Why Have the Government Bailouts Involved Only a 79.9% Equity Position?

A small but unexplained detail in the federal government's nationalization of Fannie, Freddie, and AIG has been that the deals have been structured so that the Fed or Treasury ends up owning no more than 79.9% of the nationalized entities' stock (or having warrants that, if exercised, would produce the same result). So what is the source of the 79.9% threshold? Why didn't the government do a 99.99% dilution of shareholders (and thereby a full de facto taking)?

It turns out that the explanation is not related to 80% being the threshold before the Fed/USG would have to carry the entities on their own books. Federal Accounting Standards are silent on the issue, but the Congressional Budget Office is already treating Fannie/Freddie like USG assets/liabilities (consistent with GAAP).

Instead, the explanation is tax. Section 163 of the Internal Revenue Code generally provides that interest paid on debt is tax-deductible for federal income tax. But there's an exception. If the interest is paid on a loan from an entity that controls 80% or more of the voting power and value of a corporations' total shares, then the interest is not tax-deductible. Fannie and Freddie are generally tax-exempt. They are, however, subject to federal income tax. AIG, of course, has no tax-exempt status, whatsoever.

Because the bailout deals were structured so that the Fed or Treasury will make sizable loans to the nationalized entities, they had to be careful not to reach the 80% threshold, lest the nationalized entities (which still pay taxes) lose their tax deduction for the interest paid on the Fed/Treasury loans (LIBOR +850 on $85BN for AIG--that's a lot of interest).

Of course, one might well ask why the Treasury would want to ensure Fannie and Freddie have a deduction--that just means less revenue for the government, right? I'm not sure of the answer to this--I think there are several possible explanations, but none is overwhelming. Nonetheless, the tax explanation seems to fit better than any other.

[Update 7.16.10. I might have gotten this one entirely wrong. I've heard from some tax people that I simply flubbed it on the tax points. (Ah, the perils of a bankruptcy guy venturing into tax land...) But if it's not tax, then what is the explanation? I haven't found an entirely convincing answer to this question in over two years, but I have also heard that the 79.9% was to avoid ERISA liability. This might remain a mystery...]

Comments

[Fraser]

There is a suggestion in the FT that anything above 79.9% triggers a default event under certain CDS.

[AMC]

We clearly need some new slogans to rally behind:

No taxation without nationalization.

Give me deductibility or forgive my debt.

"I pledge allegiance to the bank of the United States of America and to the public debt for which it stands....

We the Sheeple of the United States, in Order to form a more perfect corporate/government Union, establish Trust US, insure domestic bankruptcy, provide for the common pre-emptive defense, promote the general populace being on Welfare, and secure the Blessings of poverty to ourselves and our Posterity, do ordain and establish this short term solution for the United States of America.

[AMC]

The problem with the massive RTC-like bailout of the banks is that it is contrary to the philosophy this administration has been using to help individuals.

If people are going to continue to have faith that the Bush administration really cares about people as much as banks, there should be some symmetry between the relief that each is offered.

Accordingly, I have a modest proposal for assistance to the banks as they are being uncerimoniously (collecting a golden parachute check doesn't really count as a "cerimony", does it?) kicked out of their places of business.

My proposal is a voluntary program called "PHAITH NOW". This stands for "Phone Homes Asking Individuals To Help." The "NOW" doesn't stand for anything - it's just wishful Madison Avenue thinking.

The way the PHAITH problem would work is, banks would call individuals at home, and if they were around to answer the phone, they could voluntarily agree to increase their mortgage payments to help out the banks.

Of course, this program wouldn't be perfectly symmetrical with HOPE NOW - everyday people generally answer their phones promptly, and lack the ability to put calls on hold. But it offers all the benefits of the HOPE NOW program.

The government could have the same folks who collect statistics for HOPE NOW collect statistics for PHAITH NOW. That way, every time someone agrees to continue to pay their mortgage, it could counted as evidence that the program is working. This would allow the government to generate statistics that make everyone feel good, instead of bad.

Most importantly, PHAITH NOW will permit taxpayers to say they were helping the banks, without it actually costing them any money. And isn't that what's important?

