Designer Talk: Bank Recapitalization (and Bair’s Aggregator)

Sheila Bair is delivering a sensible general message: we need dramatic action to clean up banks’ balance sheets and, presumably, to recapitalize them.  This initiative apparently has support from influential senators, such as Kent Conrad and Charles Schumer.  Many Republicans also seem inclined to come on board. 

I like an aggregator-type approach; this is quite consistent with the RTC-inspired structure that we have been advocating (see the WSJ.com article linked through that post for details; such ideas are consistent with and an update of our proposals from September, November, and December).  But some of the details currently being floated seem less than ideal.  Given that the design work on this program is still ongoing and the new Administration will, without doubt, seek broad support on Capitol Hill, I would suggest that the following points be considered or even stressed in the upcoming deliberations.

1. The idea that banks should take equity in the aggregator really doesn’t make sense.  We are trying to increase available capital in the banking system, not find new ways to commit it.  (Historical aside: back in the early spring of 2008, when I was still with the IMF, our proposals contained something equivalent to such a structure; but that train has now left the station.)

2. There is really no reason for the aggregator bank/RTC to overpay for the toxic waste.  We should pay market prices – this is the only fair and reasonable thing to do, and anything else will surely lead to a nasty political backlash.  Market prices are sometimes hard to determine, but this is a matter where outside evaluation and transparent procedures can deal with the issues.  (Note: no need for a complicated auction of the kind proposed this fall.)  If these market prices are below the banks’ marks, then they will need more capital.  The RTC should be set up to provide this capital, for example on the terms that we have suggested.  In any case, it is essential to have full reporting to Congress on all details (Open Door or Closed Door, as appropriate).

3. Banks need capital and the taxpayer needs to see value from this unprecedented and regrettably necessary intervention.  There may be a temptation to conduct the entire banking program just through waste disposal, and this is what powerful people on Wall Street want.  But at the very least, the RTC should receive a considerable amount of warrants (options to buy stock) at a low strike price; these should convert to common stock (with full voting rights) when the RTC sells them.  This will enable the RTC to recover value, while selling stakes (and perhaps even control) to new owners.  Given that large banks have repeatedly demonstrated their inability to measure risk, let alone control it, we should have some confidence that this process will lead to the break up of behemoths and a more competitive financial landscape (and let’s back this up with supportive anti-trust legislation, just to be sure.)

The leadership of the US banking system failed completely.  It’s time to clean up the mess that they made, and Sheila Bair’s proposals are along exactly the right lines.  But let’s make them operational in a way that is fair to the taxpayer.  This would be appealing change for President Obama to present to the country in his first 10 days (I don’t think we can wait 100 days).

16 responses to “Designer Talk: Bank Recapitalization (and Bair’s Aggregator)

  1. Yes, finally! This might get us on the right track. The TARP has been horrifyingly unsystematic. One has to wonder if TARP has done the public a single bit of good.

    Turbo-capitalism has proven itself to be efficient in every way, including its own self-destruction. It makes no sense that the financial sector of our economy should account for 15% of GDP. Two thirds of that must come from picking pockets! These huge, “efficient” banks need to be trimmed down to size.

    I have not seen a rationale for how to re-scale banks, especially considering that banking is international. So that is my question. Are banks to be re-sized to the scale/regional size of the existing Federal Reserve Regional Banks? Or states? Or what? What is the theory on which these steps could be based? Sorry if my questions are amateur.

  2. David Pearson

    Thus far every bail out has tried to hide rather than expose the true value of bank assets. The thought appears to be, “we can’t take the hit to the budget of fully recapitalizing these banks, so let’s pretend then have capital.” Needless to say, this strategy has been a dismal failure.

    So the question is, if the government did decide to follow your advice and get AHEAD of this problem, how big would the bail-out have to be as a percent of GDP?

  3. Young Economist

    My biggest concern is the intervention without fair pricing that generates the huge debts for the next generation. Now we have FED and FDIC intervene every financial assets without fair pricing consideration in all facilities, benefit of TARP equity injection on equity and warrant lower than private investors, CITI and Bank of America loss guarantee, and no one knows how much FED and FDIC is going to get loss from intervention that is financed by public by more tax or more interest rate or more currency depreciation in case of monetization. Now We could expect to see the very steep curve (may go to 500 bps) of the long term rate and the short term rate because of the uncertainty of the future public debt (from FED, FDIC and Fannie) and the credibility of FED to utilize the financial tools and how FED finance the loss from intervention.

    The suitable system under is needed to solve the problem with fair pricing. Now the government intervention is doubted to give the fair pricing whatever it uses the bad bank policy to leverage public money from Congress that would cause more gigantic debts from the loss of the leverage policy or the old method of FED and FDIC intervention.

