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.)

The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.

The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.

One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”

By James Kwak

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.

The administration has created three main tools to help the banks – and it really, genuinely wants to help them:

1. The Capital Assistance Program (CAP) to give new capital to banks that need it (based on the stress tests).
2. The Public-Private Investment Program (PPIP) to encourage the private sector to buy troubled assets from banks.
3. The Term Asset-Backed Securities Loan Facility (TALF) to provide funding to the asset-backed securities market, which is being expanded to mortgage-backed securities.

According to the Times article, the banks want none of it – even though, as many people (including us) have argued, the terms of these programs are clearly favorable to the banks.

Instead, banks such as Bank of America and Citigroup are arguing that they are more sound than the stress tests indicate. This claim is almost not worth debunking, but I’ll give it a few words anyway. First, the “more adverse” macroeconomic scenario used in the stress tests is already more optimistic than the forecasts of respected bodies, such as the OECD. Second, the IMF recently estimated total losses on financial institution balance sheets at $4.1 trillion, future writedowns by U.S. banks at $550 billion, and U.S. bank capital needs at $275-500 billion. If B of A and Citi don’t need the capital, who does?

In addition, according to the Times, “Several big banks have declared they have no intention of participating in the [PPIP]. . . . Many banks are reluctant to sell their nonperforming loans because they could suffer big losses, forcing them to raise more capital.” Finally, only $6.4 billion in loans have been given out under the TALF – a program currently sized at $200 billion, and projected to grow to $1 trillion.

Why are the banks turning their banks on this government largesse? I think there are two reasons.

First, taking capital under the CAP or selling assets into the PPIP involves some hardship, despite the taxpayer subsidies involved. Raising capital dilutes existing shareholders, and selling assets (at prices where someone will buy them) will require writedowns from their current, unrealistic book values. Treasury really wants the banks to participate, because it will increase confidence in the banks, and that’s why Treasury is offering to share the pain, via underpriced capital and low-risk loans.

But even though Treasury is so generously offering to share the pain, what’s the incentive for the banks to suffer any pain at all? We know the government won’t use the strategic nuclear weapon and let them go bankrupt or pull their banking licenses (which amount to the same thing). And Tim Geithner’s request for a battlefield nuclear weapon – resolution authority for systemically important financial institutions, including bank holding companies – seems to be going nowhere in Congress. This is not surprising, since the banks have already demonstrated that they can count on most or all Republicans and at least a few Democrats in the Senate. With the administration’s hands tied and the banks’ political power intact, the banks are in the same position they always were: if things go well, they will make money; if things go badly, the government will always bail them out later, on terms they are willing to accept.

On the one hand, the banks are complaining about unprecedented government interference and pressure, and to some extent that is happening. But on the other hand, the banks are ultimately calling the shots, because they know Tim Geithner can’t use his only real weapon.

Second, the incentives of managers and shareholders are not aligned. A major factor in the banks’ reluctance to participate in their own rescue seems to be fear of government interference, which is code for executive compensation restrictions. 

Executives worry that whatever assurances the White House gives them, an angry Congress might impose new rules on banks that participate, particularly on pay. . . . “We’re certainly not going to borrow from the federal government, because we’ve learned our lesson about that,” [Jamie Dimon] said earlier this month in a conference about earnings.

Now, while I think some of the compensation caps discussed in Congress (but not passed by the Senate, as far as I know) were silly, I haven’t heard a lot of shareholders complaining about them; it’s the managers who don’t want them. So the situation is very simple. Participating in PPIP, for example, might be a net positive for shareholders, because even though it forces short-term writedowns, it also reduces the risk of larger writedowns in the future. But if managers think that it will lead to compensation limits, then it is a net negative for managers. I think our readers can fill in the rest of this thought.

By James Kwak

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.

Under the new Capital Assistance Program (CAP), the government will invest in banks by buying preferred shares with a 9% dividend. This is like the old Capital Purchase Program (used last fall for the first round of recapitalizations), but with one huge twist. Now the bank, AT ITS OPTION, can choose to convert the preferred shares into common, at 90% of the average closing share price during the 20 days ending on February 9 (the day before the new Financial Stability Plan was “announced”).

