Nationalization and Capitalism

This is my last post on nationalization for at least a week, and hopefully a lot longer than that. I’m tired of writing about it. But I was listening to Raghuram  Rajan on Planet Money, and things became a little more clear to me.

Rajan was saying that he had some concerns about nationalization and didn’t think it was necessary to fix the banking system. His concerns were sensible, I have counter-arguments for them, and I don’t want to get into a detailed debate here. More importantly, he agreed with the nationalizers that the system is broken, hasn’t been fixed, and needs to be fixed – he just thinks you could do it a different way.

We’ve talked and talked about it but never actually taken action. We need to take some of the bad assets off the balance sheet. We need to recapitalize the banks to the extent that is needed after that, and that might mean more and more government ownership, that’s a possibility. . . .

The real issue is the taxpayer, unfortunately, has to put more money into the system; hopefully much of it will be recovered. He has to put more money in in the short run, both in buying these assets off balance sheets, and recapitalizing the banks, so that the banks then have clean enough balance sheets such that they will begin to lend when the system recovers. . . . If you can clean up the system, my sense is whether you call it nationalization, or call it cleaning up by putting more money without nationalizing, cleaning up is the first-order thing.

I think there are three main positions in this debate:

  • A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
  • A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
  • B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

The big divide is not between A1 (Rajan) and A2 (Simon and me). In both cases, you end up with a healthy banking system, at significant taxpayer expense. (A2 should be somewhat cheaper because it wipes out the shareholders, but I agree with Rajan that it is dramatically cheaper only  if the government is willing to restructure some of the liabilities.)

The big divide is between both of these and B, the position of the Bush and Obama administrations – both of which rejected aggressive measures in favor of just-in-time, just-big-enough bailouts. Now the government is conducting stress tests on an industry it has already said is adequately capitalized, and will follow that with a public-private asset-buying program that tries to split the difference between paying real market value and paying enough to keep the banks happy. I’ve quoted these exact words before, but here’s Krugman again: “The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up.”

Now, let’s say you agree that something more needs to be done. Then you have to choose between A1 and A2. A2 is the one people typically call “nationalization.” But which is more consistent with a capitalist system: protecting the creditors who lent money to a failed bank, the shareholders who invested in a failed bank, and the managers who failed . . . or firing the managers, wiping out the shareholders, and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses? Which one better approximates the incentives you want in a free market?

63 responses to “Nationalization and Capitalism

  1. This recovery or not is going to be interesting because some of the people who are for nationalization are former economists for the IMF. The History of the IMF in handling financial problems in undeveloped countries by standard accounts see Wikipedia article on IMF is at best mixed. It is argued that IMF actions were largely to the benefits of the largee shareholders an argument which is at least plausible.

    How these events turn out given it has been said informally that the IMF is in favor of nationalization will be interesting. Should the Obama//Bush solution of not nationalizing the banks work well then the credibility of the Austerity solutions proposed by the IMF will be weakened. In fact, it is very interesting that when the US government is in positions similiar to the East Asian economies or African economies in the latest debacle they choose to act counter to the advise they gave others.

    In short the US government doesn’t at all practise what it preached. It might be that the current practises are best practices for recovery or at least better than they are given credit for. If they work real well the case for the type of Austerity documented in the Wikipedia article will be weakened.

  2. Dear James Kwak,

    Thanks you for sharing with us your insight.

    I like to make one request if possible. I, like many of your readers, are layman when it comes to banking. I’ve read many articles on this subject from this web site and from many others. These article all qualitatively describes the problem. Unfortunately, for us readers, we really have no sense of the scale of the problem.

    Can you perhaps do a analysis of Citibank’s financial statement? Focus on the big items. You can tell us which numbers are reasonble and which numbers are highly suspicious and why. As an outsider, I really don’t know just by looking at the financial statement from Citibank. It is really confusing. Especially when our governement and all the big banks are telling us that long established measurements such as Tier 1 and TCE ratio are all in great shape! Why suddenly these measurements are not reliable now?

    I think this exercise will give us a quantitive understand of the scope of the problem. It will be incredibly educational too. I will be very grateful. To simplify the task perhaps you can write a piece that expects the reader to have basic knowledge of accounting.

    Again, thanks you very much!
    Crazy Hog

  3. Despite this week’s rally, it’s hard to see how the Dow doesn’t go down to 4000 or 5000. We still have commercial real estate to go, and other various sorts of debt and credit, not to mention the world. If market declines continue, it’s hard to see how Citi and AIG don’t go down to nothing. Can Pandit’s claims really be true? True as Wen Jiabao, I suppose. In other events, I’d be willing to give Geithner’s gambit more of a try (he must be terrified of Lehman redux). But are they missing their best chance to take a systematic, firm hand? Having given so much hope to moral hazard, can they really change course now? Probably not. All credibility is being shot to hell.

  4. I’d like to hear the Baseline Scenario’s take on the idea of creating a whole set of new banks with fresh capital and clean balance sheets, and just letting the existing banks fend for themselves. I believe there were a few articles in the WSJ about this. Would this work in theory, and what would be the practical challenges for this method in practice?

  5. Your arguments make sense if one accepts the premise that the banks have truly been a part of the free market system. If on the other hand one believes that they operate on the basis of an implied government guarantee then B makes sense.

    I suspect that the political class believes that the banks have survived and prospered on the basis of FDIC insurance and the assumption that “too big to fail” is policy. In that case, isn’t B the rational choice for a politician? With an unlimited checkbook why not dole out the money as needed and hope that time cures the problem. Why invite the political problems that both A1 and A2 entail? Why destroy a relationship that enures to the benefit of both?

    I don’t disagree with either your point of view or Simon’s but I do think we need to start recognizing the harsh realities of the government/banking symbiosis. It’s a hard one to sever.

  6. I wonder why we keep talking of nationalization. If we read for instance the UK Banking Act 2009 there is no mention of it and it’s not necessarily or inevitably the only or preferred “stabilization option”. There are different property transfer instruments which do not necessarily imply any nationalization and could actually open the door to the creation of new good banks, if we just want them…

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  8. most of the money was invested by pension and mutual fund managers who are paid very well to know what they are doing. if you wipe out the equity holders along with the (unemployed) citizens’ pension plans and completely destroy confidence in banks and the capital markets, how do you recapitalize without selling everything to the PE/hedge fund insiders? what do you do about the unemployed, pensionless masses? just how exclusive will the private sector be after the execution of your plan? who pays the taxes?

  9. markets.aurelius

    As part of the nationalization process, the Pension Benefit Guaranty Corp. will have to be funded, or back-stopped in the event of a bank failure, to specifically protect the unwitting victims of this destruction of banks and former investment banks. It’ll look a lot like a federal pension program, but that would be money better spent than what we’re apparently gearing up for — leaving the US Treasury open for the current managements to loot and enrich themselves.

    http://www.pbgc.gov/

  10. In three short phrases, what should be the manifesto for a financial reform movement?

    I suggest two:
    1) No More Banks Too Big to Fail.
    2) Tax Short-term Financial Transactions

    –Wade Hudson

  11. “But which is more consistent with a capitalist system…?”

    The Obama administration has specifically adopted the position that the past is the past. Rather than punish, they will fix.

    They recognize their fix will create bad incentives, and their response is to replace incentives (which never really worked) with regulation. From their perspective, banking never was a free market system. The mistake was pretending that it was a free market by undoing the regulations.

    The “forgive the past, look to the future” attitude of the Obama Administration is evidence across policy arenas: refusal to prosecute telecom companies for violations of privacy law under Bush, refusal to release documents leading up to the war in Iraq, and now refusal to punish banks.

    Even so, the difference between full and partial nationalization seems small (even with Citi’s share price doubling this past week, there’s only 10 billion in common equity left).

    The big concern is that bank liabilities are being paid for by borrowing more money from abroad and indebting taxpayers rather than through quantitative easing (which devalues debt).

    Team Obama seems to be gambling that by keeping interest rates low and using fiscal stimulus, they can restart the economy, then pay back all the debt through tax income. Who believes this? Republicans are correct to note that the “cut the deficit in half in 4 years” pledge has optimistic growth assumptions _and_ works only by moving War spending into the main budget.

    If one tried to formulate a single guiding principle for the Obama Administration, it would be:

    “Protect Creditors at All Costs” (both foreign and domestic)

    The big losers: asset holders, companies, employees, and especially the US taxpayer.

