Picking Winners and Losers Among The Large Banks

Wednesday, February 18th at 10:13AM EST

12 Comments

Ok, so the Teacher And Firefighter Job-Preservation Act of 2009 is now law. Last week, President Obama told us that starting today, the stimulus would immediately speed saving succor to the US economy, using metaphors that suggested the stanching of an open wound. Are you feeling stimulated?

A more true metaphor is that the stimulus will be like a fart in a windstorm. Why? Three reasons: A) It’s small relative to the size of the problem; B) It won’t be spent all at once; and C) It’s programmatic rather than broad-based. The real practical effect of the stimulus bill will be to enable 50 state governors to raise taxes less than they would have been forced to.

Why didn’t Congress take the direct approach and simply enact a payroll-tax cut, which would have ultimately had the same effect, but much more immediate and more salutary? Well, I think the answer to that is more political than economic so I’ll leave it to others.

And coming up fast in the rear-view mirror are the Detroit automakers, who as I’ve relentlessly predicted since December, will soon ask Washington for tens of billions of dollars more. Unless the autoworkers union agrees to far deeper cuts (not likely), the taxpayers will be supporting GM and perhaps Ford Motor, more or less permanently.

But we need to look ahead to the continuing banking crisis. Here we have to make hard choices between who lives and who dies.

Generally speaking, the world’s capital markets are showing not robustness, but at least moderate stability. Anyone who lived through the bizarre disruptions of last autumn will take what we have now and be grateful for it. Credit markets are busily but successfully transitioning to an asset base that is heavily weighted toward risk-free government debt. Stock markets are getting ready for a protracted period of economic weakness all around the world. Stocks will rally sharply from time to time over the next few years, but the overall trend is down.

In this environment, you still have America’s largest banks failing to do what they’re there to do: intermediate the formation of credit for the economy. They’re not making loans, and none of the policy responses to date (a string of ad hoc rescues and a moderate-sized capital injection) has done anything to change that. Neither has policy succeeded in doing anything that would induce any rational private investor to buy stock in a large bank.

The picture among regional and community banks is very different. None of these is lending for much, apart from home mortgages with federal guarantees, but there are many conservatively-run, perfectly solvent banks out there. Part of their problem is an extreme reluctance by regulators to give smaller banks full credit for their capital levels.

But large banks can’t go back to normal lending until their capital levels return to safe ranges. Until then, it’s folly for them even to think about increasing their asset base. It’s a good thing that the people in charge of policy seem to recognize this. We have had some speeches from senior Congressional leaders suggesting that the job of banks is to lend, and by golly, they’ll lend as long as the US taxpayer is their primary shareholder. Such talk would be deeply frightening if it were backed by action, but so far it hasn’t.

Meanwhile, housing prices have not finished falling, and exotic mortgages haven’t finished blowing up inside of mortgage-backed securities the world over. We’re probably at least a full year away from being able to say that the end of asset-price deterioration is in sight. And beyond that, there is still far more housing stock than the US needs. Low housing prices will be with us for the duration of the coming mini-depression.

The Administration is now starting to drop hints about a “Swedish model,” which basically means bank nationalizations followed by re-privatizations in perhaps two years or so.

Such a plan at least has the virtue of recognizing reality. But Sweden in 1994 nationalized almost every single one of its approximately 115 banks. In the US, we have thousands and thousands of banks. Can we possibly nationalize them all? And yet, if we don’t, we won’t really have done anything to instill confidence in their asset books. A partial Swedenization is the best we can do, which means that many regional and small banks won’t benefit.

For large banks, there’s really no question that someone will have to eat the losses they’ve suffered, before some of them can close and others can return to near-normal. This is going to take a lot of time, even if we do everything right. For smaller banks, nationalization is fraught with danger because regulators will always err on the side of caution, yet a lot of those banks really don’t need to be nationalized.

Sticking with large banks, who is going to decide which ones can be left private, which can be nursed back to health, and which should close? It seems to me that Treasury officials are in the best position to do this. If we wait for next quarter’s earnings in early April, the market may signal that none of them are worth saving. The Treasury and the FDIC should be quietly but thoroughly going through the asset bases of all the large banks now. It will take weeks to do this right, and the time to do it is not when a bank is right at the edge of failure.