An example would probably help here. Let’s say that Bank of America (BAC) needs another $25 billion in capital. The government will give BAC $25 billion in cash, which BAC has to pay back in 7 years (that’s the mandatory conversion date). In the meantime, BAC has to pay 9% interest, or $2.25 billion, per year. But, at any time, BAC can convert any amount of that to common shares, at $5.49 per share. (The average closing price over the 20 days was $6.10.) If it converted $5 billion into common, the government would get about 910 million (5 billion divided by 5.49) common shares, but now BAC only owes the government $20 billion and is paying 9% interest on only $20 billion.

In short, BAC has just sold the government 910 million shares for $5.49 each.

This is called a put option. At any time, BAC can sell (“put”) shares to the government for $5.49, but it never has to. (The convertible shares the Silicon Valley VCs get are like call options; at any time, they can buy common shares by trading in preferred shares, but they never have to.) Having an option is always good.

What will BAC do with this option? If its stock price is above $5.49, it can either do nothing, or it can issue new common shares and sell them to private investors, say at $8. Then it can use that $8 to buy back preferred shares from the government, or just hold onto it. If its stock price falls below $5.49, things get interesting. Then BAC can buy up its shares on the market for, say, $3, and then immediately sell them to the government for $5.49. It won’t get $5.49 in new cash, but it will reduce its debt to the government – because preferred shares that have to be bought back and pay interest are basically debt – by $5.49, which is almost as good.

(This would have the side effect of supporting BAC’s stock price, because it means there is a buyer (BAC) who is theoretically always willing to pay $5.48 for the stock. Ricardo Caballero must be smiling)

In practice, it’s not quite this simple, because the bank will require Treasury’s permission to buy back common shares from other investors. But even if BAC doesn’t buy back any shares, it still has the option – whenever its stock price is below $5.49 – of reducing its debt to the government by $5.49 simply by giving the government a share worth less than $5.49.

What’s wrong with this? Well, nothing, if your goal is to give banks money. What you’ve just done is stick the government with the downside risk – we could get paid back in worthless stock – while the bank shareholders get all the upside potential. You’ve done this by giving the bank, for free, an option that has value. Back of the envelope, Peter thinks this option is worth about 65 cents per dollar of money invested. (It’s worth so much because bank stocks are so volatile these days.) Put another way, for every $10 billion of capital we invest this way, we are giving away another $6.5 billion. I think it’s probably a little less, because the option is not as flexible as the holder would like it to be, but you get the point.

As I’ve said many times before, if you think the banks need money, and you want to give it to them (instead of, say, nationalizing them), just give it to them already. Don’t come up with these ridiculously fancy schemes to hide it. Yesterday Krugman gave Simon and me credit for writing this sentence:

This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

But to tell you the truth, at the time we wrote that I didn’t realize just how much brainpower went into this one.

There are some other worrying things in the term sheet I’ll just touch on here:

• Any qualifying financial institution can get anywhere from 1 to 2% of the value of its assets under this program, simply by asking – even if it doesn’t need it. I guess if you’re going to be giving gifts (free put options) to the banks that need to be saved, you need to be fair and give the same gifts to banks that don’t need to be saved. Banks will need regulatory permission to get more than 2% – a clear sign that getting money under this program is a good thing for banks.
• On top of that 2%, any qualifying financial institution can get additional money under this program in order to retire the preferred stock it sold last fall under the Capital Purchase Program. This means they can take back non-convertible preferred stock and give the government convertible preferred stock instead, with no cash changing hands.The dividend rate on the new stuff is higher (9% vs. 5%), so a bank wouldn’t necessarily do this. But if its stock price is lower than its conversion price (the average price on the 20 days ending on February 9), then it should do the swap, and then immediately convert the preferred into common (so the dividend goes away). That way, instead of owing the government, say, $10 billion and paying interest on it, it can give the government $5 billion worth of common stock instead. (For those asking the obvious question: Citigroup’s conversion price is $3.46. Yesterday it closed at $2.52. You might call this one the “Citigroup clause,” not to be confused with Santa Claus.)
• The convertible preferred stock will have no voting rights. This is hardly surprising, given that the whole point of the exercise is to avoid government control. But it’s by no means necessary. For example, VC firms always get voting rights for their convertible preferred shares.