    This is a balance-sheet driven global recession. Creditors, in clutching to tightly to their assets, will strangle economic activity and ultimately destroy those assets.

    Nonetheless, I hope I’m wrong, and the Obama plan works. I’m in the same boat as everyone else.

  12. raivo pommer

    Raivo Pommer
    raimo1@hot.ee

    Die Reform von Weltbanks

    Weit mehr als die Industriestaaten trifft die weltweite Rezession nun die Entwicklungs- und Schwellenländer. Joseph Stiglitz leitet derzeit eine Kommission der Uno, die Konzepte für eine Reform der internationalen Geld- und Finanzmärkte erarbeiten soll. In Berlin traf er kürzlich Heidemarie Wieczorek-Zeul, die Bundesministerin für wirtschaftliche Zusammenarbeit und Entwicklung, die ebenfalls der Kommission angehört. Stiglitz hält Institutionen wie die Weltbank, den Internationalen Währungsfonds (IWF), aber auch Staatskonferenzen wie den G7- oder den G20-Gipfel für untauglich, die Krise zu meistern. “Wir brauchen einen Neustart”, sagte er. “Die Vereinten Nationen sind die einzige Institution, die den erforderlichen Maßnahmen Nachdruck verleihen kann.” Ein starker “Weltwirtschaftsrat” solle künftig über die Einhaltung globaler Spielregeln für die Wirtschaft wachen.

    Dass ein solcher Rat alsbald gegründet wird, erscheint jedoch eher unwahrscheinlich, trotz des immensen Drucks durch die Wirtschaftskrise. Selbst um viel einfachere Reformen ringen die Gremien der Vereinten Nationen teils jahrelang. Ministerin Wieczorek-Zeul setzt deshalb vor allem auf die Reform von Weltbank und IWF: “Es dauert zu lange, eine neue Struktur aufzubauen.”

  13. rather than completely plunder and then give publicly listed banks (along with their massive technology infrastructure and personal and corporate data resources) to publicly subsidized private investors for pennies on the dollar, why not sequester and reinvest the looters’ multi-trillion dollar cash stash now – surely that is the imbalance to worry about – and in the process, restore the financial health of the companies that contribute to the pension funds and pay the salaries that support home sales and trade. ensure the banks’ fee structure rewards genuine investment (anybody know anything about that?). claw back the ill-gotten gains from the bankruptcy-for-profit crowd

    “…“The magnitude and duration of hedge fund deleveraging, the amount of cash on the sidelines, and the potential buying power this represents for a market rally are among today’s key investment controversies.” http://allaboutalpha.com/blog/2009/03/05/a-graphical-look-at-hedge-fund-leverage/

    http://www.hedgeco.net/news/03/2009/hedge-fund-private-equity-titans-crowd-billionaire-list.html

    “…several firms that have the market share and global capital markets capabilities will form a core of leaders in the prime brokerage market of tomorrow,’…He believes the approximate order will be: JPMorgan Chase and Co, Goldman Sachs, UBS AG, Morgan Stanley, Deutsche Bank AG, BNP Paribas, Credit Suisse Group AG, Bank of America Corp , Barclays Plc and Citigroup Inc. Wall Street’s prime-brokerage business, which has profited from the growth of the hedge-fund sector, posted peak revenue of over $12.4 billion last year, the analyst said.” http://www.thomsonimnews.com/story.asp?storycode=50623

  14. vance geiger

    I come here a lot to get a more realistic perspective on what is happening and truly do appreciate what you are doing. I have also watched everyone interview with Simon Johnson that I could find.

    I still, however, have some questions that I wish you could answer.

    1. Banks created toxic assets by making irresponsible loans. Every time the government provides them money to cover the losses or buys the toxic assets the government is creating money that did not exist before. Isn’t this then a successful effort by the banks to print money? If not, why not? If so, why not explain the problem in these terms? It would go a long way toward explaining why there is a need for better regulation, especially leverage regulation for all investments or loans that could under ANY circumstances become an issue for the government, as in the taxpayer.

    2. Banks have toxic assets in the form of collateralized debt obligations, CDOs, that were securitized (in essence sold on a market?). The worth of these CDOs has gone down as I understand it because a lot of the assets in these CDOs were mortgages (and now a lot of commercial real estate loans) that are going into default. As I understand the mark to market issue, these assets have to be valued according to the value they could be sold for on a market. The problem is that no one wants to buy them so they cannot be valued according to a market value. Doesn’t that mean that, in a free market, their value is zero, or something close?

    3. Kanjorski and company in the US House is trying to change the mark to market rules to allow banks to value these assets at what they are supposedly worth if held to maturity. But that value is contingent on a return to the high housing values even for properties that may have gone through foreclosure, or multiple foreclosures, in the meantime. I read the article referred to on Planet Money on Looting and they argue that mark to market (as well as other regulations) is indispensible to avoiding these kinds of crises. Why would Kanjorski and company be trying to change this unless they are working for the banks? And won’t a change from mark to market just lead to another problem?

    4. Which brings up Citi again. I too would like to understand how Citi can be profitable when so much of the assets are tied up in “toxic assets” unless they are making money off of the recirculation of the TARP money they got from US (as in us, the taxpayer). How are they valuing the assets?

    If this is not the right forum for these questions could you direct me to somewhere that is more appropriate?

    Thanks. Vance Geiger

  15. Thanks for this site. Wonderful. On Thursday, I sat through the House hearing on Mark-to-Market (MTM)accounting. Although MTM is not responsible for the crisis, it has, most certainly, exacerbated the contraction of regualatory capital and lending capacity. Change is on the way – change that will be capital and taxpayer friendly. The testimony of Bill Issac and Tom Bailey best illustrate the nature and scope of the problem (pdf available by clicking on panelist name at http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr031209.shtml) In my mind, this movement explains the sudden slow-down in dealing with the banks and the financial sector’s recent rally, which now, in view of the foregoing, appears to have some legs.

  16. re: (even with Citi’s share price doubling this past week, there’s only 10 billion in common equity left).

    so if someone told you that your $500,000 house is now worth $5,000 – would you then decide it must be worthless and give it to them free of charge?

  17. in fact – in the preceeding analogy, you’d end up paying them quite handsomely to take your home…

  18. donthelibertariandemocrat

    “and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses?”

    I think that it’s really down to this. It’s a matter of sounding out these creditors and making the tough call. Unfortunately, China and the spreads have been arguing a tough stance. But, in private, maybe a deal could be worked out.

    However, and here’s where I agree with John Hempton, the bondholders know that we’ve issued a complete guarantee, although implicitly, and, on this one, they’re willing to ride the wave.

    As for not writing on this, good luck. Your blog has now become too important. Many of us feel the exasperation, which has long since passed over into stupefaction, but there’s still an argument to be won.

    Truthfully, if you look back to September, many ideas that were anathema have become possible, and blogs have taken the lead. In that sense, a lot of progress has been made.

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  20. Willem Buiter fleshes out this proposal a bit in his latest post.

  21. This site is great. My first comment is below.

    I realize you know what you mean by the term “toxic assets”–at least I hope so!–but it is as useless a term as can exist. Yet it is difficult to find any discussion of the bank problem without encountering that term, and seemingly that term alone.

    It is far preferable to describe the actual assets being discussed. For example, the recently released study by UVA professor William Lucy states that if one sums the realized losses from pre-foreclosed and foreclosed mortgage assets, it only totals about $150 billion (!). This is trivial. Yet we know that close to $1 trillion have been taken as losses, and some forecast the number should be $4 trillion.

    What are these other losses? They can only be one of a few things, at least as it relates to housing. They could be mortgages which are not in default but which the market values at a discount to par, thus causing stated losses. These are presumably the assets which caused the last 2 administrations to hope for recovery and choose “door number 3″ in your scenario.

    They could also be losses due to credit derivatives. But derivatives are cash zero sum in the purest sense—one’s loss is another’s gain. Only when banks permitted AIG to not post collateral did this become a “system issue”. But how much of the collateral which the Feds are pumping into Wall Street through AIG relates to actual underlying defaults versus “marks”? AIG is similar to LTCM in that the Street never required collateral from them before entering into contracts. I doubt many more “AIGs” are out there as the Lehman unwind seems to support.

