While the strong first quarter results posted by Goldman Sachs on Monday seemed to surprise most observers, it really comes as no surprise that the firm is now seeking to free itself from the shackles of the TARP financing that it was essentially forced to accept in October 2008. The $5 billion common stock offering announced today will allow Goldman Sachs to retire part of the TARP funding, subject to government approval.
At face value, this is somewhat of a curious decision on the part of Goldman Sachs given that the government funding is far cheaper than funds raised from Berkshire Hathaway at roughly the same time through a similar preferred stock issue. However, a brief examination of the terms of these deals and the politics of the situation makes the logic behind Goldman’s action very obvious.
Terms of the TARP Funding
Reviewing page 100 of Goldman Sachs’ 2008 10K, one can easily compare the terms of the TARP and Berkshire preferred stock and warrant deals. Here is a summary of the basic terms of the TARP preferred stock/warrant issue:
In October 2008, under the U.S. Treasury’s TARP Capital Purchase Program, we issued to the U.S. Treasury 10.0 million shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series H (Series H Preferred Stock), and a 10-year warrant to purchase up to 12.2 million shares of common stock at an exercise price of $122.90 per share, for aggregate proceeds of $10.00 billion. … Cumulative dividends on the Series H Preferred Stock are payable at 5% per annum through November 14, 2013 and at a rate of 9% per annum thereafter. … The warrant is exercisable at any time until October 28, 2018 and the number of shares of common stock underlying the warrant and the exercise price are subject to adjustment for certain dilutive events.
Perhaps more notable than the basic terms listed above is the restriction the government imposed regarding the conditions under which Goldman Sachs would be able to redeem the preferred stock. Essentially, the terms prohibit Goldman Sachs from redeeming the preferred stock unless the funds come from Tier 1 qualifying common or preferred stock:
Each share of Series H Preferred Stock issued and outstanding has a par value of $0.01, has a liquidation preference of $1,000 and is redeemable at our option, subject to the approval of the Federal Reserve Board, at a redemption price equal to $1,000 plus accrued and unpaid dividends, provided that through November 14, 2011 the Series H Preferred Stock is redeemable only in an amount up to the aggregate net cash proceeds received from sales of Tier 1 qualifying perpetual preferred stock or common stock, and only once such sales have resulted in aggregate gross proceeds of at least $2.5 billion.
The sale of $5 billion in common stock priced at $123 per share today will provide Goldman Sachs with the ability to redeem part of the funds raised through TARP. Goldman Sachs actually would like to redeem the entire $10 billion using other available cash. However, It is not clear whether the government will permit Goldman Sachs to do so for two main reasons. First, it does not appear that funds generated from operating the business can be used to repay TARP based on the terms of the financing. Second, the government “stress testing” may determine that Goldman Sachs’ Tier 1 Ratio would fall below acceptable levels if the TARP funds are returned.
Terms of the Berkshire Funding
Let’s take a look at the terms of the Berkshire Hathaway deal from last October, also taken from excepts of the Goldman Sachs 2008 10k report:
In October 2008, we issued to Berkshire Hathaway Inc. and certain affiliates 50,000 shares of 10% Cumulative Perpetual Preferred Stock, Series G (Series G Preferred Stock), and a five-year warrant to purchase up to 43.5 million shares of common stock at an exercise price of $115.00 per share, for aggregate proceeds of $5.00 billion. … The warrant is exercisable at any time until October 1, 2013 and the number of shares of common stock underlying the warrant and the exercise price are subject to adjustment for certain dilutive events.
Furthermore, the preferred shares may only be redeemed at a 10% premium:
Each share of Series G Preferred Stock issued and outstanding has a par value of $0.01, has a liquidation preference of $100,000 and is redeemable at our option, subject to the approval of the Federal Reserve Board, at a redemption price equal to $110,000 plus accrued and unpaid dividends.
TARP vs. Berkshire Funding: What Would You Redeem First?
If you put aside the fact that the TARP funding came from the government, it would appear quite clear that Goldman Sachs would want to retire the Series G Preferred Stock issued to Berkshire Hathaway prior to retiring the Series H Preferred issued to the government. Berkshire clearly was able to obtain much better terms than the government. In addition to the 10% dividend on the preferred shares, Berkshire received warrants at a lower strike price, albeit with a shorter expiration than the warrants issued to the government through TARP. In addition, Berkshire was able to command a 10% premium in the event that Goldman Sachs wishes to redeem the preferred shares.
Of course, this is somewhat of an academic exercise given that the terms of TARP also prohibit Goldman Sachs from a whole array of capital allocation choices including stock buybacks, increasing the dividend on common shares, and redeeming preferred shares including the issue to Berkshire. Still, from an economic perspective, it is quite clear that Berkshire Hathaway received superior terms on funding that was raised at roughly the same time as TARP.
Getting the TARP Monkey Off Your Back
Clearly, the benefits of extinguishing the TARP funding far outweighs the fact that the terms are quite a bit cheaper for Goldman Sachs than the Berkshire funding. For one thing, it is well known that Goldman Sachs was not given much of an option when the government came up with the TARP scheme. The Treasury Secretary and the Federal Reserve did not want to provide TARP funds only to troubled entities but to a wide array of leading banks to avoid the impression that only the weak were being assisted.
Beyond the reality that Goldman Sachs never wanted the funding, they are now saddled with all of the headaches that come with having the Federal Government as their “partner”, including restrictions on dividend policy, share buybacks, executive compensation, and a host of other issues. After the vilification of AIG’s compensation practices (in many cases for executives who had little to do with AIG’s meltdown), one can hardly blame Lloyd Blankfein for wanting the get the TARP monkey off his back so he can run the business as a private enterprise rather than a quasi-ward of the state.