The government would also avoid doing anything effective, like changing the bankruptcy code, which would have only made things worse. I guess they meant that change in the bankruptcy code that would have actually helped would have made things even worse than the present "worst financial crisis since the great depression". Can you imagine? Why THAT would have been BAD!

So write your Congressperson in support of my proposal, PHAITH NOW, because if your bank lobbied for HOPE NOW, you should have PHAITH NOW.

[Michael Guttentag]

What exactly is this equity instrument? I’ve read different accounts, and there are easily billions at stake. According to some accounts it is a warrant, which raises the question of what the strike price is? According to other accounts it is collateral, which raises the additional question of what happens if the loans are repaid? I hope Ben and Henry negotiated for the right instrument.

[tim]

something even more crazy apparently, the 79.9% isn't accurate.
check link.

"AIG issued a warrant to the Board of Governors of the Federal Reserve (“Federal Reserve”) that permits the Federal Reserve, subject to shareholder approval, to obtain up to 79.9% of the outstanding common stock of AIG (after taking into account the exercise of the warrant). AIG anticipates calling a special meeting for such purpose as promptly as practicable."

[N]

It's interesting to hear so much pro-free market animosity towards the Fed's recent moves in the wake of what actually caused this crisis. To my admittedly untrained eye, it seems like what we're seeing here is the wholesale discrediting of an entire economic philosophy--the rigid idealism that less regulation is better, and that "free markets" must be allowed to function lest the "principles of capitalism" be undermined.

This idealism finally reached a breaking point where its proponents (the Bush administration) had to either stick with it and deal with the consequences, or ditch their philosophy and take pragmatic steps towards correction. Any rigid idealism will ultimately reach this point. It's rarely a wise policy to take ideas to their logical conclusions, because the real world so frequently refuses to conform to our "logic."

The sad thing is that it took this long for the government to do anything. Banks were issuing piles of loans that nobody expected the borrowers to be able to repay. Then they were able to pass this debt upstream, get it off of their balance sheets, and let somebody else worry about it. Meanwhile, the rating agencies signed off on it all.

Any casual observer could see how this financial alchemy would eventually lead to disaster. Any trained financial manager could have easily seen why trading in subprime ARM debt was a bad idea in the long term. But our public company executives have short-term incentives. If they can find a way to pump up the balance sheet and raise stock prices in the short term (and keep it kosher with SOX), they can walk away with enough money to last a lifetime.

From my perspective, this was the market failure in this case--agency costs. Everyone knew that the housing market was a bubble, and nobody thought that someone making $5000/month could pay a $4200 mortgage when the rate reset. But so many of the agents involved in the securitization process were getting rich that none of them were going to question it. This means that the market is failing, and it's time for the government to do something before it gets worse. But this government didn't see it that way. It had decided that its role--regardless of the conditions on the ground--was to stay out and let the market work out its own problems. We all know where that got us.

So when we look at the bailout of AIG and federal backing of bad mortgage debt, who is really being bailed out? As I understand it (somebody please correct me if I'm wrong), AIG's shareholders have basically been stripped of all value. AIG's management has been replaced. So the real bailout is for the institutions and individuals who have insurance, money market accounts, etc. with AIG. That seems like a much easier pill to swallow than a simple bailout of a company that made stupid choices. AIG was a pillar propping up the financial system, and the pillar was not bailed out for its own sake but for the sake of what it supported.

In my view, this is just an administration that made it to the party too late. It waited until the last possible moment to act--not due to informed judgment, but due to a strict idealogical construction of its role in the market. I have serious worries about the US dollar in the wake of this meltdown, and I think that delayed action has led to the maximum possible damage to the world financial system. But at this point there are no good options. The Fed and the Bush administration decided to set aside free market ideology to take pragmatic steps to prevent further disaster. Better late than never.

[BJ Feng]

Well if everyone knew the housing market was in a bubble, why did so many Americans continue to buy houses? You see, the problem with regulation is that it either depends on a set guideline of rules, the judgment of regulators, or a mixture of both.

Now there were regulations in place and the banks were following them per the guidelines. So it comes down to the judgment of the regulators themselves, by what standard should they use to determine if an institution is taking on too much risk? Again, there are regulations that limit risk and are spelled out, you must have X amount of capital for X type of loan or security.