    Obviously one cannot merely dismiss the issue of “marks”. But this is where we enter the zone of the unknown/unknowable. It is not unreasonable, even if it ends up wrong, to believe recovery can happen on its own (assuming Lucy’s number or even 5-10 times Lucy’s numbers are correct). We appear to be in a self reinforcing spiral of disbelief, I believe caused almost exclusively by these 2 administrations’ public display of panic and confusion. (The Obama spending train is also not helpful). This has caused more firings, more cash hoarding, less risk taking, and more write down losses, etc., but not that much more actual realized losses yet–at least that appears to be the case if Lucy’s study is accurate.

    So why should “structural” solutions per se, like A1 and A2, fix the “self reinforcing spiral of disbelief” problem? What is the operational mechanism which would make these structures work with higher probability than, for example, waiting for godot, which is the administration”s path?
    Is it even possible the recent announcements by the 3 big US banks on Q1 earnings suggest the spiral is stopping?

    The Feds have been beyond atrocious in characterizing our situation and have contributed materially to destabilization. But the suggestions we have all made (I have too) regarding doors number A1 and A2 (and A3, whatever that is) strike me as illusory at its core. We simply assume the desire to escape the liquidity trap will emerge if we perform some technical structural accounting trickery and reassign the losses which still exist. There appears to be no “objective” reason why these structural solutions should work any more than doing nothing will work—unless we believe defined action per se can instill “confidence”. But such belief would merely be a superstition.

    The most important question to me is whether or not we are collectively causing our own problems by fearing that which we do not understand. I think a clear description of the “asset problem” by governments and critics (me too) is part of what is needed. We must demystify the nature of the asset problem, not continue to obfuscate through bad communication. We can start by banning the term “toxic” from our vocabulary! We can also describe why any of these proposals ought to work, probabilistically of course, beyond the belief itself that they will work. If it is true, as Lucy’s study implies, that the majority of losses are simply fear of future losses (i.e. mark to market losses), then that is where all solutions need to begin.

  22. What leaves me completely in the dark is how the large banks could come out this week and say they don’t need any more public money. How is this possible given everything we’ve read here and elsewhere every day? I have three possible ways:

    1. They are lying. Based on past experience I’m inclined to believe this one. They don’t want nationalization so they are lying about the need for more capital hoping to “buy more time” which is essentially been the policy all along.

    2. The “toxic assets” have been market down as much as necessary and the capital infusions so far are sufficient. I find this unlikely, but we are talking hundreds of billions of dollars.

    3. The PPIF / TALF plans are actually starting to work, and the banks are lining up non-government capital. This would obviously be the best of all the options since it would basically signal the end of the banking crisis.

    I’m still inclined to believe they are lying.

  23. Making a profit and being solvent are totally different things. If you own a new company that borrowed a million dollars to get started, and in the first quarter you make $50,000 and your expenses including debt service are $45,000 then you made a profit. However, under banking regs you would be insolvent because you owe more than the asset, in this case the company, could be sold for on the open market. In that case it doesn’t matter, most companies start this way. Banks can’t operate that way, they need to be solvent, have more in assets than liabilities.

  24. I think I speak for many lay people when I say that I am less concerned about whether or not a solution to the credit crisis qualifies as capitalist (in some economic textbook sense) than I am about whether or not it qualifies as just or fair (in some commonsensical ethical way).

    Having said that, I am willing to accept the “too big to fail” argument for nationalization insofar as the government acts as an honest broker on behalf of taxpayers and the government does not coerce (as in “threaten with violence”) the banks into the deal.

    In fact, at the risk of breaching free-market dogma, I will go one step further than James or Simon and suggest that it matters very little whether or not the said bank nationalization is temporary or permanent — so long as the flow of credit is restored to the system and the new management is no more corrupt and/or socially irresponsible than the old one.

  25. MK is right – it’s important not to confuse the legalities of bank solvency (minimum ratio of capital to assets) with whether the bank is profitable in the long run.

    With only 4% to 8% capital to asset ratios (which is higher than the European banks), any banks that suffer even temporary losses of 5-10% become “insolvent” and must be shut down.

    With markets that fluctuate dramatically (as long-term risks are projected into the present due to net present value calculations, not to mention investor psychology in a highly illiquid environment), strict mark-to-market creates tremendous risk premiums for banks. The question is whether there is a less-than-strict version of MtM that gets us the good (transparency) without the bad (excessive volatility).

  26. MK is right – legal solvency is different than long term profitability, or even cash flow.

    Cap-Asset requirements requite minimum ratios of capital to assets. With a roughly 4% ratio, a drop in asset values of 5% makes the bank “insolvent”.

    Consider that stock markets have dropped 20% in a few weeks, then recovered 10%… The CDO market is, if anything, less liquid and transparent than the stock market – potentially more volatile.

    MtM projects future losses into the present (due to net present value asset valuations). Tiny changes can mean dramatic short term consequences.

    There are proposals on the table that could retain some of the benefits of MtM (improved transparency) while perhaps relaxing the harm – so it might not be an all or nothing argument.

  27. I’m not eager to wipe out bank shareholders – I became one when I got married (my wife still has some Bank of America stock from her teens).

    However, the few tens of billions left in stock are negligible compared to the other costs of this crisis. Without TARP funds, the stock would already be worthless (insolvency).

    It’s simply that in the nationalization debate, “wiping out shareholders” seems to be inconsequential next to the bigger picture. It won’t save the govt. that much money. It’s the creditors who are being bailed out now.

    Your point below is an excellent one – destroying the bank has _real world_ consequences in terms of IT infrastructure, buildings, employees training, existing contracts, etc. Wiping out all of _this_ is something the FDIC tries to prevent by selling off insolvent banks. Nationalizing it (temporarily) does not mean destroying all of this.

    The govt. should be fully capable of taking over the bank, putting it into operating receivorship, and allowing a bankruptcy judge to downwardly adjust creditor claim in the same way that standard bankruptcy laws are applied. By adjusting creditor debt down by 10%, the bank becomes solvent and govt. losses are mimized. Taxpayers don’t hold the bag.

    Would this increase interest rates? YES. Higher interest rates are the natural disincentive to making bad loans.

    Having said all of this – there’s an easier way to downwardly adjust bank liabilities to creditors.

    Inflation.

    Instead we have near-deflation (and certainly lower interest rates than projected), meaning that creditors are being doubly rewarded – first by higher real returns on their fixed rate assets, second by government insuring deposits that the government never pledged to insure (a true giveaway).

    Meanwhile, Taxpayers and Lenders are being doubly hurt – at the same time that asset value deflation is reducing household wealth and creating a global demand crisis.

    Thus, the _exact_ method of dealing with the banks is important, but only secondarily important. Just do something.

    Then get onto the bigger issue – which is the currency and global monetary policy.

  28. I find it interesting that President Obama, who I’m guessing has access to the best economic data and the best economic minds on the planet, provides only a fuzzy picture of the problem and the possible solutions. He and his advisors are consistently vague, confusing and sometimes contradictory in their pronouncements. Obama ritually expresses his emphathy for those harmed by current conditions. He oft repeats the fact that he inherited this mess. But on points of detail, he and his surrogates are repeatedly evasive. On the other hand, there is surely no shortage of experts, with less resources, who have a crystal clear grasp of the problem and know exactly what to do. So why is the administration behaving this way?

    One possibility is that he and his advisors are fools, floundering needlessly in two feet of water. All they have to do is read the blogs to find obvious answers. Still another possibility is that the data available to them indicates the situation is more dire and more complex than most people think. Could there be constraints that are not publicly known?

    I would like to offer a fourth possible position.

    B2: The banking system is broken. There is no comprehensive fix. In the meantime, the government should triage the industry as best as possible and hope the invisible hand starts pulling it in the right direction.

    I ask the same questions as “Crazy Hog.” What kind of numbers are we talking? What will it cost to protect everyone? One trillion? Ten trillion? One hundred trillion?

  29. I listened to the Planet Money interview of Professor Rajan, too. Sure, he said he was against “nationalization,” which I think is a term that means many different things to many different people. Yet, when I listened to what he said, it sounded very much like he was in favor of something akin to FDIC receivership where bondholders take a haircut. (This is something I wrote about in “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625.) I think he wants to avoid an AIG-style assumption of all liabilities. I understood his objection to “nationalization” to be the government assuming the liabilities of an insolvent institution. Further, he is not in favor of government management of banking institutions. Thus, I believe his position was closer to A2 than you believe.