There are some very clever people in Treasury these days.

Update: Oh, I forgot the most important point. This still does nothing for the asset side of the balance sheet, which is where the big monsters are hiding.

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.

1.   Do you agree that, to restore trust in the financial system, it is essential that the Treasury (working with other relevant US authorities) take rapid steps to “once and for all” completely recapitalize the banking system? 

2.  Would you also agree it is critical that you and your colleagues tell the unvarnished and unequivocal truth regarding the needs of the financial system and your plans to recapitalize banks, so that clarity regarding the policy framework can be restored and uncertainty diminished?

3. Do you agree that a one-off, transparent assessment – with the methodology and results fully divulged in public – of the solvency and financial condition of all banks is required within three months so that we can precisely define and address the problem?

-   The only answer that should give any credibility to questions 1 and 2 is: yes.

4.  Many banks value securities, mortgages, and other loans close to the face value of the obligation on their books, while market prices for similar assets are far below book value.  Which value should be used when assessing these assets to determine if banks are solvent or not? 

-  The only fair answer for taxpayers, and the only way to ensure adequate capital comes into the banks subsequently from private investors, is: we will value all assets at market values. If market values are not available, then a highly conservative approach should be taken, i.e., assign a very low value. This will lead to major asset write downs at all banks and a larger need for capital, but it will ensure that this is the last time (in the foreseeable future) the Treasury needs to recapitalize banks.

5. Some sources report the Treasury is considering purchasing assets from banks which have been marked to market, while insuring assets which have not been marked to market.  This would enable banks to avoid marking down assets, i.e., so that they don’t need to recognize further losses.  Why should taxpayers insure any asset at a price significantly different from the market price?

-  The concept of “insuring” assets that have been priced above market value is a non-starter.  It would be a means to provide taxpayer money to banks by stealth, and is not credible since it will become transparent (and face a major political backlash) as soon as the details face serious scrutiny. 

- The Treasury needs to state clearly that most banks need large recapitalizations based on current asset prices, and it would not be fair to taxpayers if we provide cheap insurance (e.g., as if the assets are really AAA) for bad assets that are marked too high on banks’ balance sheets.  

-  If the banks are forced to mark assets to their true prices, there is no need to provide insurance.  You may as well recapitalize the banks fully to reflect those losses and then let them also manage all the remaining risk on their balance sheets.

6.  How much money is Treasury expecting will be needed in the recapitalization of banks, i.e., what will be the net new injection of capital?

-  If the answer is not at least $1trn, in line with the estimates of the IMF, then it’s not enough. (Note: the headline number may need to be larger, depending on the approach; focus on the recapitalization/increase in capital of the banking system as the bottom line).

-  We can rely on private capital also to inject funds, but only if the principles the authorities use for valuation of banks are very conservative so that there is adequate upside to new investors.

- If the headline amounts are less than $1 trillion, this is surely not enough.

- If the headline amounts are vague or we hear statements such as “it’s too early to know,” then the entire approach is not credible and we will need to reconvene when the Treasury is properly prepared and ready for a serious discussion.

7.  Where will Treasury get this amount of money at short notice?

-   The best answer would be a mix of private and public funding, but initially at least $1trn of public funding for recapitalization needs to be available.

-  If the answer for public funding is: “the remaining TARP funds plus backstop loans from the Federal Reserve”, this is unlikely to be enough.

- Treasury needs to request further funding from Congress in the next month or so, in particular several hundred billion dollars in additional debt limit authorization; this can then be combined with Federal Reserve financing to get to scale quickly.

