inevitable consolidation.”

Since 2007, Bank of America has acquired Countrywide, Merrill Lynch, ABN AMRO North America, and La Salle Bank. Apparently, it might want gobble up some more banks -- in the name of efficiency, of course.

Surprise, Surprise: Potential Participants in Toxic Assets Plan Ask Government to Stay Away From Executive Compensation

Today, Treasury Secretary Tim Geithner will begin marketing his plan to encourage private investors to partner with the government and purchase nearly $1 trillion in "troubled" mortgage-backed assets from financial institutions. The government's plan rests on the assumption that the troubled assets actually have value, but because the market cannot accurately measure their value, the assets are causing a credit collapse. After the assets are removed from companies' balance sheets, credit will flow once again. Also, once the market realizes the value of the assets, the government (i.e., taxpayers) and private investors will enjoy profits from their investments.

The New York Times reports that some potential investors fear that the government will regulate the compensation of executives who participate in the plan. Given the outrage over AIG, their concern is legitimate:

[S]ome executives at private equity firms and hedge funds, who were briefed on the plan Sunday afternoon, are anxious about the recent uproar over millions of dollars in bonus payments made to executives of the American International Group.

Some of them have told administration officials that they would participate only if the government guaranteed that it would not set compensation limits on the firms, according to people briefed on the conversations. The executives also expressed worries about whether disclosure and governance rules could be added retroactively to the program by Congress, these people said.

Obama administration officials tried to allay those fears on the Sunday news circuit:

Administration officials took to the airwaves Sunday to reassure investors that the public would distinguish between companies like A.I.G., which are taking government bailout money, and private investment groups that, under this latest plan, would be helping the government take troubled assets off the books of some of the country’s biggest banks.

“What we’re talking about now are private firms that are kind of doing us a favor, right, coming into this market to help us buy these toxic assets off banks’ balance sheets,” Christina D. Romer, the White House’s chief economist, said in an interview on “Fox News Sunday.”

“I think they understand that the president realizes they’re in a different category,” she said, adding, “They are firms that are being the good guys here.”

Nice try, but . . .
The "good guys" language undermines the government's position that the bailout is policy - not handouts to wrongdoers. It also conflicts with the government's previous opposition to meaningful limits on executive compensation. If the new investors are "good guys," while TARP participants are "bad guys," then the government has a good reason to regulate compensation for the latter.

Finally, I suspect that many of the "good guys" will come from the "bad guys'" industry. The world of sophisticated financial investors is tiny. The people with knowledge, resources, and professional credentials to manage and organize the proposed purchase of troubled assets will undoubtedly have worked in institutions that hold these same assets; they could even have work experience designing and marketing the very securities that have spread so much risk across the market. For this reason, some type of disclosure process seems relevant.

Also on Dissenting Justice:

Tangled Webs: Goldman Sachs, AIG and the Feds

Professor Balkin Defends Constitutionality of Bonus Tax

Richard Bernstein of Bank of America-Merrill Lynch Says: Sell Financial Stocks

Tangled Webs: Goldman Sachs, AIG and the Feds

Goldman Sachs Chief Financial Officer David Viniar held a conference call with journalists yesterday in an effort to calm a growing storm over the company's relationship with AIG. Goldman, like other investment banks, invested in and marketed "mortgage-backed securities," which AIG "insured" with "credit-default swaps."

The implosion in mortgage-related financial instruments, however, caused AIG to suffer enormous losses. The company ultimately required a massive governmental bailout because it lacked the resources to cover other companies' investment risk.

Goldman, AIG and TARP
After refusing to do so for many months, AIG recently released the names of companies it paid using TARP assistance. According to the disclosure, AIG has paid Goldman $12.9 billion.

Seeking to mute speculation that the federal government bailed out AIG in order to funnel billions of dollars in TARP assistance to Goldman, Viniar insists that even if AIG had entered into bankruptcy, Goldman would not have suffered financially. Viniar says that Goldman hedged its market exposure through agreements with third parties and had already received $7.5 billion in collateral from AIG prior to the company's insolvency.

But Viniar's comments raise other concerns. First, even though Goldman hedged its risks using third parties and had received collateral from AIG, it is possible that it would have received less money in a bankruptcy proceeding. Second, the close relationship between financial regulators and Goldman will undoubtedly create a wall of suspicion around the company, regardless of whether it benefited from the bailout. This suspicion will only grow deeper if it turns out that the government's decision to keep AIG alive helped Goldman, just as its decision to let Lehman Bros. implode necessarily helped Goldman because it removed one of the company's chief competitors from the market.

Bankruptcy versus Bailout
AIG avoided bankruptcy because of the federal bailout. If AIG had entered into bankruptcy, it is unclear whether Goldman would have recovered the same amount of money. For example, the government financed AIG's purchase of $5.6 billion in securities related to its agreements with Goldman. At the time of the purchase, however, the market value of the securities was 1/2 less than the contract price. Had AIG been in bankruptcy, it is highly unlikely that a judge would have allowed AIG to pay Goldman a price that greatly exceeded market value.