    Personally, I think the government would be better served by requiring under-capitalized, but solvent, mega banks to issue new common stock at close to market prices. (If the government is the buyer, so be it.) This will correct lending incentives. This view is supported by my papers at http://ssrn.com/abstract=1321666 and http://ssrn.com/abstract=1336288. None of the results of either of those papers require (or advocate) that the government exerts control or even retains their common stock positions. The Geithner Treasury as opposed to the Paulson Treasury has put in place essential restrictions on recipient banks regarding dividends, share buybacks, and cash acquisitions, which will allow any sale of new common stock to actually lead to deleveraging of the issuing bank. The restrictions on leverage increasing transactions were advocated in my previously mentioned papers and by other financial economists. In addition, the U.S. Treasury has recently also put in a provision to automatically sell the government’s common equity positions under the Capital Assistance Program.

    On the other hand, if the large or small institution is insolvent, a FDIC receivership procedure should be implemented. The existing shareholders should be wiped out and unsecured creditors’ claims need to be written down. Regulators have the authority to do just that with the mega commercial banks. During such a takeover, the government should only pay current market prices for toxic assets bought in receivership.

  30. why should u.s. taxpayers take on the cost of protecting everyone?

    “…Assets of anything from $1.7 trillion to more than $11 trillion may be [“stored”] in tax havens…’ http://www.reuters.com/article/gc08/idUSTRE52A49M20090311

    question: looking at today’s stories quoting Wen, does your version of nationalization commit U.S. taxpayers – and the shareholders you want to wipe out – to ‘guaranteeing the safety’ of “China’s assets”? Does China pay U.S. taxes – and does it offer any of its’ own guarantees to investors – foreign, institutional, private or domestic – if and when it allows them to invest in the first place?

  31. anger raising

    StatsGuy, your inflation idea is simply marvelous!! Let’s inflat our problems away!

    First, let’s start at home by screwing our freeloading seniors that live on fix income. They are useless anyway. Let’s then decimate the real value of everyone’s bank account. The stock market has cut everyone’s investment in half. Let’s finish the job by cutting everyone’s saving account’s real purchasee power in half too!

    Let’s than go screw our neighbors aboard. Let’s screw every country that traded with us. Screw everyone that has account receivable in denominated in USD. Screw anyone who lend us money. Never mind the credit worthness of of good old US of A. Cause we’ll never borrow a dime again! Globbal trade sucks anyway. We are so tire of them foreigners getting their dirty paws on our pretty little dollar bills! Screw them!

    Hey, forget all the high ideal like honor and trust. We didn’t ask people to trust us, did we?! Anyhow, it is their own god damn fault!

    Hey, what can I say. Time is tough. Let’s have a depression party to celebrate the renaming of our country to USZ, the United State of Zimbabwe! Let’s show the world how we roll!

    USZ! Yee Haw!!!

  32. The CDS market is something north of $50 trillion worldwide. Notional value. Way larger than the MBS market that Lucy studied. The fed has already pumped $180 billion into AIG to honor CDS contracts, most held by banks around the world.

    And the $1 trillion PPV program of Treasury is aimed at moving more derivatives off bank and insurance company balance sheets.

    Of course if economies do improve then the fewer CDS contracts will be called in. But if economies worsen further, and stay there, then the bills just become larger, and larger.

    The current procedure is to hope economies improve and dribble money in to cover contracts. But if they don’t improve, at some point even the national purse will not be large enough.

    The poor public. Just as they struggle to pay off debt, the national debt shoots up and may cause inflation that actually helps debtors. The public went into debt and got the double whammy of deflation, and then once they’ve reduced their debt they will become creditors and get hammered by inflation.

    What the public should be doing is levering up to buy hard assets. But the banks know what the picture is, so they definitely aren’t going to lend to Main Street now.

  33. Like most on this post, I’m an absolute sucker for theoretical and critical thinking. But, Mr. Rulee (above) is spot-on. I deal with the empirical in this milieu every single day. And, today’s reality is completely awry of the facts. That’s why people in my line of work, people who have rolled up their sleeves, sweated the details, and gotten the grit of this chaos under their nails and in their teeth are beginning to line up at the administration’s door with investor capital and lots of it. If the administration blinks under option A1, A2, or any derivative thereof as posited, and I suspect it will, we (as investors) are going to make an absolute killing going long the very “toxic” debt you and the rest of the world eschew. To paraphrase Obama, “we are a nation of workers” and “those who toil will prosper.” And, that my fellow bloggers is what has made America great. Sadly, though, I can foresee a day this time next year when blogs will be clogged with insidious commentary about bastards like me. My (our) only solace will be, I (we) told you so.

    PS: Those who continue to quote the “gross” notional value of the world’s CDS market without full disclosure are simply fear-mongering and clearly have no understanding of how the CDS process works. CDS are, indeed, a “zero sum” game (Rulee).

  34. Pedro Candela

    I agree with Crazy Hog, it would be very interesting to see an analysis of Citibank’s financial statements. We would be anxious to see a real case!

  35. Pingback: Top Posts « WordPress.com

  36. I’m with Crazy Hog, Pedro, and others who have previously asked for an analysis of a troubled bank’s actual financial statements.

    I realize that this would take both knowledge and work, but it seems that we could get past some of the merely theoretical.

    Any chance that someone like StatsGuy or another reader could do this is Simon or James (understandably) don’t have the time? Seems like it would exemplify blogging at its best.

  37. Pandit’s memo was disingenuous in that it did not include writedowns of bad loans http://www.ft.com/cms/s/2/1997b610-0d7d-11de-8914-0000779fd2ac.html and banks are now operating in an upward-sloping yield curve environment http://www.realclearpolitics.com/articles/2009/03/a_shotgun_marriage.html .

  38. Yes, Yes, and Yes.

    “The poor public. Just as they struggle to pay off debt, the national debt shoots up and may cause inflation that actually helps debtors. The public went into debt and got the double whammy of deflation, and then once they’ve reduced their debt they will become creditors and get hammered by inflation.”

    You are 100% accurate.

  39. Let The Tweaking Begin
    In moving to “reform” FAS 157, the FASB might as well admit the rule has been a disaster

    Gary Townsend
    Posted 03/13/2009
    Hill-Townsend Capital
    gary.twnsnd@gmail.com

    Well, someone was listening.

    In recent Congressional testimony, Ben Bernanke, Sheila Bair, Tim Geithner, Mary Schapiro, and other regulators have all taken reasonably constructive positions on reforming FAS 157 and Fair Value accounting, also known as Mark-to-Market. While they all say they see great conceptual value in mark-to-market accounting (for its “transparency” and “clarity”) and wouldn’t support a rescission or suspension of FAS 157 per se, they support “tweaking” it, or changing to reduce its “pro-cyclicality,” or allowing greater management judgment in determining marks and preparing associated disclosures. And we now know that the Financial Accounting Standards Board plans to issue a new disclosure draft for public comment on proposed changes within weeks.

    Can anyone spare a fig leaf?

    The truth is that any one of these “tweaks” implies fundamental changes to FAS 157–changes that will leave the rule largely unrecognizable.

    To be clear, Fair Value accounting must be reformed, in my opinion. It is fundamentally flawed and at war with FASB’s own conceptual framework for financial reporting. But in the interest of “transparency and clarity,” the FASB would do the public a great favor if, when it issues its new rule, it also provides its own full disclosure and explains what an utter and miserable failure FAS 157 has been. Here are some proposed topics it might touch on (and I invite readers to add to my list):

    * The importance of professional judgment to the valuation process. FAS 157 took judgment to the vanishing point. The new rule should explain why professional judgment is essential to the valuation process.

    * The deficiencies of the “Fair Value.” FAS 157 eliminated “market” from the definition of “fair value”. It’s time to put “market” back in. But FASB should also discuss the conceptual deficiencies of the “fair value” definition. Interested readers can find my critique here.

    * When are mark-to-market disclosures misleading? If the objective of FASB’s conceptual framework is to provide information to help “assess the amounts, timing, and uncertainty” of cash flows, users of financial statements may be misled if losses are recorded based on the market’s perception (or misperception) of an asset’s value. Here’s the real-life experience of Bank of New York Mellon when it disclosed the “fair market” value of its Alt-A mortgage portfolio along with the portfolio’s estimated cash-flow value. The difference? Only $1 billion.