- There is no substitute for an early and completely frank conversation with Congress regarding why this new funding is needed, how exactly it will be used, and what the impact will be on various stakeholders (including insiders at the large banks, new investors, and the taxpayer).

-  If the Treasury requires banks to write down assets to market prices, it will provide the clarity needed for private investors to re-enter the market.  The stock prices of the worst banks will fall because it becomes clear the government is not prepared to provide further cheap taxpayer money as a subsidy, but this will finally put the banks at valuations that attract new private owners willing to make substantial investments.  The government will then be providing funds alongside the private sector and less government funding will ultimately be needed.

8. How many of the largest 5 banks will likely end up with government as majority owner?

-  Any honest market-based valuation of bank assets will show a majority of large banks are presently insolvent but can be righted with substantial new capital. 

- If the answer isn’t “at least two,” then either the Treasury does not plan to properly value assets, or someone is not yet prepared to tell the full truth.

9. How does Treasury plan to use its shares when it has a controlling stake?

-  If the answer is, “as a passive shareholder,” then we are really in for a rough ride (as seems to be the approach of Gordon Brown in the UK). 

- The Treasury needs to have a plan to get shares back to the private sector quickly.  We need new, strong private owners.  This is the only way to really restructure the banks and force the necessary changes in management personnel and systems.

10.   Does Treasury anticipate changes in management at these banks as a consequence of these actions?

-  There is a critical need for new management in banks, but this should generally come alongside the infusion of new private capital.  New private owners should restructure the banks and greatly improve how they are run.

- It is important that strong anti-trust provisions be attached when the government sells its stakes to new investors.  This will ensure they have an incentive to break the largest banks into smaller, more manageable entities, all of which could productively be placed under new management.

- Any bank that is “too big to fail” is also “too big to exist”.  This should be a fundamental principle applied by both regulators and anti-trust authorities overseeing all dimensions of the financial system.

This Q&A was drafted by Peter Boone and Simon Johnson.

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.

So what did Sweden do? If the options on the table in the U.S. right now are (a) additional recapitalization, (b) an aggregator bank to buy up bad assets, and (c) nationalization, the Swedish solution included all three. First, in late 1992, the government guaranteed all bank creditors (but not shareholders), with no upper limit. Because investors did not at the time question the solvency of the government, this meant that they would continue to lend money to the banks, and the central bank provided unlimited liquidity just in case. Although the U.S. has guaranteed new debt issued by banks, and there is virtually an implicit blanket guarantee for at least the largest banks, there is still uncertainty among bank creditors, as witnessed by credit default swap spreads.

However, even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency. As a condition of government support, government auditors reviewed the balance sheets of the all the banks involved, with the goal of taking writedowns immediately and showing the true state of affairs. When it turned out that two major banks, Nordbanken and Gota, were insolvent, they were nationalized (Nordbanken was already largely state-owned), giving the state control of over 20% of the banking system (by assets). Gota was merged into Nordbanken, which only held onto “good” assets, and the “bad” assets were moved to two new entities, Securum and Retriva. These entities were capitalized by the government, and bought 21% of Nordbanken’s assets and 45% of Gota’s assets. This is an example of the good bank/bad bank plan that has gotten so much attention lately. Nordbanken itself (the good bank) was recapitalized by the government, to the tune of 3% of GDP, and become a healthy bank, while Securum and Retriva were told to get whatever value they could out of the bad assets.

Securum and Retriva were run like a cross between private equity firms and asset management companies, both managing and improving assets and also finding buyers for the assets. According to the Cleveland Fed, they managed to return $1.8 billion out of their $4.5 billion in initial capital to the government, for a net taxpayer loss of $2.7 billion. (I can’t figure out if the government also lost money on the loan guarantee, although the sources I read implied that it didn’t.) And Nordbanken, after being run by the government, was eventually privatized (the government’s ownership share is now 19.9%), and the taxpayer recovered the capital put into it in the rescue. As I said above, this is generally seen as a success story, although the Cleveland Fed does have a sobering conclusion:

the cost of the crisis to Sweden was not limited to the capital spent by the [asset management companies]. There have been significant income and output losses associated with the crisis. In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared. Cerra and Saxena (2005) found that the crisis caused a permanent decline in output that can explain the entire fall in Sweden’s relative income. So, even well-managed financial crises don’t really have happy endings.

