by HAL SCOTT and MAXWELL JENKINS

Originally published by Financial Times on March 2, 2009

While no one can be sure its big new bet on Citigroup will be a winner, the US government priced it right by agreeing to a reported $3.25 a share conversion price with no new investment for the preferred stock it is buying. This premium of 32 per cent over Citi’s closing market price on February 26 gave the US government the possibility of owning 36 per cent of Citi’s common stock, a substantial improvement in the financial terms of its prior investment. It also gives Citi the prospect of a major equity infusion. These terms reflect the important fact that the Treasury is a public rather than a private investor.

This deal must be seen against the background of the February 6 report of the Congressional Oversight Panel which, based on a valuation analysis of Duff & Phelps, accused the Bush-Paulson Treasury of “shortchanging” taxpayers by “overpaying” by some $78bn for the preferred stock and equity warrants (at a 30-day trailing average stock price) it received in return for its $254bn in troubled asset relief programme investments in major banks and AIG. More recently, COP attacked the Obama-Geithner Treasury for not responding to its earlier criticisms. On deeper inspection, this claim of overpayment is seriously wanting because it fails to recognise a central fact: the Treasury is a public, not a private, investor. There is nothing unreasonable about valuing Tarp investments on the basis of comparable securities issued by Tarp recipients and available for purchase in the public market. The danger, as Duff & Phelps itself articulates, lies in assuming that the comparison is dispositive. None of these comparison investments were designed, as the Treasury’s have been, to encourage redemption as soon as an issuer secures replacement capital. The Treasury did not invest for the long term – its objective was to exit from its investment as soon economically feasible. Indeed, the Treasury’s main objective in making its investments was to stabilise the financial system and promote new lending, not to make money.

It is also important to note that these investments were not entirely consensual transactions – the Treasury in effect compelled some of the Tarp recipients to accept investments which some of them, for example Wells Fargo, did not really want. The investments carried onerous terms. They permit the Treasury to amend any provision of its contract retroactively if new legislation is introduced at a later date. They also put limits on executive compensation and subject the banks to political pressures to reduce “perks” and increase lending. If you want to compel someone to accept an investment – in order to accomplish a public purpose – you will have to provide a financial incentive.

Criticism has also been directed at the Treasury for offering standard terms to all participating institutions. If the Treasury had offered materially less favourable terms to the weakest issuers, weaker institutions that accepted such terms would have faced a loss of confidence in the market. Indeed, the Depression-era Reconstruction Finance Corporation’s public disclosure about which banks received government capital undermined confidence in the recipients and hastened the collapse of the nation’s banking system. The Treasury standardised its terms simply to prevent its investments from precipitating a similar breakdown in confidence.

COP also ignores the possibility that the Treasury can restructure its investment, as it has now done with Citi. Duff & Phelps premised its valuation on the assumption that the Treasury’s preferred securities in Citi lacked a conversion option, which was true. But it did not take into account the fact that the Treasury might demand and get convertibility in the future. The Treasury is not your ordinary investor. The government can close Citigroup if it determines it to be insolvent – this gives it plenty of leverage in demanding a restructuring. While the Treasury’s new preferred securities with a convertible option may be favourably priced compared to the market today, they significantly improve the government’s position since the old equity warrants that it received are deeply out of the money and the new convertibility feature gives it the right to own 36 per cent of Citi’s common stock for no additional cost. Indeed other foreign government investors have reportedly agreed to exchange their preferred shares on the same terms as Citi.

Finally, at the time the Treasury made its initial investments it may have possessed more detailed information about the asset value of bank balance sheets than was available either to the public or to Duff & Phelps – an independent valuation firm with no connection to the Tarp. In this circumstance, the Treasury would not have been overpaying for the shares so much as the market would have been undervaluing them.

Ultimately, the panel’s fundamental mistake was analysing the securities as economic investments rather than instruments of public policy. This may, in part, be the result of how Treasury officials have themselves described their investments. Nevertheless, the analysis fails to account for the less tangible, but nevertheless crucial, value that has been “purchased” on behalf of taxpayers – the avoidance of a massive collapse of the financial system.

Mr. Scott is professor of international financial systems at Harvard Law School. Mr. Jenkins is a student at Harvard Law School