Effective Bank Recapitalization
October 5, 2008
Congress’ $850B “bailout” plan is not much more than a giveaway to a handful of well-connected banks. So, what sort of plan would work? I think we are quite close to a workable plan. John Hussman has been promoting a plan that is very, very similar to what just happened with WaMu. Note that Hussman says: “you can’t rescue the financial system if you can’t read a balance sheet.” Do you understand now why I insisted that you learn how banks work?
If you understand how banks work, Hussman’s plan makes sense. If you don’t understand how banks work, it’s gobbledygook. How many Congresspeople do you think understand how banks work? Probably less than one. They are basically hopeless babes in these matters, so they stick to their core competencies like stuffing legislation with unrelated chump-change giveaways like a bicycle commuting deduction.
Let’s look at the government’s perspective. What are the government’s objectives?
1) The government is already on the hook for insured deposits. So, the government might as well support the bank, which can then pay the depositors, rather than having a messy liquidation.
2) The government would like to avoid turmoil from bank liquidations, and would like to maintain basic banking services. This means basic deposits, checking, money transfers etc. It also means not defaulting on uninsured deposits, often deposits of corporations, municipalities, etc. It means making loans to qualified borrowers, especially working capital loans to corporations, the disappearance of which could cause distress on the corporate level. In short, all the “systemic” stuff.
This could be accomplished via the Washington Mutual model, but instead of letting JP Morgan steal the goodies, the government could take it over themselves and recapitalize it. As Hussman suggests, the junior portions of the capital structure (common equity, preferred equity, subordinated debt) would take a loss — basically everything below the deposits. There should probably be some provision for recoveries — thus, subordinated debt would get partially paid back depending on how the assets of the company eventually perform to maturity. Then, if necessary, the government would recapitalize the bank, perhaps by adding $40 billion in equity. The new bank would thus be well-capitalized, and thus safe and reliable, and people could do business with it without fear of Friday night surprises. The government could then IPO the bank back to the market at some point, possibly quite quickly. This could actually lead to a profit for the government, maybe quite a large profit! A nice, clean bank typically sells for about 2x book. So, if the book value amounts to the government recapitalzation, of $40B, the government should eventually be able to IPO WaMu for $80 billion, making a nice profit.
As part of this plan, probably derivatives liabilities should also be wiped out. Derivatives liabilities would be wiped out anyway in a bankruptcy, so nothing new there. Poof — the CDS problem (for WaMu) disappears. This would also mean there are no more off-balance-sheet nasties to worry about.
These off-balance-sheet nasties, especially derivatives liabilities, are one reason why banks are still in trouble despite many recapitalizations to date. Losses from derivatives could be in the trillions. Maybe they won’t be — but who wants to wait and find out? Thus, it seems we need what amounts to a flash-bankruptcy process, as was done with WaMu, in which liabilities outside of deposits can be made to disappear.
This is also why foisting WaMu off on JP Morgan/Chase doesn’t solve the systemic problems. JP Morgan/Chase, in my opinion, is the biggest potential derivatives disaster in the world. Thus, if your local WaMu has its sign changed to “Chase,” that doesn’t exactly make you want to keep your deposits there, does it? Nor is JP Morgan/Chase bringing any new capital to the table, as a government recapitalization would.
This plan would be easy, it would make investors take a well-deserved haircut, it would be profitable for the government, it would establish a new squeaky-clean amply capitalized bank that people can do business with, and it would resolve broader “systemic” issues.
Well, sort of.
The problem with this is what happens next:
1) WaMu’s equity, preferred and subordinated debt investors get blown out, which causes immediate losses elsewhere. Probably no avoiding this.
2) WaMu’s CDS etc. derivatives counterparties get a nasty surprise. Nothing different than if WaMu went kablooey, though. Actually, this plan would be reserved for banks that already went kablooey (it is essentially a quick bankruptcy process), as an alternative to liquidation.
3) WaMu then becomes everybody’s go-to bank. Why hold your deposits anywhere else? This creates immediate stress on all the other weak banks.
These are not really new problems, they are more like the resolution of pre-existing conditions. However, one aspect of this solution is that it would probably be necessary to nationalize several banks at once. Nothing in particular wrong with that. The other banks are pretty much bust anyway, but the process would be accelerated. So, the government should be prepared for system-wide resolution, not just a bank here and a bank there. (Alas, at this stage “system-wide” probably means worldwide!)
Fortunately, when you deal with things on a system-wide basis, the problems tend to cancel each other out. Citibank’s CDS with WaMu becomes a non-issue, because Citi’s CDS liabilities are also vaporized. All the off-balance sheet stuff, system-wide, disappears at once. It’s really the off-balance sheet stuff that scares people, not the on-balance sheet loans and mortgages, which are relatively easy to value and deal with. All kinds of counterparty issues become irrelevant. The end result is that you have a nice, clean, shiny banking system with boodles of capital. Common and preferred equity, and subordinated debt, get blown out, but that was merely what they deserved.
