Undercover Economist

Why US banks and taxpayers owe big thanks to Hank

On October 13 2008 – a public holiday in the US – the Treasury Secretary of the day, Henry “Hank” Paulson, summoned bank bosses to a meeting and made them an offer they couldn’t refuse: $125bn of taxpayers’ money in exchange for equity in nine US banks. Some banks, such as Citigroup and JP Morgan, received as much as $25bn each. The Treasury also guaranteed new issues of bank debt. It was a bail-out of enormous value to bank shareholders and bondholders, so it can hardly be a surprise that the Obama administration is planning to try to get the money back with some kind of levy.

But how much did the banks benefit from Hank Paulson’s “gift”? Did the policy have the desired effect? If so, why? All these questions are answered in research carried out by Pietro Veronesi and Luigi Zingales, economists at the University of Chicago, updated last month. One fascinating conclusion is that Paulson, a former chief executive of Goldman Sachs, may have missed a huge money-making opportunity.

The plan apparently stabilised the financial system in the short run; in the long run, it may have the opposite effect by encouraging some future generation of bankers to take more risks. Both these effects are impossible to quantify.

Veronesi and Zingales restrict themselves to the narrower question of whether the gain to bank shareholders and bondholders outweighed the loss to the US taxpayer. (Perhaps that sounds like a low threshold. It isn’t: most government protection costs the taxpayer or consumer far more than they ever benefit the beneficiaries – witness almost every trade tariff in history.) They conclude that shareholders and bondholders in the banks were about $130bn better off as a result of Paulson’s gift. Taxpayers stumped up less than that, taking a loss of perhaps $20bn-$45bn. As much as $5 may have been gained for every tax dollar spent. Infuriating as it may be to those taxpayers who had no desire to write a cheque to bank bondholders, it may be some consolation that the policy was terrific value for money.

It is no surprise that injecting cash into banks would increase the wealth of their shareholders and bondholders. What is less obvious is why the effect was so large. Veronesi and Zingales believe the gift prevented runs on the banks, the risk of which was depressing bond and share prices. A bank run is a situation where a bank can be bankrupted simply on the strength of the fear that it might happen. If a government guarantee can relieve such panic, it can create great value at little cost. And, indeed, the banks that gained most from Paulson’s gift are also the banks that were in imminent danger of a run.

The mix of guarantees and equity injection also appears to have been superior to most of the other ideas floating around at the time. The original idea behind the Troubled Asset Relief Program (Tarp) was to buy assets from the banks, apparently at market value. This would have required a cool $4,000bn of purchases and subjected the taxpayer to enormous risks – and profit opportunities. A straight equity injection also looks expensive and would have required near-nationalisation of many banks.

Pats on the back all round then. But one lingering question: if the plan created such gains, why didn’t Paulson ask for more from the banks, as Warren Buffett had done three weeks earlier when he invested in Goldman Sachs? Veronesi and Zingales reckon that if Paulson had secured the same terms as Buffett, the taxpayer would have made more than $40bn, a roughly even split with the banks’ creditors. Easy to say now – but it would have made a big difference to the politics of the bail-out. No wonder the Treasury is drawing up a bill for services rendered.

Also published at ft.com.