The real problem with the Swedish approach is the sheer magnitude of the losses, coupled with the fact that we don’t really need as much banking capacity as we swing into depression. Many banks should close, and the Treasury should decide who those will be (and may they choose well).

But it will still take at least $2 trillion in capital, tied up for three to five years, to recapitalize the banking sector. That’s simply inescapable. And only the US taxpayer has a balance sheet that big.

This post also appears at The New Ledger.

12 Comments Leave a comment

Francis, a couple of questions

texas214 (Diary) Wednesday, February 18th at 10:45AM EST (link)

Isn’t the model you are advocating simply to take the bad banks into receivership and orderly dispose of the assets, not unlike the RTC days here in Texas? I’m not sure there is a distinction other than the language being used.

In that enviroment the assets got marked to market by and were sold to repay the taxpayer; seems like some version of that is what we are talking about here.

Unlike that enviroment where there was outright fraud and looting of the S&L’s, what this situation is, is a massive decline in asset values based on “mark to market” accounting rules.

Even at the worst case scenerio of a 20% default rate on each and every home loan in American and you recover say 50% of the value from the default, that would mean loan portfolios should written down 10% + some processing cost and a factor for net present value. Not the $.25 on the dollar that mark to market accounting requires. With some reasonable modeling (or the new term of stress testing) the “mark to market” model should be adjusted for long term assets that these banks hold. That alone could free up the capital markets and not cost the taxpayer a dime.

The whole mark-to-market controversy really bothers me

Francis Cianfrocca (Diary) Wednesday, February 18th at 11:00AM EST (link)

It bothers me because even smart people are now starting to advocate a relaxation of mark-to-market rules (I guess we’re talking about FASB 157), that would allow banks to claim higher capital levels.

One thing I’ve heard some smart people (including a lot of bank presidents) say is that we could distribute the capital hit from an MBS portfolio over five years instead of taking it as a current mark in a down market. And how convenient, five years is a typical maturity term of many MBS.

But you’re now assuming that the banks which hold MBS today will actually hold their MBS portfolios to maturity. Let’s also assume that housing values and default rates will hold at current levels rather than get worse (a bad assumption, but work with me).

I’d have to run the numbers, but I think the “restructuring” of loss recognition might have the effect of getting banks up to nearly-adequate capital ratios (again, assuming no deterioration from here), certainly not a lot better.

What have you solved? If you thought you were going to get private capital into these damned banks, you’ve just made that an even more remote possibility. Investors don’t like it when companies cook their books.

At best, you can declare the crisis over, and hope for a brand new set of banks to emerge and start lending again. Because the banks that you “save” with this proposal still won’t have much capital left to support new assets.

Yeah but,

texas214 (Diary) Wednesday, February 18th at 11:26AM EST (link)

There is no question that all these long term assets, especially those that do not have a “market place”, by that I mean CBOE, NYSE…, values are being driven by what ever the latest round of distressed sales within the market place, not some sort of maturity or asset value. Example: if you own a house in a stable neighborhood and someone on your street is in dire financial shape and had to sell their house (and I’m not talking about CA. here) sold for 60% of it’s value would you then conclude your house is only worth 60% of it’s value?

I read a good article lately (and I can’t remember where) that gave an example of such and went on to explain that everytime someone sells their house at 60%, no matter the reason, it sets a new benchmark in “mark to market” accounting and creates a new benchmark down that sets up a new round of lows, not based on value, but of recent sales comps without respect to the circumstances.

There is a term that seems to be missing from this whole equation “asset value”. If vulture funds are willing to buy pools of loans at a certain levels, they are not paying what something is worth, they want to pay less than value. I do not fault them for such, they are using the system to create depressed prices below the real value of the assets.

I see where you are coming from

The_Gadfly (Diary) Wednesday, February 18th at 12:58PM EST (link)

Let me try a slightly different example from an outfit I worked for some years ago. They were involved in testing agricultural products before they went to market. On any test there are two false results you get: false positives, and false negatives. If the result is a false negative, the consumer gets the short end of the stick. If the result is a false positive, the seller gets the short end of the stick. If seller has too great a risk of getting the short end of the stick, he stops selling and the market for the product, at least while that test is controlling whether or not he gets to sell collapses. The same thing occurs if the buyer has too much risk of getting the short end of the stick.

