More on Fixing the Banks

Europe may need to pull a Chapter 11 – a US-style bankruptcy, which would permit a market shutdown and Euro Zone reorganization before reopening for business. …

So what form might a Chapter 11 for the Euro Zone take? It is increasingly likely that some kind of total “bank holiday” is enforced to put a stop to market pressures – and then to reinforce and relaunch a stricter EU Growth and Stability Pact as a price for cranking up the ECB printing presses to full speed.

Before accusing me of lunacy on my idea of a market holiday, it’s important to point out that banking holidays are not without precedent. In 1933, President Roosevelt declared a bank holiday that ran for an entire week in March of 1933, during which he passed the Emergency Banking Act and the Federal Reserve moved to supply currency to banks. …

We are headed toward a new recession because our policy makers never addressed the underlying problem in the first place, which was, and remains, the need for debt restructuring. This is an issue that I suspect will re-emerge to the forefront of public debate in the next year. Hopefully, the response of our policymakers will be at different.

Think of restructuring this way. U.S. stocks just lost $2.5 trillion last quarter. Why should the public bail out the bondholders of financial institutions when the assets of these companies are far beyond what is needed to cover their liabilities to depositors and customers? The problem for banks, of course, is that they are leveraged, so even a drop of a few percent in their assets wipes out much of their own capital and threatens to make them insolvent. That should be a major concern for the lenders who have allowed the managements of those banks to leverage their bets with increasing lack of transparency (thanks to the FASB). But “failing” institutions can be restructured without any loss to depositors or counterparties. When banks become insolvent, my view is that receivership and restructuring is exactly what should happen, and swiftly.

Look at Bank of America’s balance sheet, for example. Reported assets are $2.261 trillion. Against that, liabilities to depositors amount to less than half that, at $1.038 trillion. Add in $239 billion for securities that they are obligated to repurchase, $129 billion in trading account and derivative liabilities, and $155 billion for accrued expenses. Now you’ve covered counterparties, as well as vendors or others who might have invoices outstanding. Even then, and you’re still only up to $1.561 trillion of the liabilities. The remaining 31% of Bank of America’s liabilities represent obligations to its own bondholders and equity of its own shareholders. This is well beyond what is sufficient to buffer any loss that the company might take on its assets, while still leaving customers and counterparties completely whole. To say that Bank of America can’t be allowed to “fail” is really simply to say that Bank of America’s bondholders can’t be allowed to experience a loss.

What “failure” really means is that bondholders lose money, and the operating part of the institution is taken into receivership, sold for the difference between assets and non-bondholder liabilities, and recapitalized under different ownership. Often the only thing that customers and depositors notice is that there is a new logo on top of their statements.

Now take a look at Citigroup’s balance sheet. Reported assets are $1.956 trillion. Against that, liabilities to depositors again amount to less than half of that, at $866 billion. Add in $204 billion in repurchase obligations, $209 billion in trading and brokerage liabilities, and $73 billion in other liabilities, and you’re still only up to $1.352 trillion. The remaining 31% of Citigroup’s liabilities, again, represent obligations to its own bondholders and equity of its own shareholders. And again, to say that Citigroup can’t be allowed to “fail” is really simply to say that Citigroup’s bondholders can’t be allowed to experience a loss.

You can do the same calculations for nearly every major financial institution in the world. The amount of bondholders and equity coverage varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions. Make no mistake – that choice is what the oncoming crisis is going to be about (See An Imminent Downturn – Whom Will Our Leaders Defend? ).

But who are those bondholders? They include corporate investors, pension funds, endowments, mutual funds and ordinary investors. And all of them willingly take a risk in order to reach for return. As do stock market investors. And if the risk doesn’t work out, none of them should look to the government to fire teachers, lay off social workers, underfund the National Institutes of Health, cut Medicaid, and print money (because until the Fed sells its Treasury and GSE holdings, it has indeed printed money), just because they take their risk in a different type of security.

My impression is that the scare-mongering of self-serving financial “experts” on Wall Street is shortly about to become deafening. It would be catastrophe, utter catastrophe, no, Armageddon, to let the global financial system collapse – collapse! – because the world as we know it will indeed collapse, as day follows night, if bondholders, who knowingly and voluntarily take risk and invest at a spread, are actually allowed to lose anything! We cannot, in a thinking society, allow losses to befall risk-takers who make reckless loans and bad investments. We must, must at all costs, divert money away from health, education, and welfare, in order to save these companies from failure, because neither health, nor education, nor welfare are even possible unless we save the financial system from unthinkable meltdown. We have no choice. No choice at all. They are too big to fail, and we cannot hesitate – they must be saved, for the sake of our children, for our children’s children, for our freedom, for the flag, and to honor the legacy of our forefathers, so that these Champions of Disfigured Capitalism can continue to do their vital work with impunity, unbound by any of the incentives or consequences that actually allow capitalism to work in practice.