    The new definition of Fair Value accounting must look first to the purpose of the assets or liabilities being valued, rather than their value in liquidation. One of the great ironies of FAS 157 was that it has undercut the public’s confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles. For instance, banks typically mark only a small proportion of their assets and liabilities to market for purposes of their financial statement presentation. However, all are required to disclose in footnotes the “fair value” of their financial assets and liabilities. Though MTM results can bear little relevance to the intrinsic value of a loan or security that the holder plans to hold to maturity, the disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Here’s what happened to Capital One: the company’s tangible book value per share of $28.24 according to GAAP became minus-$1.21 after adjusted for disclosed FV marks. Such absurd contradictions are extremely harmful to public confidence.

    Washington, D.C. hasn’t done much to boost investor confidence lately. That needs to change. It’s time that the SEC, FASB, Treasury, and bank regulators embark on a full-court public relations press to affirm GAAP financial results, while detailing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as the current one.

  40. Sadly, the public does not have the luxury of levering up at the current time – even if a bank would lend.

    Hedge funds, however, don’t need to worry about banks lending, when they can simply buy a bank and then loan themselves money.

    http://money.cnn.com/2009/01/06/news/companies/ross_banks/index.htm

    Wilbur Ross: “What is important is to get access to a stable, low-cost source of funding,” Ross said. “That is what we are interested in.”

    The public’s best option would be to have Congress compel the Fed to print money (QE), use this it to buy up the toxic assets and fully recapitalize banks and fund the stimulus (if needed put banks into receivorship and possibly shave a bit from creditors), and not bother seeking hedge funds to provide capital. The notion that “the govt. can’t do it alone” is being used to justify including hedge funds on the deal.

    Yet one can be certain the hedge funds will not jump in unless the opportunity for profit is huge and the downside is relatively mitigated (at taxpayer expense).

    Of course, this assumes the turnaround is successful – which is still in doubt. The public is deeply in debt, median incomes are down, and the global economy is suffering.

  41. James, something tells me that “THE FIX” is in for the outcome of Geithner’s stress test by what Simon calls the Wall Street Oligarchs: “Now the government is conducting stress tests on an industry it has already said is adequately capitalized.” [Although Pandit’s memo was disingenuous in that it did not include writedowns of bad loans http://www.ft.com/cms/s/2/1997b610-0d7d-11de-8914-0000779fd2ac.html ; and geez, if he can’t make money with an upward-sloping yield curve then he should be shot!] Moreover, Geithner and the Wall Street Oligarchs framed “the problem” as capital adequacy (read, keeping alive zombie banks); the “real problem” is the creation of fresh lending capacity to finance the new industries of what Obama calls the post-bubble economy.

    I just listened to Raghuram Rajan on Planet Money and you got it right when you said, “different people ascribe different meanings to this word; in particular, opponents like to define nationalization as the government taking over every bank permanently and turning banking into a government service.”

    You have offered three main positions in this debate (A1, A2, B). With the following two ideas I would like to offer a fourth position (amending A2’s definition of nationalization) that perhaps you & Simon could champion that not only overcomes all of Professor Rajan’s objections, but most importantly for President Obama’s budget, creates a magic silver bullet by making lemonade out of lemons to kill two birds with one stone (sorry for the mixed metaphors) by using the same issuance of federal debt to bailout BOTH bad banks and the federal entitlement trust funds!

    With “THE FIX” in at Treasury, the battle line against the Wall Street Oligarchs will be when Geithner asks Congress for more bailout money. Under this new fourth position Wall Street would be working for Main Street, which would make bank nationalization *politically palatable* for Congress. (In fact the greater the expenditure to recapitalize banks today, the less strain on the federal budget tomorrow [read baby boomer’s Medicare benefits and US sovereign debt credit rating].) And yes, Rajan is right that the government will create an unlevel playing field, but at least it will be to the advantage of the American People!

    Most importantly, this BOLD, FRESH START BIG BANG approach would once and for all drive a stake through the heart of zombie banks — thereby boosting confidence by irrefutably showing that America’s banks are ready, willing and able to lend to rejuvenate both the U.S. and global economy.

    ——————————————–
    IDEA #1: Nationalization (err, “Recapitalization”) of Insolvent Bad Banks To Create Ultra-Clean New Banks

    The simplest, most straightforward, and easiest-to-understand good/new bank proposal is for the government to create ULTRA-CLEAN NEW BANKS with pristine balance sheets and tabula rasa loan portfolios.

    » Ultra-clean new bank gets insolvent bad bank’s deposits and core operational assets (including capital market operational assets essential for financial system stability). Freed from the headaches of delinquencies, workouts and charge-offs of legacy loans, the “expert” old management team (e.g., Citigroup CEO Vikram Pandit) manages the new bank.

    » ENTIRE old (performing & non-performing toxic) loan portfolio plus cash from consideration of operational assets go into the Chapter 7 bankruptcy estate for old creditors, counterparties and shareholders (after all, that was the bet that they took!) to liquidate in an orderly fashion (like run-off mode of insurance companies)–thereby avoiding asset liquidations at “fire sale” prices. Depending on how much economic capital was reserved for bad loans, the bad banks are probably borderline-inadequately capitalized, which suggests that together with the massive cash flows from the bankruptcy estate’s performing loans the unsecured creditors will be made whole–and even shareholders might be something back. (Note that with the ENTIRE loan portfolio there is no MESSY need for the FDIC to sort out current toxic from now-performing but soon-to-be toxic loans, which would be the case for Sheila Bair’s aggregator bank proposal. Of course the ultra-clean new bank could be paid a servicing fee by the Chapter 7 estate and buy its performing loans in an arms-length transaction on the secondary loan market.)

    » U.S. Government capitalizes new tabula rasa (blank tablet) loan portfolio. A bold FRESH START catalyst to revive the American economy, under the Fed’s current 10% reserve requirement a $700 billion capitalization creates fresh $7 trillion lending capacity OVERNIGHT http://www.cnbc.com/id/15840232?play=1&video=1051910745 [per Joseph Stiglitz, seek 1:25 to 2:00]. Moreover, because a new bank has zero loans in its portfolio it would have NO EXCUSES not to lend to creditworthy borrowers. How is that for restoring confidence!

    » Regarding the CORPORATE CONTROL issue of nationalization, as suggested by Nicholas Kristof http://www.nytimes.com/2009/02/12/opinion/12kristof.html , EVERY man, woman and child in the United States could be granted common shares (including voting rights) of every government-created ultra-clean new bank. Since the American People individually–and not the federal government–will elect the board of directors, corporate control will be in PRIVATE HANDS. As is the usual case, additional equity capital could be raised through initial and secondary public offerings–which would have the salutary benefit of creating a float for trading in the stock market.

    For more see:
    http://cift.haas.berkeley.edu/docs/nabi/nabi-Nov11.pdf [see especially Figure 4 (p. 8)]
    http://www.youtube.com/watch?v=_ZAlj2gu0eM [seek 10:20 to 12:15 for elevator pitch].

    ——————————————–
    IDEA #2: Contribute Common Stock of Ultra-Clean New Banks to Social Security & Medicare Trust Funds.

    For example like killing with two birds with one stone with the same issuance of federal debt, the $645 billion and $453 billion planned for Social Security and Medicare in President Obama’s FY2010 budget could initially be directed to recapitalize bad banks whose issued common stock would then be entirely contributed to the federal entitlement trust funds.

    » Using the Peter G. Peterson Foundation’s present-value fiscal exposure estimate of $56 trillion http://www.pgpf.org/newsroom/MainFeature/feb20/ with a 75-year horizon (stipulated by Congress) and 3% discount factor (guess-timate), for a $1 trillion investment in ultra-clean new banks the minimum total annual return-on-investment (capital appreciation, dividends) is ROI = 8.7% based on the following ballpark calculation:

    $56 trillion x (1 + 3%)^75 = $1 trillion x (1 + ROI)^75.