It's easy to spot a bubble AFTER the fact, and know that there is a crisis AFTER the fact, but if you look at the stats, foreclosures were at a very very low level until recently. So how are regulators going to justify new restrictions on the lending practices of the banks? Would a regulator say, well, I have this gut feeling that you're taking on too much risk. I know the evidence isn't there, but i have this strange feeling, so you can't lend out any more money? That would be insane right? So in practice, how would a regulator justify imposing tougher requirements and restrictions before the evidence appeared? And by the time evidence did start to appear, it was already too late. The severe downturn in the market late LAST year was the result of seeing the new data for the first time. Too late.

No the market isn't perfect, but would a system based on the abilities of a regulator be better? This regulator would need some very smart people to be able to spot bubbles and tell them apart from non-bubbles. Many people, including myself, thought the Treasury debt market was in a bubble, I mean why would you lend money to the government for 10 years for a mere 4%, especially when commodity prices are going through the roof? And with inflation higher than 4%, the real return is negative, this has to be a bubble right? Well I've been wrong so far, it's hard to spot bubbles, until you have a rear view mirror.

[N]

Greenspan saw the bubble in June of '05 when he spoke of "froth" in the market, and prices that had risen to unsustainable levels. The foreclosure rate jumped in '07 when a huge amount of ARM debt reset to payments at levels that no reasonable person should have expected the subprime borrowers to be able to repay. Again, this was perfectly predictable. I was warned by a knowledgeable real estate investor NOT to buy a home in 2006 for this exact reason--that the market would soon be flooded with foreclosures.

Nobody on the outside of these transactions thought that negative amortization or interest-only loans were a smart way to buy a house. Everyone knew that zero down-payment transactions were very risky, and subject to fluctuations in housing prices.

People kept buying houses because they needed a roof over their heads, and because home-ownership is the American dream. For many people, buying a home is more an emotional decision than an economic one--see some of the previous posts on this blog. If you give the option of buying a home through some instrument that lets you pretend that you own it (when you're really just leasing it from the bank), many people will take it so they can "own" their dream home. So much for bounded rationality.

If the banks originating the loans were holding onto the debt, we could probably count on their judgment to make wise risk decisions. But they weren't. We assumed that the upstream parties could look at the underlying transactions and make reasonable judgments about risk. But they couldn't.

I certainly wouldn't advocate for a system of total government control. But markets can do very very stupid things when they are poorly regulated. And it wouldn't have taken a terribly smart regulator to figure out that no matter how you package it, a loan that has little or no possibility of being repaid is junk.

[dfb]

This reason is consistent with Treasury writing an exception into the IRS regulations so Fannie and Freddie may preserve Net Operating Loss (NOL) carryovers as a result of the conservatorship.

http://www.cfo.com/article.cfm/12079734/c_12079931?f=home_todayinfinance

The more that comes out about these deals, the more I think they smell. Treasury needs to open up the kimono and show more than the usual transparency.

[Why Tax]

Tax is not the only arena in which 80% signifies "control." This comment from the NY Times Dealbook blog seems like a far more convincing explanation:

#
The 79.9% is accounting driven. The ownership of these GSE’s would be classified as “Enterprise Funds” on the financial statements of the federal gov’t. (If such statements were even prepared) “Enterprise Funds” are required to follow normal US Generally Accepted Accounting Principals, whereas Governmental, Trust and Agency Funds follow different governmental accounting standards. Thus, keeping it below 80% eliminates the need to consolidate these GSE’s and bring them “on the books” of the gov’t. Even our government is engaged in “off-book financing!” The end is near.

— Posted by CPA-Dork
http://dealbook.blogs.nytimes.com/2008/09/08/the-subtle-takeover/#comment-343141

[Adam Levitin]

Can you point me toward a specific accounting rule for 80% as control? I don't know of any--I thought GAAP required consolidation when there was over 50% voting power ownership. There' is another tax angle, however--80% ownership triggers a consolidated tax return. I'm willing to believe there's an accounting issue, but no one has been able to direct me to it.

Fwiw, our government has long been engaged in off-book financing--that's exactly what Fannie and Freddie were in the first place--the government's SIVs.

[Jim K.]

