Sunday, October 5, 2008

Let Buffett Run the Bailout Or at least try and get the good deals he gets.

The Senate's approved version of the $700 billion financial rescue legislation, laden as it is with tax breaks and other help for special interests, begs a question: Who could run this huge fund of taxpayers' money without getting distracted by the power that comes with so much money and the potential for political interference?

Warren Buffett's name should be high on the list. Sure, the legendary investor and chairman of Omaha, Neb.-based Berkshire Hathaway almost certainly has more rewarding things to do. But it's worth a hypothetical look at how he might go about it.

To start with, he clearly thinks taxpayers could eventually do just fine with the Troubled Asset Relief Program, as Treasury Secretary Hank Paulson's rescue package is called. "I would love to have 1 percent of the action," he told CNBC on Wednesday-he said that was the most he could afford-and believes the rescue is likely to make money.

Provided, Buffett added, that the Treasury takes banks' troubled mortgage-related assets off their hands at market prices. That's a crucial caveat. In congressional testimony, Federal Reserve Chairman Ben Bernanke wavered on this point, suggesting the TARP fund might buy assets at above their current market prices.

How prices will be set for the TARP's purposes is an elephantine and as yet unanswered question. Buy at today's fear-laden market prices, and it could force banks that haven't yet written down assets sufficiently to take big losses-perhaps big enough to put them out of business, exactly what the plan is supposed to avoid. But buy at prices that are too generous, and the Treasury's plan would unjustly let the shareholders and executives of troubled banks off the hook while also making it less likely that taxpayers eventually make money on the deal.

This is where the TARP's recently added provisions for taking equity interests in banks come in-and where Buffett's deal-making skills, as recently demonstrated with both Goldman Sachs and General Electric, would matter most. The $5 billion that the Sage of Omaha invested in Goldman and the $3 billion he has stumped up for GE are in the form of dividend-earning preferred stock. In both cases, the preferred stock comes with warrants over an equivalent dollar amount of common shares-essentially, the right to buy shares at around the current price at any time in the next five years.

This is a neat structure for investors and representatives of taxpayers eager to protect against possible losses. It's much less risky than buying common stock, the owners of which receive no dividends until Buffett's are paid in full and who are first in line to take losses. And the warrants also amplify any upside as and when share prices rise.

There's a good argument that recapitalizing banks this way, rather than buying dodgy assets at all, would be the most efficient use of taxpayers' money. But the TARP as it stands involves both elements. The advantage of taking investments through preferred stock and warrants as well as buying assets is that it makes the asset pricing question slightly less critical.

Why? If the Treasury fund buys mortgages and other distressed securities at prices that are painfully low for banks, at least the banks can expect a capital infusion to help cover losses. And if the fund's managers are too generous, they stand to collect at least some of the difference by sharing in banks' stock price gains.

Buffett also appears to have scored bargains. Aside from collecting 10 percent dividends on his preferred stock investments in both Goldman and GE, his warrants to buy their shares are worth, according to standard option pricing models, billions extra.

The idea is catching on. In return for backstopping certain losses on Citigroup's purchase of Wachovia's banking operations, the FDIC collected $12 billion in Citigroup preferred stock and warrants.

Buffett said during his CNBC appearance that the House of Representatives should pass the TARP this time around-he called the state of financial markets "a national emergency." Assuming that happens, Paulson will have to work out how to put the legislation into practice. The lessons from Goldman, GE, and Citigroup may help in part. And while he may not be able to have Buffett, it could well make sense to try to think like him.

By Richard Beales Posted Thursday, October 2, 2008 - 12:39pm [the_big_money171:]

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