Also, a bankruptcy judge could invalidate (as a "voidable preference") the transfer of collateral or money from AIG to Goldman if the transfer took place within 90 days of the filing of the bankruptcy petition. Bankruptcy law disfavors payments to creditors on the eve of bankruptcy because they tend to benefit more powerful creditors and frustrate the underlying policies of bankruptcy law, which include the distribution of the debtor's assets to all creditors in proportion to the debt owed them. Early payments to an individual creditor could drain the debtor's resources and make them unavailable for a proportional distribution. It is unclear whether Goldman could have recovered from third-parties the same amount of money it obtained from AIG, but it is definitely debatable whether it could have extracted the same amount from AIG had the company entered into bankruptcy.

Tangled Web
Viniar's conference call will likely lead to greater scrutiny of Goldman's relationship to AIG because many influential politicians and banking industry executives have connections to Goldman and to the Treasury Department -- the federal agency that administers TARP.

Henry Paulson, Secretary of Treasury during the Bush administration, is a former Chairman of Goldman Sachs. Paulson was responsible for administering TARP, and he had a large role in structuring the legislation.

Robert Rubin, Secretary of Treasury during the Clinton administration, was a Co-Chairman of Goldman (along with Stephen Friedman -- see below) before he earned a Cabinet post. Although Rubin does not have a formal position in the Obama administration, he has served as an informal economic advisor to the President. Also, current Secretary of Treasury Tim Geithner worked as an assistant to Rubin (and later to Lawrence Summers -- former Secretary of Treasury and current head of Obama's National Economic Council) when he headed the agency. Paulson was also a partner at Goldman when Rubin was Co-Chairman.

Mark Patterson, Geithner's Chief of Staff, is a former lobbyist for Goldman. Obama waived his anti-lobbying rules in order to secure the job for Patterson.

Tim Geithner, current Secretary of Treasury, served as the President of the Federal Reserve Bank of New York until his current position. In that capacity, he helped to structure the federal bailout of AIG. Geithner, unlike many of the other individuals listed in this article, never worked at Goldman, but he worked for Rubin during the Clinton administration and for Summers, who replaced Rubin. Summers heads Obama's National Economic Council.

Stephen Friedman, the current Chairman of the Federal Reserve Bank of New York, was the Co-Chairman of Goldman with Rubin, and he has held several other executive positions at the company. In his current position, Friedman presumably will have a significant role in the ongoing federal bailout of AIG. Friedman also sits on the board of directors of Goldman.

Update: After discussing this issue with a friend of mine, I have an additional comment. Assume that the AIG bailout was a wise policy decision that coincidentally benefited Goldman. This still does not explain the differential treatment of Lehman Bros.

Although I mention the disparate treatment of Lehman Bros. in the original essay, I primarily discuss why bailing out AIG helps Goldman. But allowing Lehman Bros. to collapse helped Goldman tremendously, because it eliminated one of its main competitors. The deeper story may lurk behind this issue.

Senator Dodd Fights Back: Says Obama Administration Pressured Him to Change a Provision He Sponsored That Would Have Banned AIG's Bonus Payments

Yesterday, a few bloggers reported that Senator Christopher Dodd inserted an amendment to the bailout that strengthened the constraints on executive compensation for companies that receive TARP assistance, but which did not apply retroactively. That story -- as other bloggers and the media suggested earlier today -- is not completely true.

Dodd has set the record straight on the issue, and his account parallels media descriptions of the proposed amendment that were first published in February. Dodd certainly introduced an amendment to the stimulus package which would have toughened restrictions on executive pay, but the measure would have applied retroactively.

After Dodd proposed his amendment, White House and Treasury Department officials publicly stated their disagreement with the measure. The Treasury Department had previously issued a weaker regulation that was made even weaker because it only applied prospectively to companies that had not received any TARP assistance.

Dodd's amendment, however, passed in the Senate. But when the final bill emerged from the conference committee, the language making Dodd's amendment retroactive had vanished.

Dodd now confirms that the Obama administration pressured him to delete the retroactivity clause while negotiators worked on the final version. Dodd says that he feared losing the executive compensation provision altogether, and this made him compromise with the Treasury Department (which undoubtedly spoke for the President).

The Huffington Post has the full story. Here is a clip:

The Treasury Department demanded that Sen. Chris Dodd insert exemptions into the stimulus bill that allowed bailout recipients to receive bonuses, the Connecticut Democrat said on Wednesday.

According to Dodd, officials at Treasury expressed concern that if the government were to prohibit payouts, it risked being sued by companies like AIG, which had contracts stipulating that bonuses were to be paid.