The Swedish story is usually used as an argument in favor of nationalization, and that’s not an implausible inference to draw. But another lesson you can draw is that it’s not the nationalization per se that matters, but the pricing of the bad assets. The key was that the banks were forced to write down their assets in one shot and then to sell them to the bad banks at realistic prices. That cleaned up their balance sheets and, once they were recapitalized, allowed them to operate as healthy banks. As we said a long time ago, TARP was a fine idea as long as it paid fair value for assets and was combined with recapitalization to fill the resulting hole in bank balance sheets. The same holds for an aggregator bank. The problem would be letting the banks decide which assets they want to sell, and then letting them unload them on the aggregator bank at inflated prices. That solves nothing.

1. 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.
2. 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.

First, there will be an immediate clamp down on regulated banks and hedge funds. This will be popular.  By itself, of course, it brings some dangers as pro-cyclical regulatory action is a good way to deepen a recession.  But the goal here will be to flush out everyone and anyone who does not have enough capital to stay in business.  This makes good economic sense and it will build support for the idea that this Administration can be tough on the financial sector while also turning it around.

Second, the fiscal stimulus will pass soon.  This will be widely popular, particularly as there is something for almost everyone in the short run. 

Third, some of the TARP II money will go into a program for refinancing housing.  I expect this will run to $100bn+ (likely leveraged to a higher headline number) and will get broad support; who can really resist trying to break the death spiral of house prices, foreclosures and forced sales?  Tim Geithner will probaby announce the broad contours within a day or two of being confirmed – in part because it also makes the point that the remaining $200bn or so in TARP II will not be enough to recapitalize and clean up the banking system properly.

Fourth, we will begin to understand that our intervention in the banking system is not nationalization but rather taxpayer participation in the upside gains from the impending recovery.  Here is the right way to begin selling this,

“If we are going to put money into the banks, we certainly want equity for the American people,” said Pelosi, a California Democrat. “If we are strengthening them, then the American people should get some of the upside of that strengthening. Some people call that nationalization; I’m not talking about total ownership, but we’re just saying.” (From Bloomberg‘s coverage of the House Speaker on television today.)

Of course, we also need a technical solution for how the government gets in and then gets out of the banks, without becoming ensnared in a political and lobbyist quagmire.  (We have proposals for this; so do others.)

Fifth, we need to have what Senator Kent Conrad emphasized today on CNN: “sufficient resources.”  This is where the discussion only just begun (e.g., listen to some of Diane Rehm’s Thursday show) and where we will need to make rapid progress – probably just as soon as the fiscal stimulus is a done deal.

Did I miss anything?

Summary

1.       Debt and equity prices for U.S. banks at the close on Friday, November 21, indicated that the market is testing the resolve of the government to support the banking system. Allowing major banks to fail is not an option, as was made explicit in the G7 statement in mid-October. Significant recapitalization will be necessary to stem the pace of global deleveraging (the contraction of loans and sale of assets by banks around the world). However, the administration’s strategy is not clear.

2.       While full bank recapitalization is not a panacea, it is an important part of the policy mix that will get us through mid-2009, at which point a broader set of expansionary fiscal and – most important – monetary policies can begin to take effect.

3.       The response this weekend by the U.S. authorities in providing financial support to Citigroup is a partial, overly generous, and nontransparent recapitalization, including a large guarantee for distressed assets – which is very close to the asset purchases that Treasury only last week said it would not do.  This U-turn confuses the market (again), leaves the fate of other major banks unclear, and implies much larger contingent liabilities and little upside for the taxpayer.  This approach will be difficult to repeat multiple times because of likely political backlash.

