COMMENT Paulson still doesn't get it
By Peter Morici
Once again, we have good news and bad from Wall Street.
US Treasury Secretary Henry Paulson has announced that Citigroup and three
other banks will begin issuing covered bonds in an effort to rejuvenate
commercial bank mortgage lending and the housing market.
Concurrently, Merrill Lynch announced it is taking yet another big write down
on its subprime securities, selling paper with a face value of US$30.6 billion
to private equity firm Lone Star for $6.7 billion. It will dilute its common
stock 38% through the sale of additional shares to make up the losses.
Paulson's covered bonds would be backed by specific mortgages
held by the banks. In essence, these would be large certificates of deposit.
Though not necessarily insured, the bonds would be backed by specific assets on
the banks books, and the banks would to take steps to ensure these mortgages
were good - not the junk Merrill Lynch, Citigroup and others have been hoisting
on investors.
Whether the bond market accepts these securities - essentially whether
insurance companies, pension funds and other fixed-income investors take the
plunge - comes down to trust in the banks. Recent events at Merrill Lynch,
Citigroup and others indicate that such trust will require a bold leap of
faith.
The basic problem at the big banks is compensation schemes that encourage bank
executives to make risky bets that allow them to profit when things go well and
to push the losses on bond and stockholders when things go sour. Upon taking
over Merrill Lynch, John Thain increased executive bonuses but established a
risk management scheme. That hasn't worked.
At Citigroup, chief executive Vikram Pandit is selling off assets to cover
losses, but he has not given back the $165 million he took from shareholders in
his sale of the Old Lane hedge fund to his employer. The bank subsequently took
more than $200 million in losses, yet the Citigroup bonus machine continues to
payout to its executives.
USB is under investigation for fraud in the sale of auction rate securities.
It seems hard to find a major bank without some a record of sharp practices.
Paulson is trying to sell trust in the banks with his new covered bonds. It's
tough to sell trust in a Wall Street bank these days because there is not much
to trust.
An insurance company that buys Paulson's covered bonds will likely be all
right, but it is taking an imprudent risk. That should tell you something about
the competence of its management, and it would be signal to dump its stock.
Paulson's scheme to reopen the bond market to banks for mortgage lending will
only work, if the commercial banks clean up the management practices that
caused the subprime crisis, and massive losses imposed on shareholders and bond
customers.
The federal government is imposing new a regulator on Fannie Mae and Freddie
Mac, which will have authority to regulate executive compensation. The Federal
Reserve has loaned hundreds of billions to Wall Street banks and securities
companies without any real commitments for management reform. The asymmetry is
puzzling.
Paulson will only get the mortgage market, housing crisis and economy turned
around when he resolves the confidence gap on Wall Street. That requires
systemic reform in the business practices and compensation structures. What's
good for Fannie and Freddie would be good for Citigroup, Merrill Lynch and the
others.
Peter Morici is a professor at the University of Maryland School of
Business and former chief economist at the US International Trade Commission.
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