To reiterate the observations of Sheila Bair, the outgoing head of the FDIC, in her discussion of the 2008-2009 crisis (see Sheila Bair’s Exit Interview ): “‘We were rarely consulted. They would bring me in after they’d made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.’ If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.’ No analysis, no meaningful discussion. It was very frustrating.’ … As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management’s risk-taking.”

I feel it is important to emphasize – as we move toward recession – that we shouldn’t blame what is happening here on capitalism or free markets. We really have only a caricature of those here. We have a system that is constantly eager to abandon the proper role of government in the markets – which is effective regulation of risk – and to substitute it with the worst role of government in the markets – which is absorbing losses for those whose losses should not be absorbed, and pursuing policies tilted toward the constant creation of speculative bubbles and the avoidance of required economic adjustments, rather than the productive allocation of capital.

Free markets work – provided that they operate within a framework of government policy that enforces property rights, provides reasonable regulation, coordinates objectives that cannot be achieved privately (e.g. certain infrastructure, insurance coverage for pre-existing conditions – which otherwise creates an adverse selection problem even for companies that would like to offer it), and maintains reasonable consumer protection (because there is a huge “information problem” in requiring each consumer to have all of the requisite facts to avoid abusive practices). To blame our economic problems on the free market is an insult to what has proved for centuries to be the most effective economic system for creating prosperity and raising living standards. We would be wise to stomp out the incessant policy of bailouts and monetary distortions if we hope for that to continue.

BAC is a too big to fail zombie created by the Obama Administration and the Fed to protect US financial markets, but is now so vast and unstable that it threatens the global economy. But more corrosive and dangerous than the torrents of red ink inside BAC is the steady erosion of public confidence. Uncertainty is the enemy now, both with respect to BAC and to its large bank peers.

The only way to end the uncertainty and also accelerate the economic recovery is to put BAC through a restructuring using the powers under the Dodd-Frank legislation. While a restructuring by the FDIC may seem to be a horrible prospect, in fact it offers the first real hope of definiteness in the housing crisis, the multi-trillion dollar millstone around our collective necks. Indeed, the BAC situation illustrates why the Founders of the US embedded bankruptcy in the Constitution, namely the need for finality.

In mechanical terms, here is how it works. Let’s start the narrative with a last, Hail Mary move by BAC CEO Brian Moynihan, who put the shell corporation that is the legal successor to the Countrywide business into bankruptcy after settlement efforts fail. This engraved message from Moynihan to BAC’s creditors, litigants and even Treasury Secretary Timothy Geithner — “foxtrot oscar” — begins the real endgame.

Hopefully Secretary Geithner will know about the BAC filing before it occurs and will have begun the process under Dodd-Frank to give regulators and especially the FDIC the power to move immediately to protect BAC and its subsidiary banks. In our narrative, FDIC enters the bankruptcy litigation for Countrywide and asserts control of the entire BAC group. BAC becomes effectively a subsidiary of the FDIC, with the full capital and assets of the entire industry behind it.

Once the FDIC is in control of BAC, the process will then proceed like a typical bankruptcy, with the operating units continuing to do business in the normal course. For consumers and business customers, the situation at BAC will be mostly the same. But for investors and especially creditors, the situation will be far from normal.

In a Dodd-Frank resolution, the creditors of BAC will have an opportunity to file claims, much as with any failed bank. Unlike a bankruptcy, however, the FDIC will make all depositors of the subsidiary banks whole before considering claims of creditors of the parent, a significant difference investors ought to consider. Most important, however, will be the process of converting debt to equity in the restructured BAC, providing the resources to absorb losses, fund continuing operations and restructure.

The beauty of a restructuring is that it forces all parties with a claim on the failed company to speak now or forever hold their peace. It also requires the conversion of debt to equity, which increases capital dramatically and also lowers the operating expenses of the enterprise. A super-capitalized BAC with 2-3% asset returns, 30% tangible equity and gobs of cash flow will then be ready to sell assets, modify mortgages and do whatever it takes to restore the ability of the bank to support new leverage. That is why restructuring is the key to US economic revival.

“Larry Kotlikoff grabs us by the collar, brilliantly unveiling the truth about our financial system: ‘It’s a system virtually designed for hucksters.’ With scintillating arguments, vivid examples, and terrific wit, he shows us a path of powerful reform that would stop banks from gambling and restrict them to their legitimate purpose, ‘connecting borrowers to lenders and savers to investors.’ This is economics at its very best: deeply insightful and powerfully useful. It will change the global debate.”
— Jeffrey Sachs, Director of The Earth Institute, Quetelet Professor of Sustainable Development, and Professor of Health Policy and Management at Columbia University