4.       The most important goal now is to put in place a stable, transparent set of rules for bank recapitalization, with sufficient political support and limits on the scope for further policy changes.  Mr. Paulson’s seemingly haphazard approach has become a part of the system problem.

5.       While all recapitalization options have problems, the “least bad” is requiring firms to raise more capital and, for those that cannot, injecting capital through substantial purchases of common stock by the government. These can be managed through a special purpose agency or control board, which is designed to keep credit from becoming politicized and to sell the equity stakes when market conditions are sufficiently supportive.

6.       Another TARP-type round, on slightly tougher terms than October, may serve as an emergency stop-gap measure, but it will not solve the underlying problems and any positive effects could be short-lived.

Below, we briefly review the current situation, discuss important considerations in any scheme, and then run through what appear to be viable alternatives. Finally, we make our own “least bad” proposal.

1. Current Situation

We published a broad assessment of the situation and policy options early on November 20 (Thursday) on WSJ.com. On Thursday and Friday the outlook deteriorated significantly. Citigroup received the most attention, but credit default swap (CDS) spreads increased throughout the banking sector, suggesting that we (again) face a system problem.

U.S. authorities responded with a Citigroup bailout on Sunday night. The terms of this bailout are startlingly generous. Essentially Citi is partitioning off $300 billion of “bad” assets, and the government is absorbing 90% of the losses on these assets after the first 9.5%, in exchange for non-convertible preferred stock; this amounts to buying Citi’s troubled assets at a high price, since they are probably being handed over using book values as of September 30, which means those assets have already fallen in value. Treasury is also injecting $20 billion under similar terms to the first TARP round. This looks like a great deal for shareholders (and Citi’s stock gained 57% on Monday).

Unfortunately, this is far from a definitive solution to problems at Citi, let alone in the banking sector overall. Although Citi may be able to claim a larger amount of new capital, it only receives $20 billion in cash, and it faces up to $29 billion in losses on the guaranteed assets and an unknown amount of losses on the remainder of its assets (over $2 trillion, including off-balance sheet entities). Creditors need to see something sustainable and scalable to the entire system.  The potential hole in U.S. financial balance sheets remains large.

Insolvency of the banking system

The underlying problem is that the banking system is severely undercapitalized if we mark to market banks’ loan portfolios.  The recent sharp fall in bank stock prices reflects rapid deterioration in asset prices on secondary markets and growing concerns that banks are already, in reality, insolvent. For example, AAA subprime debt issued in first half 2006 fell in value by 23% during the last month. This was previously considered “safe” subprime debt.  Commercial backed mortgages and consumer debt fell sharply in November.  Banks have also not provisioned for the implied losses in their hold to maturity portfolios. For example, Citigroup has provisions equal to 1.2% of total (on balance sheet) assets.

In the medium term, the best thing for the banking system will be overall macroeconomic improvement, which will improve expectations for the assets on bank balance sheets. In this context, an aggressive stimulus package can reduce the amount of money that will be required to protect core banks.

Inconsistent policy

American banks have been hurt by the inconsistent policy responses to bankruptcies so far. Despite being more leveraged, having less Tier 1 capital, and being backed by weaker sovereigns, the cost of funding to European banks (measured by credit default swaps) has remained relatively low because creditors are confident the governments will recapitalize banks without hurting the value of debt.  Citigroup’s default swap rose to 492 basis points on Friday, implying a high risk of default over the next five years.  Even after Monday it was still priced at 249 bp.

By contrast, European banks such as Barclays and UBS default are substantially below US levels, at 147 and 160 basis points respectively.  This US-Europe difference reflects nervousness that future US bailouts may be similar to those of Lehman or AIG, in which creditors lost a substantial amount.  Because the US government lacks a clear, stable strategy for dealing with banks both now and in the future when they have capital shortfalls, creditors do not understand exactly what risk they are taking.