    As a point for comparison, from the end of 1949 to the end of 2000 the S&P 500 provided a total annual return of 13.1%. (To account for entitlement disbursements, perhaps $2 trillion or more could be contributed to the trust funds, which would also be to the government’s benefit because it can now issue debt [100-year bonds?] at low interest rates.) Economically, think of this as a gigantic version of David Swensen’s equity-oriented Yale endowment fund (NB. Swensen is on Obama’s Economic Recovery Advisory Board) in which the government is getting in on the rock-bottom ground floor as an opportunistic VULTURE INVESTOR by contributing first-round seed capital to create “fresh start” ultra-clean new banks with pristine balance sheets, tabula rasa loan portfolios, and the core-banking operating assets of insolvent banks; but unlike the speculative nature of vulture investing, the now heavy hand and watchful eye of prudential supervision by bank regulators should make investing in these ultra-clean new banks safe and suitable for the federal entitlement trust funds. Most importantly, as the economy improves, the common stock prices and dividends of the ultra-clean new banks should rise, thereby improving the solvency of these federal entitlement trust funds.

    » Piggybacking off its annual mass mailings and leveraging paperless electronic proxy (e-proxy), the Social Security Administration has the logistical capacity to facilitate the proxy voting of 300 million Americans. This will not only engage the American People in corporate democracy but will also give them a say in setting Wall Street compensation.

    » According to ZeroHedge, “The TALF…will generate up to 20% virtually risk-free returns to investors.” http://zerohedge.blogspot.com/2009/03/could-talf-be-biggest-disappointment.html If this is true then instead of hedge funds and private equity funds the FEDERAL ENTITLEMENT TRUST FUNDS should benefit from this SWEETHEART DEAL, which could use the cash flows for their entitlement disbursements. Again, newly-issued asset-backed securities (under TALF, only AAA-rated tranches) should be safe and suitable for the federal entitlement trust funds if together with TALF’s low-cost loans and guarantees from the Fed and Treasury, the originators were prudentially supervised and as recently proposed by Congressman Frank last week to align incentives http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a2poB5rN4YIc , retain the first-loss equity tranche on their balance sheets.

    ——————————————–

    In closing, the Financial Times (02-07-09) reported that the much-larger-than-subprime Option-ARM default wave will not crest until the summer of 2011 [ http://www.ft.com/cms/s/0/1ed1d3e2-f4f3-11dd-9e2e-0000779fd2ac.htm , see graphic], which suggest that the two-year horizon test to March 2011 of Secretary Geithner’s stress is not at all a “worst-case” scenario . The predictable consequence is that even after raising more equity capital during the six-month period after the stress test, bad banks will again need to raise even more equity capital through 2012.

    From a public policy perspective, “the problem” to be solved is not maintaining the capital adequacy of borderline-insolvent bad banks but rather creating fresh lending capacity in the U.S. banking system: the former is Secretary Geithner’s piecemeal approach of keeping alive zombie banks like Japan did during its lost decade—-the latter is a BOLD, FRESH START, BIG BANG APPROACH of once and for all detoxifying bad banks by sequestering their entire old (performing & non-performing) loan portfolio into Chapter 7 bankruptcy estates for orderly liquidation, and recapitalizing them as ultra-clean new banks which would irrefutably show that America’s banks are ready, willing and able to lend to rejuvenate the U.S. economy.

    Increasingly the American People see insolvent banks as black-hole money pits where good money is being thrown after bad. The fresh start approach of contributing the common shares of ultra-clean new banks to the federal entitlement trust funds would bring the American People onboard by:

    » Killing two birds with one stone by using the same issuance of federal debt to solve the problem of insolvent bad banks and the future insolvency of the federal entitlement trust funds (which has the counter-intuitive argument that the greater the expenditure to recapitalize banks today, the less strain on the federal budget tomorrow);

    » Turning lemons into lemonade by affirming the federal government’s promise of Social Security and Medicare (while avoiding the politically suicidal “third rail” decision of cutting benefits)—-and hopefully, passing Universal Health Care;

    » Creating a magic silver bullet that provides budgetary headroom for President Obama to accomplish his ambitious goals of restructuring the American economy to compete in the 21st century while balancing the federal budget through a new revenue source to finance the federal entitlement trust funds.

  42. The majority of the bank solvency issue will be addressed if MTM is adjusted, as statutory capital will be boosted.

    I have always thought, the answer was there, and it had some simple tendencies, such that; Equity = Assets – Liabilities.

    Un-impair the assets, (fasb157) and simple math tells you what happens to the Equity.
    And then further, what happens to the solvency ratios. ..

    Will someone please pay me a huge fee for this revelation ? a Wall street bonus ? ,g>
    Have a great week everyone.

    (The fasb will fret on how to account for the income statement and balance sheet issues on the paper markdowns,as they relate to accrual based accounting, but that is what academic accountants are for)

  43. Would the government’s response in the 1980’s be considered “Nationalization” in today’s hyper-sensitive parlance? Pragmatism people! The government been in the banking business since the 30’s.

    As far as wiping out the stockholders, it certainly seems like a reasonable proposition. I do think, for the most part, that these were widely/duplicately held stocks in mutual funds and will touch many 401k accounts(people).

  44. This is from Nouriel Roubini’s latest post
    http://www.calculatedriskblog.com/2009/03/roubini-reflections-on-latest-suckers.html :

    With policy and borrowing rates equal to zero or close to zero for banks and broker dealers their intermediation margins are obviously positive as lending rates are much higher. But this is a direct HUGE SUBSIDY of the financial institutions that is being paid by savers that are now earning 0% or close to 0% on $10 trillion of bank deposits. …

    … So it is no wonder that Citi, Bank of America and JP Morgan can argue that they will be making this year a profit “BEFORE PROVISIONS”. That is the most important caveat: while operational margins can be positive if you borrow at 0% and lend at much higher rates, the ACTUAL P&L and BALANCE SHEET of banks and broker dealers depends also on WRITEDOWNS. And delinquencies, charge-off rates and writedowns are rising rapidly as both the loans and securities are showing mounting losses given the worsening of the economic recession. Losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to credit cards, auto loans and student loans; to leveraged loans and corporate boans; to industrial and commercial loans; to loans to real estate developers; to muni bonds and sovereign bonds of emerging markets and European economies where sovereign spreads are rising; and to the entire alphabet soup of credit derivatives that securitized these loans and mortgages (MBS, CMBS, CDOs, CLOs, CMOs, CPDOs, ABS, etc.). So for the MAJOR BANKS to argue that they are PROFITABLE before provisions on losses IS A JOKE such losses are now officially over $1.2 trillion globally (and $900 billion for US financial institutions) and they will be at least $2.2 trillion (according to the conservative estimates of the IMF and of Goldman Sachs) and as high as $3.6 trillion according to the peak time estimates of such losses according to our most recent study.

    And according to independent analysts of the financial system -– Meredith Whitney, Chris Whalen -– CHARGE OFF RATES ON LOANS -– let alone additional losses on securities -– are rising at alarming rates: they are already at levels twice as high as in the 1990-91 recession and they will soon enough – given recent trends be much higher double further. So, regardless of whether you got smarter management or not (i.e. it does not matter if you are JP Morgan and run by someone as brilliant as Jamie Dimon) the MACRO PICTURE trumps any other bank-specific factors (the loan book of JP Morgan is as exposed to residential and commercial mortgages, consumer credit and other loans as any other major bank): i.e. with the unemployment rate going above 9% in 2009 and highly likely to reach 10% in 2010, with GDP growth likely to be 1% or lower in 2010, with home prices likely to fall – conservatively – at least another 15%, with commercial real estate rents now falling about 40 to 50% and valuation bound to fall 30 to 40% then losses on any category of banks loans and mortgages and consumer credit will sharply rise over time; and losses on the assets that securitized these loans/mortgages will increase over time.

  45. that’s the problem – simon and james should have time to lay this out, if only to back up their A2 recommendation

  46. There are some of us out there that believe it all has to start rethinking what the whole purpose of our banks should be. Just making them profitable again does somehow does not seem to suffice. There are many questions out there… like the following two:

    Do we want our banks to continue to be consumption lending machines with the consumers working full time 24x7x365x100 on their credit, even though they do not really understand these scores, or do we want our banks to generate that growth that allows the consumers to pay cash for all their needs?

    Do we want our bank to get back to the same disastrous regulatory environment or do we have in mind something else?

  47. vance geiger

    Mark to Market

    I have read the responses here on the mark to market issue, several times in fact. I think I understand to some degree what has been said. To make it clear I wonder if a concrete example could be explained.

