The PIMCO Assistance Program

The Treasury released the terms of the PIMCO Assistance Program (“PAP”) today.

Executive summary:

• How much?
  Between 1% and 2% of “risk-weighted assets” per bank.  For the larger banks this will be tens of billions of dollars.  (But then, this is just the initial pass.)
• What do we taxpayers get?
  “Preferred shares” with a face value equal to our investment, plus warrants to purchase 20% of that value in common stock at the  “conversion price” (see below).  The preferred shares pay a 9% annual dividend and must eventually be repaid in full.  Except…
• Except what?
  …the preferred shares are convertible into common stock at the “conversion price”, defined as 10% below the bank’s average stock price for the 20 trading days ending Feb 9.  Conversion is at the option of the issuer; i.e., the bank.  After conversion, we no longer get our preferred dividend, nor are we owed our money back.  (Although we do then own common stock at a “10% below Feb 9” cost basis.)

By the way, Feb 9 was the high point for all of these bank stocks during the month of February.  What a coincidence.

Remember when Warren Buffett made preferred stock investments in Goldman Sachs and General Electric?  Those had somewhat similar terms (preferred stock + warrants), except the firms had no option to convert the preferred shares into common stock.  So while Buffett gets to participate in the upside and is somewhat protected on the downside, we taxpayers get to participate in both.  The option to convert means that if things go badly, we join the common shareholders as first in line to bear any losses.  But hey, what are the odds?

Simply put, these terms protect bondholders — and even existing preferred shareholders! — from taking any losses whatsoever until after we have lost our entire investment.  Private equity and even sovereign wealth is just not stupid enough to make this sort of investment.  So the U.S. taxpayer gets to do it instead.

These terms are pretty bad; should I be grateful that they could have been worse?