Two years ago, Warren Buffett and then-Treasury Secretary Hank Paulson each made significant investments in iconic Wall Street firms. The controversial deals—Buffett's in Goldman Sachs Group (NYSE: GS - News) and the Treasury Department's huge investment in Citigroup (NYSE: C - News)—were made out of different motivations, but both have made money.
If you had to guess which investment worked out better, would you go with Buffett? Investors have been well-served following the advice of the "Oracle of Omaha," and former Treasury Secretary Henry Paulson and his successor, Tim Geithner, haven't exactly been lauded by taxpayers for their shrewd deployment of capital. And in this tale of two trades, Buffett once again proved his savvy. Still, against all odds and predictions, the taxpayers have come out just fine on the Citi investment.
Oh How the Mighty Have Fallen
First, let's take Citigroup—please. The largest bank in the U.S. ran into plus-size troubles in the fall of 2008, having made every conceivable poor lending decision in the bankers' handbook. As a result, it received the largest aid package of all the banks.
In October 2008, the Bush administration's Treasury department bought $25 billion in preferred shares in Citi; at the same time it made similar investments in all the other largest banks, including Goldman ($10 billion). A few months later, having determined that Citi needed more help, Treasury Secretary Henry Paulson put another $20 billion into Citi, and then sold Citi insurance on a large chunk of its assets. In early 2009, this seemed like an enormous waste of public capital. As the economy contracted and Citi's losses mounted, the stock sunk to a low below $1 per share in March 2009.
Paulson engineered and timed the entry, but his successor, Timothy Geithner, engineered and timed the exit. Realizing that it would be difficult for Citi to raise $45 billion to pay back the taxpayers, Geithner agreed to convert the first $25 billion of aid into 7.7 billion shares of common stock in the summer of 2009, at a conversion price of $3.25 per share. The hope was that the government could slowly sell the shares into the markets over time while breaking even.
As the financial and credit markets reflated, Citi began to recover. In December 2009, Citi paid back the government's remaining $20 billion TARP investment and ended the guarantee program. In April 2010, the Treasury began to sell off the shares—at a decent profit. So far, it has sold 4.1 billion shares at an average price of $3.98 (22 percent above the conversion price), yielding $16.4 billion in cash. Details on the Citi stock sales can be seen here (on page 15). Last week, the Treasury also announced the sale of $2.25 billion in securities it had received from Citi as a premium for guaranteeing its assets.
Adding up the repayments and the stock sales, plus dividends, the Treasury says it has reaped $41.6 billion of the $45 billion it put into Citi. There's more to come: 3.6 billion shares of common stock (worth $14.6 billion), plus the upcoming sale of securities pledged to the Treasury ($800 million), plus the sale of warrants the Treasury received (about $1 billion). If market conditions hold (a big if) through the winter, the returns could add up to $58 billion, leaving taxpayers with a $13 billion profit. That's a 29 percent return in about two and a half years. Not bad.
But it might have come out better if Paulson had outsourced the dealmaking to Buffett. In September 2008, at about the same time the Treasury was preparing the TARP investments, Warren Buffett made a complicated $5 billion investment in Goldman Sachs. Buffett extracted much better terms from Henry Paulson's former employer than Paulson was able to extract from Goldman and the other banks.
While banks participating in the TARP were only asked to pay a five percent dividend, Buffett secured a 10 percent annual dividend on his Goldman preferred shares. As a sweetener, he received warrants to buy 43.5 million shares of Goldman common stock at a strike price of $115 for five years. What's more, if Goldman wants to retire the shares, it must pay Buffett a 10 percent premium.
So how has Berkshire Hathaway done on this deal? In two years, Berkshire has collected dividends of $1 billion on the $5 billion investment. At today's market prices, the warrants are worth about $2.2 billion, according to options professionals. That's a 64 percent (paper) return in two years. And that's not even considering any increase in the value of the preferred shares, which had a fair value of $3.86 billion when they were issued, according to Goldman's quarterly report (see page 122).
Given his track record, it's not surprising that Buffett was able to capitalize on the chaos on Wall Street and rack up better returns than one of the few entities with deeper pockets than him. But there are a couple of points worth considering. First, Buffett's bet was purely economic; the Treasury was focused more on saving the system (however clumsily) vs. booking a profit.
Second, Buffett's bet worked out in large measure because of the extraordinary assistance Goldman received: cheap capital through TARP, billions in credit default insurance funneled to it through AIG, and FDIC guarantees on debt that it issued.
What's more, investors who followed Buffett's lead by buying Goldman's common shares in the fall of 2008 haven't done quite as well. Buffeted by challenges in the capital markets, new regulation, and a SEC investigation, Goldman's stock has essentially moved sideways over the past two years. While Goldman weathered the crisis better than its peers and rivals, many of them have done a better job in this recovery—including Citi. In fact, since the market lows of March 2009, Citi, a bank in which the government has a major ownership stake, has significantly outperformed the firm often known as "Government Sachs."
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