    A mortgage is created. This consists of a loan for the price of the house plus the interest on the loan. Principal plus interest. When this is securitized it is sold as a package. The value of this package would be a total of what the borrower would pay. For a fixed rate 15 year mortgage this would be easy to calculate. For a variable rate mortgage this would be more difficult but possible within a range.

    Ok, the borrower defaults, the house goes into foreclosure.

    1. At that point does the value of the package become the value of the house?

    2. Do mark to market rules force the bank to value the house at its current value? Which could be lower then the original loan.

    3. As I understand it the bank created a liability when it paid for the house. The bank created an asset in the income stream from the interest paid on the loan. The equity would be the liability in the payment for the house plus the income stream from the interest. Thus if the loan was paid off the equity in the bank would increase. But, if the loan defaults the equity goes down. According to mark to market rules at what point does the equity go down? When the house goes into foreclosure? In the next quarterly report?

    4. I can understand the critics of mark to market because of cyclical issues. A house is still a house and will be worth more someday. Interest rates will go up, a house resold to a later buyer can produce an recovered asset. However, if there is going to be a market, then shouldn’t assets be valued at what they can be sold for?

    5. If you take away the constraint of the market value then isn’t there an incentive for the creators of these “assets” to create something for which the only market is the government? This was one of the essential points of the “Looting” article. It seems that the bankruptcy option of the savings and loans of the 80s has been replaced by the too big to fail option of the present, but with the same effect.

    6. It seems that for governmentally charted institutions there should be a ban on creating assets that cannot be held to a market value. Why is this not the case?

  48. I wasn’t trying to respond to the “profit” calls of the banks. I understand how that is manipulated and that it doesn’t mean anything. What BofA and Citi said this week was not just profits, but that they will not need any more public money on the asset / solvency side of the ledger. That’s what I was responding too, and what I can’t reconcile.

  49. Seems like MTM would reduce, not increase, equity of companies with “toxic assets.” Unless they were allowed to use a “market” value that’s not available in the market. Doesn’t make sense to me.

    Also seems to miss one of the main problems. Most U.S. banks meet solvency requirements but aren’t lending enough to make the economy work.

  50. Here you go on MTM and Solvency, Townsend says it best,
    Posted 03/09/2009
    Hill-Townsend Capital
    gary.twnsnd@gmail.com

    Fair value accounting has hijacked GAAP accounting. It is one of the great ironies of the day that the Financial Accounting Standards Board’s own rulemaking has managed to undercut public confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles, turning financial reporting on its head. Value is now based on a bankruptcy model, one that assumes that a firm’s value is only that in distressed liquidation, rather than the net present value of cash flows generated as a going concern. The damage to our economy and its growth prospects is enormous and gives life to many of the misguided, unhelpful policy prescriptions (the recent push for a general bank nationalizations being one), that would take a bad situation and make it worse.

    Fair-value accounting needs to be fundamentally reformed. “Fair market value” concepts in accounting are long-standing, but the “fair value” measurements of FAS 157 became effective just this past year. And it’s not that the new rule required banks to mark more of their financial assets to “fair value”. Though most commercial banks mark only a small portion of their balance sheets (e.g., General Electric marks just 2% of assets), FAS 157 required that all banks disclose in footnotes the “fair value” of their financial assets and liabilities. So, in our unhappy present economic circumstances, these disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Look, for example, at Capital One.

    To many market participants, GAAP has become irrelevant. That’s crazy. Even crazier is the confidence that so many investors attach to these “fair value” results. As promulgated by FASB, fair value’s conceptual flaws are fundamental and run deep.

    It’s worth noting, first off, that “mark-to-market” accounting is a misnomer. FAS 157 actually removed “market” from the definition of “fair value.” Under previous rules, “fair market value” meant the value implied by the non-compulsory exchange of property between willing buyers and sellers, with equal knowledge and equity to both. Now, FASB defines “fair value” as a sale in an “orderly transaction” between “market participants.”

    The differences are subtle, but they yield strikingly dissimilar results. The prior definition, for instance, determined “fair market value” from an actual transaction between willing participants. But under FAS 157, “fair value” is premised on a hypothetical, immediate sale to yet another “market participant.” Recall from Economics 101 that when a market is in equilibrium, the marginal buyer is induced to purchase only when price falls. As defined, then, “fair value” tends to impair asset values even in stable environments.

    In unstable environments, by contrast—well, you’ve seen what’s happened. According to the FASB and the SEC, forced or liquidating sales represent neither “fair market” nor “fair” value. And yet such sales nonetheless must be taken into account under FAS 157. Consider Merrill Lynch’s sale of its large securities book at 22 cents on the dollar. The company was surely an “unwilling seller.” But the transaction was nonetheless “orderly,” as ownership was transferred to the hedge fund buyer. Was the price paid, then, “fair value”? It is really a judgment call, but under FAS 157, the answer, ultimately, was yes.

    What about investments that the owner has no intention of selling? Why should those investments’ “fair value” matter to investors at all? In the FASB’s conceptual framework, remember, the objective of financial reporting is to provide information to help “assess the amounts, timing, and uncertainty” of an entity’s cash flows. But users of financial statements are actually misled if losses are recorded based on the market’s perception of an asset’s value, if in fact that asset has experienced no credit problems and is performing fully in accordance with its terms. In recent quarters, we’ve seen frequent examples of “other than temporary impairment” (OTTI) losses in precisely such circumstances.

    In a recent article in Strategic Finance magazine, Alfred M. King, a recognized expert in the art of financial valuation, concludes persuasively that the “very essence” of valuation is professional judgment, and that FAS 157 is “fundamentally flawed.” “One can argue that management should be willing to sell any and all assets,” he says, “but we have not reached the point where creditors and shareholders actually run the company. In fact, the only time creditors do … make such decisions is after the company has filed for bankruptcy … There is a vast difference between valuing assets for the purpose for which they were acquired, and valuating them as though they would or could be liquidated.”

    It astounds me that the SEC, FASB, Treasury, and the bank regulators are not engaged in a full-court public relations press to affirm GAAP financial results, while at the same time emphasizing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as this one. What’s the matter with these people? They give idleness and bureaucracy a bad name.

    It’s time to suspend this misguided and flawed rule. Mary? Tim? Are you listening?

  51. Let The Tweaking Begin
    In moving to “reform” FAS 157, the FASB might as well admit the rule has been a disaster

    Gary Townsend
    Posted 03/13/2009
    Hill-Townsend Capital
    gary.twnsnd@gmail.com

    Well, someone was listening.

    In recent Congressional testimony, Ben Bernanke, Sheila Bair, Tim Geithner, Mary Schapiro, and other regulators have all taken reasonably constructive positions on reforming FAS 157 and Fair Value accounting, also known as Mark-to-Market. While they all say they see great conceptual value in mark-to-market accounting (for its “transparency” and “clarity”) and wouldn’t support a rescission or suspension of FAS 157 per se, they support “tweaking” it, or changing to reduce its “pro-cyclicality,” or allowing greater management judgment in determining marks and preparing associated disclosures. And we now know that the Financial Accounting Standards Board plans to issue a new disclosure draft for public comment on proposed changes within weeks.

    Can anyone spare a fig leaf?

    The truth is that any one of these “tweaks” implies fundamental changes to FAS 157–changes that will leave the rule largely unrecognizable.

    To be clear, Fair Value accounting must be reformed, in my opinion. It is fundamentally flawed and at war with FASB’s own conceptual framework for financial reporting. But in the interest of “transparency and clarity,” the FASB would do the public a great favor if, when it issues its new rule, it also provides its own full disclosure and explains what an utter and miserable failure FAS 157 has been. Here are some proposed topics it might touch on (and I invite readers to add to my list):

    * The importance of professional judgment to the valuation process. FAS 157 took judgment to the vanishing point. The new rule should explain why professional judgment is essential to the valuation process.

    * The deficiencies of the “Fair Value.” FAS 157 eliminated “market” from the definition of “fair value”. It’s time to put “market” back in. But FASB should also discuss the conceptual deficiencies of the “fair value” definition. Interested readers can find my critique here.