Now the markets the company I worked for were mostly involved in weren’t the sort of health endangering areas that have been getting so much attention lately, it was more along the lines of how effectively it would help you grow something (and we “sold” the tests, not the product). So for us, the aim was to get the number of false positives low, and spread the risk about 50-50 for the product. If there are health risks, obviously you play with your thresholds and the risk spread for sellers and buyers.

Where I see the problem with the current mark-to-market rules, is that the number of false indicators of problems is too high, and ALL of the risk is being put on the seller. That causes the market to collapse. The market has to come back in order for the recovery to occur. That means buyers need to sharing some of the risk with sellers. More importantly, the test itself needs to be improved so it doesn’t generate as many false results.

Everybody knows the MBS crap is worth more than 0 and less than 1. But right now mark to market essentially requires recording it as 0. Most people seem to think the right value is somewhere between .8 and .9. Some like yourself would set it lower. Fine, pick a number and start there. Set a date certain, and say as of March 1, MBS can be valued at .5 of maturity for asset valuation purposes, and that the valuation rate will be re-evaluated every 90 days/6 months/1 yr (whatever the experts decide is an appropriate interval for the market given current conditions). There would now be a market for those assets. Once it gets going, you should be able to find the right valuation level for the assets through the market itself. If the market operates properly without freezing for some period of time, you might even be able to eliminate the arbitrary valuation level you set to get the market working again. I think it would have the added value that the drop in housing prices might even recover before falling below what it should, which is what will happen if current conditions continue.

I think you're leaving out something very important

Francis Cianfrocca (Diary) Wednesday, February 18th at 1:24PM EST (link)

There’s no financing available to buy MBS in the aftermarket. We’re in a credit crisis. Much of the market activity is by real-money investors and hedgers. Even if people were inclined to pay fifty cents for your average MBS, no one can.

As regards marking to market, the banks would love to be given credit for holding assets with a long-term stable value. And you could actually make a case that, in financial accounting terms, this makes some sense.

But from a counterparty-risk perspective, this totally distorts reality. So what if a bank is holding something that will be worth eighty or ninety cents in five years? If the only available market price for it today is 15 cents, that’s how you have to price it when evaluating that bank’s risk of default in the near term.

And if we get another flaming crisis, there will be no liquidity in the market at all, so the value of the portfolio is zero. Again, for purposes of managing counterparty risk.

Now if a bank tries to get around current marks-to-market, I look at them and say, you bastards, you just took what little transparency there was and wiped it out. Now FOR SURE, I’m going to value your portfolio at zero, no matter what you say.

As you see, you can make a case that banks with large MBS portfolios can probably be kept on life support for a long time. But they can’t return to normal lending.

Great discussion, to all

texas214 (Diary) Wednesday, February 18th at 4:22PM EST (link)

The only concern with what you are saying Francis is that any institution or company reporting under “mark to market” will have no incentive to make a long term investment. At some point in the economic cycle of the investment there is likely to have a down period or a the previously exampled liquidation sale of a similar asset. That should not severely devalue (maybe an adjustment is in order) your investment of your long term assets.

Under your scenerio, if I owned a bank I would never make a home loan because I may have to mark it to zero simply because it is illiquid at some point in its life span.

Okay, now I think we've gotten to the heart of the matter

The_Gadfly (Diary) Thursday, February 19th at 1:32PM EST (link)

For your purposes, the asset is worth 0-15%. For another person, even though there is a risk of default in the short term which would wipe out 90% of the investment, in the medium term, the asset is worth 50% and the risk is tolerable. For yet another investor, whose horizon is long term, the asset is worth 90%, and the risk is tolerable. But instead of letting those medium and long term investors make that decision to take that risk, the law says they can’t. Even though on average, the their investment strategy will work.

I agree each investor needs to be supplied with the marks-to-market number as part of full disclosure. But the same thing is true of the long term valuation, because neither number is the ‘real’ value of the asset. To borrow from Heisenberg, what we’ve got here is a box with a live-dead cat. You don’t know the valuation until either the MBS is fully paid, you sell it, or until it fails. And picking any valuation state until the box is opened is not an accurate reflection of the valuation of the box.

Francis, what will happen to the small banks

civil truth (Diary) Wednesday, February 18th at 10:53AM EST (link)

Speaking as an investor in a small, regional bank that was rather solid, with very modest losses through 2008, but in the past month has dropped more than 50%. These have gotten caught in the downdraft of the big banks problems and the government inaction on mortgages, evidently.