I thought 163(j) required only 50% ownership, not 80%.

[Adam Levitin]

26 USC 163(j)(1) says no deduction for disqualified interest. 163(j)(3)(B)(i) defines "disqualified interest" as including interest paid on a disqualified guarantee. 163(j)(6)(D) defines "disqualified guarantee" with the 80% ownership stake. 26 USC 1504(a)(2) defines 80% control/value as the threshold for an affiliated group (and hence a consolidated return).

[MarkT]

Adam,
CPAdork's point is that the GOVERNMENT's accounting rules require consolidation of companies in which IT owns at least 80%. The government does not apply GAAP to itself.

[Adam Levitin]

MarkT--I can't find anything in the FASAB standards (available at http://www.fasab.gov/) that requires consolidation at 80%. Again, I'm not saying that it's not there, just that no one has been able to point out the actual rule when questioned about it.

Fwiw, I'm told that the Fed doesn't use FASAB for its accounting. It has its own system, the rules of which I have not been able to find.

[Jim K.]

I think you are misreading the terms of the deal, as well as the Internal Revenue Code. At least according to various press accounts, there is no guarantee by the federal government. The government is the actual lender. Moreover, how is Treasury a "related person", as required by 163(j)(6)(D)? I am not sure the federal government is a person for purposes of the Code, much less a coporation, as required by 1504(a).

[Hapless Taxpayer]

Will the issuance of the warrant by AIG trigger an ownership change under Section 382?

[Adam Levitin]

On rereading, I think Jim K. is right. 163(j)(3) (A) disallows interest paid to a related person if that related person is tax exempt (government, Fed). 267(b) and (f) define related person (at least as between two corporations) as 50% control. So the interest deduction theory doesn't seem to work. (Of course, there is still the question of whether the government is a "person" for IRC purposes--the definition of person doesn't seem to include the government.)

The IRC's consolidated return requirement of 80% still seems like a viable theory, however.

[Sarah Lawsky]

A few tax points:

Consolidated returns are not a requirement. A corporation that owns at least 80% of another corporation can *elect* to file a consolidated return, but it need not make this election. IRC 1501. Also, all entities in the chain of ownership must be corporations in order to permit a consolidated return; I'm not sure (and I really mean not sure--I actually don't know) whether the entity that holds the 79.9% of Fannie and Freddie stock will be a corporation, or will just be the government directly.

As for Section 382, there is an ownership change if the percentage of stock held has increased more than 50 percentage points, so 80% isn't the magic number there either. IRC 382(g)(1). (Though the separate question of the application of Section 382 to this transaction is a really, really interesting one.)

Finally, it might take some more analysis to determine whether Section 163(j) would apply here in any event, as it applies only if the requirements in Section 163(j)(2) are met, which isn't immediately clear to me (this is purely a factual question, related to net interest expense, debt-to-equity ratio, etc.).

Fascinating discussion!

[ZP]

163(j)(6)(C) treats all members of an affiliated group as one corp. I don't know, but say the govt funds a corp with loans or guarantees that corps debt issuances. That corp then funds all of these entities. That corp could then be tangled up in 163(j) if they were part of the affiliated group of these other entities? Just a thought

[David Johnston]

As fascinating as this is, does anyone know if there is any chance of me getting my 79.9% back? I am an AIG shareholder. Is this deal really legal? Can the CEO and BOD really hand over 79.9% of the company without a shareholder vote? That seems kind of like communism to me. Why didn't AIG just go into Chapter 11. They had roughly $100B in tangible equity (some say $180B). That would be $37/share versus the $3/share they now trade at. Why wouldn't that have been better than giving 80% of the company away for a loan.

It seems like it was the financial system (i.e. Goldman Sachs) that got the bailout not AIG shareholders.

You can read my polemic here
http://certainruin.blogspot.com/2008/09/rape-of-aig-open-letter-to-mr-paulson.html

[ZP]

Well, since Hank sold a lot of his stock, probably not good.

[ZP]

So the AIG shares are issued to a trust with the Treasury the beneficiary. This sort of blows the theory that tax law is behind the 79.9% interest, it seems.

http://dealbook.blogs.nytimes.com/2008/09/30/aigs-bailout-terms-revealed/