This is a plan that would be easy to implement, relatively cheap, include necessary losses for capital (no socializing the losses), would probably be profitable for the government, and would resolve all the systemic issues. Also, it would shut off the “cheap distressed assets from the government” method of theft, because the government would be selling its shiny, new non-distressed banks on the open market in the form of an IPO.
So, what’s the problem with this plan? The biggest problem is the cost: it doesn’t cost anything. If it doesn’t cost anything, then nobody gets any free goodies from the government. Probably Congresspeople should just toss some money around to friends. Briefcases full of twenties types stuff. Like a reverse bribe. Here’s some cash so you can get off my back and we can create some decent solutions.
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I actually support the move away from “mark to market” accounting. This doesn’t mean that banks don’t have to take writedowns of bad assets. However, they can get a reasonable estimate of asset impairment, from a third party if necessary, and apply that. It wasn’t that long ago when banks simply made loans, and kept the loans on the books to maturity. There was no “market” because people didn’t trade loans. Actually, banks still do this to a large extent. What I am suggesting here was, and is, common practice for these “held to maturity” loans.
The problem is, basically, that markets are nuts. This is true all the time. Have you ever wondered why brokers won’t let you lever up an S&P500 position more than 2:1, but a private equity investor can lever up a company 5:1? The earnings of the S&P500 are actually quite stable, more so than the vast majority of individual companies. The problem is market volatility. Market volatility introduces risk (volatility anyway) far in excess of the underlying economic risk. We looked at the case of Thornburg Mortgage some months ago:
This is supposedly the problem that is being fixed by the $700 bailout package. But that is only a cover. After all, they could just pass a rule that says banks can mark assets to a “reasonable estimate of economic value,” which is what they are supposedly (not on your life!) going to sell them for to the government. No $700 billion, just a rule change — a rule change that is actually part of the final bill. I think the package is merely a way to channel Treasury funds to certain “made men” banks — JP Morgan/Chase, Bank of America, Goldman Sachs, Morgan Stanley, maybe Citibank — which they will use to cover their own losses and then to buy banking assets cheap. The FDIC seems ready to accommodate this land grab, through its system (introduced with Washington Mutual’s sale to JP Morgan) of making the non-depositor liabilities and equity disappear. In short, it is thievery plain and simple, and using just the model we’ve seen so often all around the world: 1) Socialize the losses, and 2) Get the government to sell you distressed assets cheaply.
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Money market funds: yech! Thank goodness money market funds are now federally insured! I took a look at a money market fund that I use, as a sweep account in a brokerage account. The fund, which will remain nameless, holds $16.8 billion of assets, and yields 2.07%. This is a regular, plain-jane MMF, not an “enhanced” or other bells-and-whistles fund.
US Government and Agency Obligations 26.19%
Federal Farm Credit Bank
Federal Home Loan Bank
Federal Home Loan Mortgage Corp (whoops!)
Federal National Mortgage Assoc. (whoops!)
Bank Notes 2.33%
Wachovia Bank (whoops!)
Wells Fargo Bank
Certificates of Deposit 16.81%
Abbey National Treasury Services
Bank of Montreal
Bank of Tokyo-Mitsubishi UFJ
Credit Suisse First Boston
Fortis Bank (whoops!)
Lloyds TSB Bank
Royal Bank of Scotland
American Express, Federal Savings Bank
Bank of America
State Street Bank and Trust
Commercial Paper 24.31%
Asset Backed Commercial Paper 12.22% (remember ABCP? mega-whoops!)
Automobile OEM 1.16%
Banking US 7.01%
Bank of America
Dexia Delaware LLC (whoops!)
Fortis Funding LLC (whoops!)
Consumer products nondurables 0.56%
Integrated Energy 0.12%
Finance, noncaptive diversified 1.27%
General Electric Capital Corp
Short-term corporate obligations 11.54%
Banking, non-U.S. 8.87%
Bank of Scotland
La Caja de Ahorros y Pensiones de Barcelona
National Australia Bank
Banking, US 0.77%
Bank of New York Mellon
Finance, captive automotive 1.90%
Toyota Motor Credit Corp.
Repurchase agreements 17.87%
Lehman Brothers (whoops!) collateralized by FHLB obligations and FNMA obligations (whoops!)
Merrill Lynch (whoops!) collateralized by FFCB, FHLB, FHLMC (whoops!), FNMA (whoops!)
Money Market Funds 9.00%
doesn’t that cause Mad Cow disease?
I always thought MMFs were mostly t-bills and some high-grade CP from non-financial entities. Maybe they were, in the past. I don’t think this MMF was any worse than many others. Probably above average. Makes you think, doesn’t it?