A Letter to Treasury Secretary Paulson
By: Dr. Charles Lieberman
Date: 10/27/2008
Dear Mr. Secretary,
I wish to commend you for your latest strategy to inject capital into banks without invoking your concern with moral hazard to wipe out or to punish common shareholders. In keeping with this new approach, I would strongly recommend that you reconsider your Fannie Mae and Freddie Mac strategy and allow both institutions to resume payment of preferred stock dividends immediately. Doing so would increase bank capital instantly, reinvigorate the preferred stock market and enable banking firms to issue new preferred stock, should they need/wish to raise still more capital.
Initially, a somewhat classic run against Bear Stearns warranted focused policy action to segregate the problems of Bear Stearns from the rest of the financial system. However, while selling Bear to J.P. Morgan eliminated the market's concerns over Bear, it did little to calm market fears that other institutions might also be at risk. Similarly, the handling of Fannie Mae, Freddie Mac, and AIG addressed market concerns with each institution, but little was accomplished in ameliorating worsening credit market conditions on a broader scale. So, some credit markets ceased functioning and the credit crisis only worsened.
I strongly endorse and applaud the recently announced and promptly implemented decision to invest directly in banks by buying preferred shares without punishing common or preferred shareholders. This approach strengthens these institutions by adding capital directly and, thereby, improves investor confidence in our banks and financial system. These banks will also now more easily be able to sell new securities to raise more capital if they so desire, because investors know that their capital position has already been boosted by the Treasury's investment. This approach has already improved market conditions considerably and I expect additional gains as Treasury injects capital into more banking firms.
The contrast with the handling of Fannie and Freddie suggests that reconsideration be given to how those companies were handled. When dividend payments on the outstanding GSE preferred shares were halted, the plunge in value blew a capital hole in the balance sheets of all the banks that owned these securities. This was particularly unfortunate, since regulators encouraged banks to buy GSE preferred stock, because these issues were considered very safe. The loss in value of these holdings exacerbated bank capital issues and forced more banks to raise capital in a very inhospitable environment. Moreover, while halting preferred dividend payments retained capital in both GSEs, this action also threatened the entire preferred stock market. It is understandable that investors might fear buying any preferred shares, if they thought the value of that investment might be severely damaged should Treasury become involved. Thus, halting the preferred dividend payments on GSE shares reduced bank capital and also made it more difficult for banks to replenish their losses by issuing new preferred shares, a very troublesome combination.
In contrast, the new strategy injects capital into banks on very reasonable, yet profitable terms to Treasury, while it has enhanced the ability of our banks to raise more capital directly in the public market, should that be needed. A 5% yield on these preferred shares will be profitable to Treasury, even before any gains are realized on the warrants that come with the investment. But the 5% yield is sufficiently low cost that banks should be able to profit from this additional capital. It is critical that Treasury's policies be seen as supportive of our banking institutions, so as to encourage more investment, and not as a threat to the value of these assets, which sends investors running in the opposite direction. These preferred stock purchases should accomplish these objectives.
The decision to purchase unsaleable assets off the balance sheets of banks will help restore a market in such assets over time. While you have taken lots of flak over this plan and there are some hard problems to solve, mostly related to the appropriate price to pay for such securities, adding a larger buyer, the U.S. Treasury, to this market should help bring back buyers and get this market working once again. This part of your program may take a bit longer to help, but if implemented well, should help these markets start working again.
I sincerely hope you will consider my suggestions, which are offered in an effort to provide some helpful criticism. You have had a very difficult situation to contend with and little time to consider how to address the many problems that have arisen. I wish to thank you for your public service.
About Advisors Capital Management, LLC
Advisors Capital Management, LLC (ACM) is a provider of managed portfolios and financial services for industry professionals and their clients. As investment strategist, Dr. Lieberman oversees the company's "Portfolio Partners" investment program. Additionally, he provides guidance to the ACM Wealth Coordinators who integrate the work of financial advisors, financial planning, tax, estate and portfolio management professionals to build, protect, and maintain clients' wealth. Although the information included in this report has been obtained from sources Advisors Capital Management, LLC believes to be reliable; we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
©2005 Advisors Capital Management, LLC 
