Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”
This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)
I’ve been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.
The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.
But there’s a much bigger, slower game going on at the same time, and the administration’s basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how “a growing number of banks are resisting the Obama administration’s proposals for fixing the financial system.” It didn’t have a lot of new information, but it summarized the outlines of the game.
AKA, Convertible Preferred Stock for Beginners.
There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a “preference,” which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.
When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.
But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department’s new Capital Assistance Program has this precisely backwards.
Next week, Tim Geithner will have an opportunity to explain his plans for the financial system (Cash Room of the Treasury, Monday, 12:30pm), and defend these plans in front of the Senate Banking Committee (Tuesday, starting at 10am) and Senate Budget Committee (Wednesday, also from 10am).
Here are the questions (in bold) we would ask him. And, just in case any of you are involved in preparing the Secretary’s briefing book, we also suggest some answers. Continue reading
For a complete list of Beginners’ articles, see the Financial Crisis for Beginners page.
With the regularity of a pendulum, the focus of discussion has swung back to the banking system (September: Lehman and AIG; November: Citigroup; January: Bank of America, and everyone else). And as everyone waits in anticipation for the Obama team’s first big swing, there has been increased discussion of . . . Sweden, including a recent New York Times article and a fair amount of blog activity, with a broad overview by Steve Waldman. (For other accounts, see this Cleveland Fed paper and a review of the crisis published by the Swedish central bank (which, according to Wikipedia, is also the world’s oldest central bank).)
Why Sweden? Because Sweden had its own financial crisis in the early 1990s, and by many accounts did a reasonably good job of pulling out of it. A housing bubble, fueled by cheap credit, collapsed in 1990, with residential real estate prices falling by 25% in real terms by 1995 and nonperforming loans reaching 11% by 1993, while the Swedish krona fell in value by 30%, hurting a banking sector largely financed by foreign funds. As Urban Backstrom said in a 1997 paper, “[the] aggregate loan losses [of the seven largest banks] amounted to the equivalent of 12 percent of Sweden’s annual GDP. The stock of nonperforming loans was much larger than the banking sector’s total equity capital.” In other words, the banking sector as a whole was broke.
Here’s a tough problem.
- The nation’s leading banks are short of capital, and only the government can provide the scale of resources needed to recapitalize, clean up balance sheets, and really get the credit system back into shape. Any sensible approach will put some trillions of taxpayer money at risk. We should get most of it back but – as we’ve learned – things can go wrong.
- Everyone hates bankers right now, and these feelings only deepen as we learn more about how the first part of the TARP was spent and mis-spent. No one wants to hear about anything that sounds like a bailout to bankers and their careers.
How does the Administration and Congress sort this one out? This weekend we seeing an approach take shape which, most likely, will work. There are five closely related moving pieces. Continue reading
This is so brilliant I’m going to just copy Mark Thoma’s entire post right here:
Tim Duy emails:
Discordant headlines in Bloomberg:
Fed’s Kohn Says Regulators Should Encourage More Bank Lending Amid Turmoil: U.S. regulators should rise to the “challenge” of encouraging an expansion in bank lending amid a weakening economy and continuing financial-market turmoil, Federal Reserve Vice Chairman Donald Kohn said.
Fed’s Kroszner Urges Banks to Increase Capital Reserves to Buffer Losses: Federal Reserve Governor Randall Kroszner urged banks to hold more reserve capital to protect themselves from future “cascading losses,” as potential market fixes are “no guarantee” against another credit crisis.
It’s nice to see the Fed getting its communication problems under control.
This is the inconsistency I pointed out in the goals of the financial sector bailout. Banks need new capital to protect themselves against falling values of their existing assets. But if they use the new capital to make new loans, you defeat the purpose of the new capital, because that new capital is no longer helping support the existing assets. These are two separate and somewhat contradictory goals. Note that, according to Bloomberg (see the second link above), financial institutions have taken $978 billion in writedowns – so far – and raised only $872 billion in new capital. So while politicians rail against banks that took TARP money but haven’t expanded lending, the banks at least have logic on their side. I’ve been surprised that no one in Washington that I’m aware of has been willing to point this out.
(And do visit Mark’s blog – it’s a great place to get a variety of perspectives, updated throughout the day.)