Treasury Bailout Terms Better Than Buffett's

Can I please be a bank? I want to be able to borrow money from the U.S. Treasury on the same remarkably sweet terms as the $125 billion that will be lent to nine leading banks, announced Tuesday as part of the government's Troubled Asset Relief Program. Another $125 billion will be available to other banks in the future.

I'm not objecting. If we're going to rescue the banking system, let's really do it. Enough of these "Saturday night massacres" in which the Treasury, the Federal Reserve and the FDIC gang up on helpless companies like Bear Stearns, Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG), Lehman, Merrill Lynch (MER), Washington Mutual and Wachovia (WB) -- and destroy them while pretending to rescue them.

This latest move is different. It's really a bailout. You may not think it's fair to prop up banks and brokers that have gotten into trouble, but we're way beyond that kind of emotionalism. If you can't hear what the crashing stock markets of the world are trying to tell you, it's that the banking system desperately needs a real rescue, whether it's fair or not. There's no choice about it.

The only choice is whether we do it right. And after six months of doing it wrong -- destroying banks and brokers, and each time creating the conditions that will make it necessary to destroy another one -- we're finally doing it right.

The banking system can do a lot with $250 billion, especially when you remember that banks typically hold assets that are multiples of their capital base. If you assume a 10-to-1 capital ratio, that means the banks will be able to use the $250 billion to acquire -- or just hold onto -- $2.5 trillion in assets.

You know how much $2.5 trillion is? It's enough to buy every leveraged loan and high-yield bond in the market, plus every subprime and Alt-A mortgage not already owned or guaranteed by Fannie or Freddie -- and all at par value, when in fact all these are trading at deep discounts. There'd even be a little change left over.

Now let me walk you through the details of what the Treasury has done here, as well as what it has not done. And then let's compare that to a very similar deal that Warren Buffett made with Goldman Sachs (GS) about a month ago.

Here's a preview of how this is going to turn out: I'd much rather get a loan from Treasury than I would from Buffett. He drives way too hard a bargain.

The Treasury will buy $125 billion in perpetual senior preferred stock from nine banks, and another $125 billion from others yet to come. It's been widely reported that this means the Treasury is "taking a stake" in these banks, or "become an owner," or that the banks are being "partially nationalized." This is not true.

Perpetual preferred stock is really a misnomer. It's not really stock at all. Preferred stockholders have no voting rights, and no claim on a company's earnings beyond a fixed dividend rate. It's really more like a bond or a loan. The interest on the loan is called a dividend, but in every sense it is just interest.

The dividend -- or effectively, the interest rate -- on the preferred stock is 5% for the first five years, and rises to 9% after that. Subject to some unimportant conditions, the company can retire the preferred stock at any time simply by returning the initial value to the Treasury, just like paying off a loan.

The only detail of the deal that makes the Treasury an "owner" of these banks is that, in order to get the Treasury's money, the bank must issue warrants on its common stock equal in value to 15% of the amount the Treasury is investing. The warrants allow the Treasury to buy common stock at any time over 10 years, at the price prevailing at the time the investment is initially made. If the stock is lower, then the Treasury wouldn't exercise the warrants; if it's higher, the Treasury would exercise at some point, but when it did so it would have to kick in more money to buy the shares to which the warrant entitles it.

When you figure the cost to the bank of issuing the warrants, and add that to the 5% dividend it has to pay for the first five years, I calculate that the Treasury's investment is costing these banks about 6.8% a year.

Now let's compare that to the $10 billion investment that Buffett made in Goldman. It, too, was in the form of perpetual senior preferred stock. But instead of the 5% dividend the Treasury is getting, Buffett will be getting a 10% dividend. Instead of warrants on 15% of the amount of the preferred, Buffett will be getting warrants on 100%. And those warrants won't just let him buy Goldman stock at the price prevailing when he made the deal, but at a 5% discount to that.

Finally, if Goldman wants to redeem the preferred, it doesn’t just pay off the loan as it will with the Treasury's investment. It will have to pay Buffett a 10% bonus.

Even if you ignore the cost of the redemption premium, I estimate that the total cost to Goldman for Buffett's investment is about 18% a year. That's very expensive financing. In fact, it's the kind of interest rate that banks charge ordinary consumers on their credit-card balances. And it's almost three times the cost to Goldman of the Treasury's investment, which is just 6.8% a year by my reckoning.

I suppose the investment by Buffett has a special element: The prestige of being supported by such an eminently wise investor. But it seems to me that the Treasury isn't such a shabby partner, either. As rich as Buffett is, the Treasury's pockets are even deeper.

I think the reality is that a month ago Goldman simply had no choice except to meet Buffett's onerous terms. And if Goldman could mask its desperation by trumpeting an affiliation with the Oracle of Omaha, then so much the better.

The important point here is that Buffett's investment established a market price for investors taking the risk of backstopping troubled banks and brokers. Against that benchmark, the Treasury's program is indeed a bailout, not a true investment.

That's fine by me. I wish we lived in a world in which safety nets like the Treasury, the Federal Reserve and the FDIC didn't even exist. Without them, banks and their customers would have to behave more prudently.

But as long as we're going to have those safety nets, they sure better be there when we need them. Throughout the credit crisis, those safety nets have not done their job. They've either failed to act (as in the case of Lehman) or they've acted in a destructive way (as in the case of AIG).

This new action by Treasury sends a transforming signal, that the government is finally ready to get real and do some serious rescuing. And not a moment too soon. If that's the case, then last week's horrific lows in stocks should mark the bottom of the panic.