In Paulson We Trust

Focused on the election? Might be a good idea to watch your pockets at the same time. Here's a glance at what's happening to the Wall Street bailout.

Hank Paulson is, no doubt, the most impressive of the Bush administration cabinet members (admittedly not a high bar). He made hundreds of millions on Wall Street, ascending to be the head of Goldman Sachs. Now, as Treasury secretary, he has brought in colleagues from Goldman to help manage the $700 billion bailout of troubled Wall Street banks, including Goldman, and... Wait one minute. Doesn't something ring false here? Hank Paulson no doubt is honorable, but even he has conflicted interests.

When the bailout bill was before Congress, a number of outside groups, including the Campaign for America's Future, pushed hard for the bailout to be managed by an independent agency, with an empowered board that included independent representatives of workers and consumers. Whatever the form of the bailout—Paulson's initial demand for $700 billion left that undefined—it was vital that the transactions be accountable to more than once and future bankers.

And now we know why. After initially proposing to buy toxic securities from the banks at inevitably elevated prices, Paulson sensibly decided to follow the British model and inject capital directly into the major banks in exchange for equity. The first nine banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Bank of New York Mellon and State Street Corporation—are getting $125 billion. This, plus a guarantee of new debt over the next three years, is designed to reassure other banks of their solvency, and hopefully get them to resume lending to one another and to businesses.

But Paulson didn't exactly cut a great deal for taxpayers. He didn't get the terms that Warren Buffett demanded, putting up a lot less cash, to invest in Goldman Sachs. And as a New York Times editorial complained [1], he made government a passive investor, leaving in place the boards and the directors that led their banks into crippling losses.

Paulson made no demands that the banks begin lending again instead of just hunkering down, girding for future losses. And remarkably—unlike the British—he didn't demand that the banks stop paying out dividends to shareholders. Nor is it clear that bank regulators will perform the triage needed, merging and purging the banks of excess capacity.

That failure is likely to be very costly to taxpayers and very generous to the very folks who led us into this mess. In a New York Times op ed, [2] David S. Scharfstein and Jeremy C. Stein show that dividends, if paid at current levels, will redirect more than $25 billion of the $125 billion to shareholders in the next year alone. One in five dollars will go out the door, and thus be unavailable to plug the large capital hole on the banks' balance sheets.

Will those dividends be paid? Most likely, since the directors and officers of the nine banks are leading shareholders. Scharfstein and Stein estimate their personal take will amount to $250 million in the first year, nothing to sneeze at.

Worse, Paulson does nothing to curb the bloated compensation levels that characterized Wall Street in the days of debauch. Jonathan Weil of Bloomberg News shows the effect [3]. Morgan Stanley, for example, gets $10 billion in taxpayer dollars. Yet this year it has racked up $10.7 billion in employee compensation—the vast majority not yet paid out—even as its stock market value plummeted $34.7 billion since the beginning of the company's fiscal year. With taxpayers' help, Morgan Stanley may well pay those bonuses.

Weil reports that the "five families of Wall Street"—Goldman, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Sterns—lost about $83 billion in stock market value from the start of the 2004 fiscal year. At the same time, they reported about $239 billion in employee compensation. For every dollar of shareholder value destroyed, the employees pocketed almost three. And that was before they got taxpayer money.

No one doubts that the bailout is needed to prop up the global economy. But under Paulson's plan, we may end up, in Weil's words, "throwing money at an industry that pays too many people more than they're worth, to perform services the world has too much of already."

What's needed is an independent agency with summary powers and an independent board, to work with the Federal Deposit Insurance Corporation and other agencies to sort out the solvent banks from the broke, those that need to be saved from those that should fail. And, as in the Chrysler bailout, a suspension of dividends to shareholders until the government has been repaid.

Now maybe Paulson is making the best choices possible given the extent of the crisis. He's got more information and is far better banker than the rest of us. But with $700 billion in taxpayers' money at stake, surely it would be wise to have an independent board that can hold him accountable.