Going forward, will these just be confiscated by the government and share values drop to zero, or will these be allowed to continue to function. In other words, is there any chance the shareholders holders of these small bank won’t be held up at government gunpoint.

Or does nobody know what’s going to happen to these small players?

The greatest evil…is conceived and ordered (moved, seconded, carried, and minuted) in clean, carpeted, warmed, and well-lighted offices, by quiet men with white collars and cut fingernails and smooth-shaven cheeks who do not need to raise their voice. Hence, naturally enough, my symbol for Hell is something like the bureaucracy of a police state or the offices of a thoroughly nasty business concern. -C.S. Lewis

http://www.gmsplace.com/

Obama’s a “Swede”?

Marcus_Traianus (Diary) Wednesday, February 18th at 11:15AM EST (link)

One needs not to look far in order to determine the lessons learned by the Swedish. For example, in the early 1990’s they experienced a deep economic crisis which was the result of, wait-for-it, government market intervention and overspending.

How did they correct it? Well, they implemented a cap on spending and used a very restrictive monetary policy to bring economic stability. They also deregulated and decreased the regulatory burden across business sectors. What happened? Well consistent with almost every other similar study, private sector productivity shot up- especially once they entered the EU in 1995 and had to become more competitive.

The downside for Sweden? They employ about 30% of their workforce in the government (I believe the EU average is about 10%?) which is shockingly inefficient, their overall job creation rate is anemic and “real unemployment” is about 15% last I checked. Why? Well one of the reasons is the high taxes on labor, statutory wage regulations that are “union like” in mandate and other labor regulations. They are also facing a growing crisis as their population ages and welfare payments increasingly rely on taxing productive workers to support their continuance. Sound familiar?

I read a study on the banking sector activity in Sweden that summed it up something like this; there was positive productivity growth but no gain in labor efficiency, nor any substantial post merger gain in overall operating efficiency. The larger the institution, the more pronounced this phenomena.

That’s what happens when you have no idea what you are talking about, Obama.

“Both of our political parties, at least the honest portion of them, agree conscientiously in the same object—the public good; but they differ essentially in what they deem the means of promoting that good. One side believes it best done by one composition of the governing powers; the other, by a different one. One fears most the ignorance of the people; the other, the selfishness of rulers independent of them. Which is right, time and experience will prove.”.Thomas Jefferson

Your percentage have to be wrong.

The_Gadfly (Diary) Wednesday, February 18th at 1:09PM EST (link)

I’m not not sure what the right ones are, there are no conditions under which I can envision the semi-socialist EU having only 10% of their workforce employed by government. I just ran the numbers from the BLS (http://www.bls.gov/news.release/empsit.nr0.htm) and here in the US, using the 3rd quarter statistics, we have about 15% of the employment base working for the government.

The rest of your point stands of course. Government never runs things as effectively as private industry, but nobody in the current regime is likely to believe anything Hayek wrote.

Obama’s a “Swede”?

Marcus_Traianus (Diary) Wednesday, February 18th at 11:15AM EST (link)

That’s what happens when you have no idea what you are talking about, Obama.

I think bank ownership in Sweden is another issue

Francis Cianfrocca (Diary) Wednesday, February 18th at 11:30AM EST (link)

They nationalized over a hundred banks, basically wiping out the existing shareholders and inviting them to either recapitalize or see someone else do it.

I believe (subject to confirmation) that most banks in Sweden are either family-owned or family-controlled. And since most of the leading citizens (who might be bankers) are already tight with the government, this made the whole adventure easier to pull off. From my vague recollection, there are only a handful of banks in Sweden with widely-held ownership, and they were among the most troubled. Yet again, subject to confirmation.

Japan’s banks were among the biggest in the world, with equity cross-holdings among each other and among Japan’s industrial companies. Pretty dang hard to nationalize in an environment like that.

America’s banks aren’t cross-held among their customers (that’s against the law here), but they are very widely held among individuals, fiduciary investors (including government pension funds) and foreigners (including sovereigns, like the Chinese government).

That’s why I think Swedish-style nationalization will be far harder to pull off here than there. Unlike Sweden, the shareholders are just too numerous and too diverse.