    The best way now the public should focus on FED and FDIC whether they intervene at fair pricing or not and should focus how much the expected loss from those intervention that no one knows.

    Bad bank is good idea on the expansion of intervention size without Congress and public awareness that the leverage is not public debt but it actually is, but if there is no fair pricing, it will create the unexpected mountainous loss that will cause the calamity in the financial and economic systems.

    We could expect to see the leverage bad bank idea to be used by other countries in EU and Japan, so we should not be the concern too much about currency devaluation.

  4. The WSJ piece suggests that this program be mandatory for banks in order to completely restore confidence in the financial system: “We’d recommend a mandatory system that aims to get a “fair” value for tax payers.”

    I do not think mandatory participation is necessary. Rather, what should be mandatory is a very in depth audit of banks finances by the responsible regulating agency (usually the FDIC?). After the audit is complete, a public report should be issued which indicates how sound the bank is: what percent of assets are questionable, what percent of assets are likely to suffer degradation from the recession, what the reserves are, etc. The bottom line of the report should indicate what the auditors feel is the capitalization needed for the bank to continue as a going concern.

    This is information which investors, creditors, customers, and the public in general deserve to know.

    Then leave it up to the banking officials to decide whether they want to participate in the asset purchase and recapitalization program offered. Obviously, if a financial institution receives a questionable audit, they will have little choice but to participate, unless the questions regarding the financial health are fairly minor.

    Public disclosure of the audit report would also provide a fair degree of tranparency about the financial health of institutions and the financial sector in general.

  5. You may want to take a look at the recapitalization process of the Big 3 Chinese banks as an example of a strategy to address issues of solvency and liquidity. A recent China Economic Quarterly article described it as “China’s financial sector recapitalization has been an enormous success”

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  7. A note for Tom K, who suggests “what should be mandatory is a very in depth audit of banks finances.”

    Full audits are usually a sound idea. I would normally agree with you, however, I doubt there are enough CPA’s, accountants and government auditors on the planet to get it done quickly enough. Time is of the essence here. Full audits of banks, especially many of the size we are talking about, take many weeks. I was a VP of an S & L in CA, and I know when it was audit time it took the better part of six weeks. Six weeks is an eternity right now.

    One other thing to think about: Politicians don’t like transparency. Sure, they talk a good game, but when it comes down to it, they’ll prefer fuzzy numbers and generalities over hard and fast facts any day. And if the American public finds out exactly how bad things really are, it would instill a greater degree of fear, panic and lack of confidence in our system than we have now.

    We’ll get the Bad Bank. We’ll see roughly $6 trillion (more) spent on these toxic assets. Then we’ll see foreign money rush back in to the U.S. system, which will kill many economies around the globe and ignite a firestorm of inflation in the U.S. Europe will go into deep recession, and we’ll see one global currency within two years.

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  9. Dear Mr. Hames,

    You raise a good point. I may have overstated the case by using the term “in depth”. It may be sufficient to simply identify the distressed assets.

    And then such audits would probably have to be limited in the near term to the largest banks: global, national, and super regional.

    Even so, identifying the distressed assets of major banks in this country and then isolating them in an “aggregator” could do wonders for confidence in the financial system.

    Hopefully such a task could be performed expeditiously.

  10. If I remember correctly, we spent about $110 billion on the S & L crisis. I believe we’ve spent 10 times that number already with not much end in sight. Nothing to show for it, except taxpayer ownership in some of the largest financial institutions in the world. Just terrific.

    I do like the Bad Bank plan, it worked in the past and it seems as though it should work this time as well. I hope it will work.

    But I am curious … do any of you feel there is much more to this than meets the eye? Do any of you feel that this is (potentially, I guess) a catastrophe that is out of anyone’s hands? There seems to be one bubble after another. One grand scheme after another that doesn’t work. If we do A, it makes B worse. If we do B, A and C seem to be adversely effected, etc. This has become like water in a toilet bowl, it gains speed as it swirls around, and then ….. it’s gone.

    I think we’re going to see 3-4 more Bernie Madoff’s, or 10-12 “little Bernie’s”, or a combination of both, totaling perhaps $125-$175 billion. The second wave of mortgage resets is coming with more ferocity than the sub-prime crisis. B of A’s jumbo loans have a 13% delinquency rate. 13%! Three times what our “acceptable target” rate was at my S & L in the mid-80’s.

    Despite our efforts, I see China, Russia, Britain, France and Germany being seriously injured in all this.

    Sadly, I see a 40% probability of Global total economic collapse by September 2009.

    Am I the only Bozo on thise bus? What percentage would you give this happening?

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  16. The new proposal is about “good bank” or parallel bank system, which I made already in October, and Prof. W. Buiter is now proposing in details and Soros is also urging U.S. to go about it.