At the urging of Treasury officials, Dodd modified a clause he had previously inserted into the stimulus that prohibited bonuses from being issued by bailed-out companies. An exemption was added to allow bonuses that applied to in-place contracts.

Fascinating.

Feds Converts Value of AIG Bonuses Into a Short-Term Loan: Geithner Says He Will Deduct $165 Million from AIG's Next TARP Installment

Treasury Secretary Tim Geithner has announced that the government will deduct the amount of the controversial bonuses AIG has paid its executives from the company's next TARP installment -- a sum of $30 billion. That deducted amount only represents approximately .55% of the money AIG is slated to receive from the government.

Geithner's decision looks more like a "short-term" loan than a solution to the controversy. AIG has borrowed and will continue to borrow TARP funds. The government has decided to take back the dollar value of the bonuses at the time of the next installment -- which is the same thing as a decision to accelerate AIG's "loan" repayment schedule in the amount of $165 million.

My Guess: The President wants this thing to go away -- NOW. This decision could help put the matter to rest, but nothing is certain with this story.

Paulson, Geithner and Rubin: How the Big Three "Hooked Up" Citigroup

Citigroup has received a massive federal bailout -- the largest to date, in fact. Today's Washington Post examines how a powerful trio of men -- Paulson, Rubin and Geithner -- worked to secure the deal. Turns out that Robert Rubin -- former Secretary of Treasury under Clinton and a Director of Citigroup -- is an old colleague of Paulson back from their days together at Goldman Sachs. Geithner, Obama's pick as Secretary of Treasury, worked for Rubin in the Clinton administration. Rubin made several calls to Paulson pressuring -- I mean persuading -- him to make a really big move with respect to Citigroup. Although it does not appear that Paulson will have a role in the Obama administration, Geithner will, and Rubin has acted in an advisory role for the president-elect on economic issues. Furthermore, Summers, Obama's Chief Economic Advisor, is a protege of Rubin. Could turning to these guys to fix the economy amount to "disease as cure"?

Read more here: Washington Post on Citigroup.

Obama Might Abandon Campaign Promise on Taxes, Names Economic Team; Plus: Rubinomics and Citigroup

Obama Names Economic Team
Although the rumor mill had already leaked the information, Obama named his economic policy team today. Tim Geithner will head the Department of Treasury, while his mentor Larry Summers will serve as the Director of the National Economic Council. Christina Romer will head the Council of Economic Advisors.

Source: CBS News

Rubinomics?
Members of the Democratic Wing of the Democratic Party are already up in arms over some of Obama's staffing decisions. Today's New York Times adds more coals to the fire in an article that links Obama's economic team with Robert Rubin, who served as Secretary of Treasury to Bill Clinton. Liberals and progressives blame "Rubinomics" for free trade and deregulation, which they argue caused job losses and the current credit crisis. The article states that:

The president-elect’s choices for his top economic advisers — Timothy F.
Geithner as Treasury secretary, Lawrence H. Summers as senior White House
economics adviser and Peter R. Orszag as budget director — are past protégés of
Mr. Rubin, who held two of those jobs under President Bill Clinton. Even
the headhunters for Mr. Obama have Rubin ties: Michael Froman, Mr. Rubin’s chief
of staff in the Treasury Department who followed him to Citigroup, and James
Rubin, Mr. Rubin’s son.

All three advisers — whom Mr. Obama will officially name on Monday and
Tuesday — have been followers of the economic formula that came to be called
Rubinomics: balanced budgets, free trade and financial deregulation, a
combination that was credited with fueling the prosperity of the 1990s [Editor:
And the recession of the 2000s].

Source: New York Times

Speaking of Rubin: Citigroup Gets Largest Bailout Package to Date
Citigroup, the troubled financial conglomerate where Rubin serves as a Director, will receive the largest federal bailout of any financial institution to date during the present credit crisis. Under the plan, the government will give Citigroup at $20 billion cash infusion and insure losses on the bank's $300 billion portfolio of bad debt -- largely from risky mortgage instruments. Geithner helped negotiate the bailout pursuant to his role as Chair of the Federal Reserve Bank of New York.

Source: Los Angeles Times

Obama: "No New Taxes"
Taxation became a major debate issue during the general-election campaign. McCain promised to cut taxes for the "middle class," but he also said he would maintain Bush's controversial tax cuts for high-income earners. Obama, by contrast, promised to cut taxes for the middle class, but raise taxes on upper-income earners in order to fund his social programs and to prevent an explosion in the deficit. Many economic experts argued that both candidates' plans (which involved higher spending and fewer taxes) would increase the deficit. McCain's plan, however, would cause greater injury to the deficit because it would not involve any tax increases (as would Obama's).

Now, less than one month after the election, it seems that Obama's tax plan suddenly looks like McCain's. According to Reuters, Obama's team is now considering abandoning its plan to impose new tax increases due to the poor state of the economy. Wasn't the economy bad a month ago?

Source: Reuters