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Uncle Sam's Bank Venture Risky But Will Pay When Credit Crisis Ends

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By DAVID PAULY

Bloomberg News

Published: November 1, 2008

Now that American taxpayers have committed hundreds of billions of dollars to save the banking system, it's appropriate to assess what they are getting for their investment.

A prospectus for Uncle Sam Inc. securities would list three areas of potential profit and loss.

Uncle Sam is acquiring a stake in the entire U.S. banking industry. By the end of the year, it will have invested $250 billion in preferred shares of banks across the country.

The government also says it might use some of the $700 billion rescue plan approved by Congress to buy stakes in other financial companies, such as insurers. Overall, this looks fairly safe, even if some of the companies fail.

The new financial colossus created by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke also has taken 80 percent equity stakes in three giant companies: Fannie Mae and Freddie Mac, which own trillions of dollars in mortgages, both good and bad, and American International Group Inc., an insurance company with 2007 revenue of $110 billion.

In no way are these safe investments. All three companies may need additional billions in federal disaster relief. Still, their shares now trade for nickels, but they might rally if the credit crisis ever ends.

Finally, some or most of the remaining $450 billion in bailout money might be used to buy distressed mortgages that are at the heart of the credit debacle. Exactly how much and at what prices is unknown, making this the riskiest of Uncle Sam Inc.'s endeavors.

Decent Return

Uncle Sam's preferred stock in banks such as JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. will pay annual dividends of 5 percent for the first five years and 9 percent after that.

Since the Treasury can now borrow for five years at about 2.6 percent, there is a profitable spread. Banks can buy back the preferred at face value after three years.

At 5 percent, the Treasury gets a steady annual return of $12.5 billion before its interest costs. What's more intriguing for taxpayers is that Uncle Sam gets warrants to buy common shares in all the banks equal to 15 percent of the value of the preferred investment.

The price to be paid would be based on recent values for the banks' common, that is, very low. If banks recover in the months ahead, Uncle Sam will enjoy some great trading profits.

The Good And The Bad

Uncle Sam is pushing Fannie and Freddie to buy more mortgages. While that might help home buyers and lenders, it adds further burdens to the money-losing mortgage portfolios of both companies. Treasury says it might invest as much as $200 billion in the two companies combined, for a 10 percent return.

AIG, the insurer that lost big selling credit-default swaps, has had to borrow $123 billion from the government and says it may need more.

Uncle Sam earns interest on the $85 billion portion of its loans to AIG at 8.5 percentage points higher than the three-month London interbank offered rate, now about 3.5 percent. AIG wants to repay its borrowing by selling assets, a tough task given current credit conditions.

Even at today's distressed market prices, Fannie, Freddie and AIG have some value. At Monday's close of trading, the trio's combined market value was about $24 billion, making Uncle Sam's 80 percent share worth about $19 billion.

Uncle Sam may end up with an even larger stake in U.S. banks. Under terms of the rescue, the government will get equity in banks selling distressed mortgage assets to the Treasury. Even if the mortgages eventually produce a net loss, Uncle Sam may recoup something on these stakes.

There is no way to guess at a final result for the taxpayers' commitment. The government will borrow all the rescue money, including billions more for projects not mentioned in this story. To avoid an overall loss, the government has to get back all the money laid out plus its interest costs.

It's clearly too early for a public sale of Uncle Sam Inc. shares.

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