    * When are mark-to-market disclosures misleading? If the objective of FASB’s conceptual framework is to provide information to help “assess the amounts, timing, and uncertainty” of cash flows, users of financial statements may be misled if losses are recorded based on the market’s perception (or misperception) of an asset’s value. Here’s the real-life experience of Bank of New York Mellon when it disclosed the “fair market” value of its Alt-A mortgage portfolio along with the portfolio’s estimated cash-flow value. The difference? Only $1 billion.

    The new definition of Fair Value accounting must look first to the purpose of the assets or liabilities being valued, rather than their value in liquidation. One of the great ironies of FAS 157 was that it has undercut the public’s confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles. For instance, banks typically mark only a small proportion of their assets and liabilities to market for purposes of their financial statement presentation. However, all are required to disclose in footnotes the “fair value” of their financial assets and liabilities. Though MTM results can bear little relevance to the intrinsic value of a loan or security that the holder plans to hold to maturity, the disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Here’s what happened to Capital One: the company’s tangible book value per share of $28.24 according to GAAP became minus-$1.21 after adjusted for disclosed FV marks. Such absurd contradictions are extremely harmful to public confidence.

    Washington, D.C. hasn’t done much to boost investor confidence lately. That needs to change. It’s time that the SEC, FASB, Treasury, and bank regulators embark on a full-court public relations press to affirm GAAP financial results, while detailing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as the current one.

    Rick Boyle

    14 Mar 09 at 9:58 pm

  52. For me the never acknowledged elephant in the room is the size of the derivatives out there. If we start with the last Bank for International Settlements figure from June ’08 of a notional value of $596T, that’s more than ten times the GDP of the whole world. Just suppose US banks and companies (don’t forget the corporate involvement in this securitization venture) has a notional value of $181T, which I read somewhere. Or take Bank of America’s $39T and Citbank’s which is about the same size and JP Morgan Chase’s notional figure of $90T. I think the real problem is that the US doesn’t have enough money now and into the future to deal with all of this even if we hypothesize that only 1/2 to 1/3 have no intrinsic value to speak of. I find it very interesting that we never hear about how much the stuff is out there and how much at these mark to market prices any of this is worth as a whole.

  53. @MK: What BofA and Citi said…they will not need any more public money on the asset / solvency side of the ledger. That’s what I was responding too, and what I can’t reconcile.

    I absolutely agree with you. I hate to believe in conspiracy theories but I think “THE FIX” is in: Geithner’s stress test is *not* a worst-case scenario (e.g., the worst-case horizon should include the effects of the entire Option-ARM default wave, which will not recede until 2012 [ http://www.ft.com/cms/s/0/1ed1d3e2-f4f3-11dd-9e2e-0000779fd2ac.htm , see graphic].

  54. vance geiger

    The Townsend explanation was very helpful. I must say that I do understand the situation better. Thanks. There was this though…..
    In a recent article in Strategic Finance magazine, Alfred M. King, a recognized expert in the art of financial valuation, concludes persuasively that the “very essence” of valuation is professional judgment, and that FAS 157 is “fundamentally flawed.” “One can argue that management should be willing to sell any and all assets,” he says, “but we have not reached the point where creditors and shareholders actually run the company. In fact, the only time creditors do … make such decisions is after the company has filed for bankruptcy … There is a vast difference between valuing assets for the purpose for which they were acquired, and valuating them as though they would or could be liquidated.”

    I can see where this analysis is correct, shareholders do not run the company and there is a difference between valuing assets for the purpose for which they were acquired versus their worth liquidated. What happens, however, when a company is not run for the benefit of the share holders and the purpose that some assets are acquired for the purpose of creating a perception of high returns in the short term for the purposes of bonuses and the execution of options.

    The article on Looting by savings and loans makes it clear that there were deliberate decisions made to over leverage to the point of insolvency for the purpose of short tem gain and creating bankruptcy and a government investment. Their point is that the only way to prevent acquiring assets for the purpose of short term gain, in the S&L crisis by owners, in this one by CEOs and upper management is mark to market.

    Since shareholders do not run a company and it is possible to run a company, or bank, for the benefit of the management, not the shareholders, to what extent do you think this has been exacerbated by the conveyor belt of money provided by 401Ks for those of us who have no other pre-tax retirement investment? Doesn’t this conveyor belt lead to the dilution of shareholder influence when shares are so widely dispersed, versus a few large shareholders who if they don’t like they it can just sell out, which is not the case for those in Employer negotiated 401k providers primarily in mutual funds who have to pay fees for changes, fees for buys outside of the provider such as Fidelity, and just plain fees for breathing….

    Doesn’t modern management feel much less restrained? And aren’t they acting like they are far less restrained?

    Would GAAP lead to an equal constraint?

  55. Hi,

    I’m not sure if this view has already been expressed, but the part about the Planet Money piece that angers me the most is the idea that nationalization is going to scare away the ‘talent’.

    Are you kidding me? The talent?

    This is a disingenuous argument, making it sound like, if we don’t offer the huge salaries, we’ll have nothing but chuckling morons staffing the economists’ desk at a nationalized bank.

    The flaw in this thinking is that, for years, talent has been recognized by who could make the best profits. Well, I think we’ve all seen that that’s achievable by taking nonsensical risks and blindly shooting for short term profits.

    No – let the ‘talent’ wither and blow away in the dust. Give us economists with rational, long-term views.

  56. Pingback: Some clarity on the nationalization debate « Managing Uncertainty by Nicholas Davis

  57. Who can seriously doubt that:

    “(A2) The banking system is broken (AND that)Banks need to get rid of their toxic assets and need more capital”.

    Who can doubt that:

    The solution is for the government to take them over,identify and cauterize their toxic assets, help recapitalize them, and (when possible) act as midwife, remaking them as institutions that serve the greater good.

    The President’s men, Tim Geithner and Larry Summers, appear to doubt it.

    What do they know that we don’t? Do they have commitments or a perspective that inhibits the way they approach and make policy? Are they still struggling to make sense of what is happening and to fashion a policy that matches the insolvent condition of some of the biggest Banks?

    Like many observers of the calamity on ‘Wall Street’ I had hoped that Geithner and Summers were wrestling with unprecedented difficulties but, acting more slowly that I would have liked, framing a policy – for the President – that recognised that critical parts of the banking system were broken and needed to be put under new management so that they could be mended and the financial system rebooted. Informed commentary and the evidence (coming in part from their own public statements) makes it virtually impossible to believe they share Obama’s commitment to evidence based policy making.

    It is time to look elsewhere for the change we need.
    Try Robert Kuttner and, most particularly, Thomas Hoenig who understands that banks are servants rather than masters and that banks that fail to serve the commons cannot be too big to fail.

    And – BaselineScenario – please don’t give up on writing about receivership and conservatorship; it is too important to let go.

  58. Come on Guys look at my posts above, and Townsend rePosts on FASB 157 M2M. Mark To market has killed the Capital Ratios of Banks and Insurance Companys as liquidity dried up, Once Bear Stearns bit the dust the Banks and Insurers were headed for a crash, as the Accountants having done such a fine job in past events with Valuing assets and Auditing and Verifying financials , like Enron and Global Crossing to name a few, suddenly realized that the Statements they were now Auditing for Insurance Companys and large Banks contained 20;1 leverage CDS backed portfolios and must be marked to market.
    How did the CPAs who have Audit responsibility miss that risk, ??…. then, on top of that, how did they decide to unilaterally apply Mark to Market in a frozen illiquid market ?
    Its absolutely amazing the folly of such accountancy.

  59. On the issue of mark to market and the capital ratios of banks.

    Clearly mark to market, as a somewhat too efficient messenger can make things worse by reminding us continuously of all the bad news. That does not take away from the fact that mark to market is still only a messenger, not to be killed.

    If you really want to understand the craziness imbedded in the high financial leverages of the banks you should go instead to the Basel Committee and there in the “Minimum Capital Requirements” you would discover such nuggets like that the banks are actually authorized to, when they lend to corporations that are rated AAA or AA- to leverage themselves 62.5 to 1.

    62.5 to 1? Yes, that is what the Basel Committee has authorized. That was the extent of their naive faith in the infallibility of the credit rating agencies. I invite you to go to http://www.bis.org/publ/bcbs128.htm and read (pages 12 to 27)

  60. Pingback: The Baseline Scenario | EthicalMarkets.com

  61. Pingback: Grow Financial Roots - Free financial Calculator : Credit created Acute Debt in the hundreds of trillions of dollars.