2. Elements for Any Potential Recapitalization Scheme

Direct recapitalization is the purchase of common or preferred equity by the government (as TARP has been used since mid-October).  An indirect approach would involve the government buying troubled assets (as in the original TARP proposal).  Here are some issues to consider for each element of these potential approaches.

Equity Injection

The market capitalization of the major banks is now so low that any recapitalization program in which the government buys common equity at market prices will effectively lead to nationalization. For example, if the government provides Citigroup with new equity equal to 33% of book value ($41bn at end 2Q), the government will receive a majority of the equity. If the government injects similar new equity into Bank of America (pre-merger with Merrill) or JPMorgan it would own 30-45% of the bank.

If the government takes preferred equity, it would need to be at a fairly low (below-market) coupon in order to ensure that the banks can afford to pay the coupon without depleting capital.  Since the coupons on preferred equity reduce future cash flows of the bank, these payments increase the cost of borrowing for the bank compared to common equity.  It should be possible to provide a mix of common and preferred for some banks, but if the problem worsens, the balance will need to shift towards common equity.

It is impossible to know how much equity is needed given the current economic uncertainty. The more severe the coming recession, the more equity will be needed; any deflation would exacerbate the problem by causing the value of collateral at banks to fall. If we err on the side of providing a large amount of capital, the government will be the major source of capital to most banks. In any case, there needs to be a satisfactory pricing mechanism for common stock.

Some alternatives for common equity pricing are:

1.       Price the capital well below market in order to avoid taking large ownership stakes in banks. This would be a major gift to shareholders and probably cause bank equities to rally sharply, easing access to capital in the equity markets.

2.       Price the capital at market, but with a clause which permits the banks to buy back the equity at a reasonable return to the government in, say, five years time. This would help ensure that the taxpayer gets a decent return, while also leaving upside for bank shareholders if the banks can repay the government. The main negative is that it could encourage excess savings by banks in order to conserve capital to repay the government at the end of the five years. In this scenario, the government would then have temporary control of most of the banking sector.

3.       Price the capital at market and own effective controlling stakes in most large banks.  The government would get full value today for taxpayer money at market prices.  It would leave the government with effective control of most of the banking sector.

Injecting Capital By Buying Assets

The government could inject capital into banks by buying assets from banks. By removing nontransparent, illiquid assets, asset purchases should increase confidence in bank solvency.  However, the government would take more risk since pricing of these assets would be unclear.

One means of reducing the risk of losses would be requiring contingent equity allocations to the government which are triggered if the assets do not achieve a reasonable return for the government over five years. This would mean that the government does not effectively control banks initially; however, in reality the government would still be a major source of capital.

Overall: Reducing Uncertainty is Key

Whatever form of recapitalization is chosen, a long term strategy with a credible structure is needed to remove uncertainties caused by policy U-turns. Clear, credible institutional structures for recapitalizing banks would allow all authorities to have a clear understanding as to what the obligations of taxpayers are. It would also provide markets with a clear statement as to how the government plans to deal with banks now and in the future, and it would reduce the uncertainty that has resulted from changes in policy direction.

One possibility is to create an entity similar to the Resolution Trust Corporation which is mandated to recapitalize banks via a chosen scheme. The key point is that the RTC was rules-based. (Of course, it was for financial institutions that had failed or had been taken over, and the situation today is not at that stage.)

The existing TARP program is an example of what not to do. The leeway provided to Treasury gives market participants and banks little understanding as to what terms will be, who has access, etc. TARP is fine for emergency temporary relief, but a clear formal structure is needed in the future.

3. Specific Options

Three specific options are below.  In each case we are assuming that the regulators initially determine whether the bank is a going concern.  If they are, clear rules need to be published to determine the extent and terms of access to funds.

OPTION ONE:  EXPAND THE TARP PROGRAM AND MAKE IT PERMANENT

The most simple and least obtrusive solution would be to continue with TARP but make the program far more clear about terms for funds, who is eligible, application procedures, etc.  The government could provide equity to banks via preferred shares at a low interest rate, and a small number of warrants. TARP is cheap financing for banks, so shareholders will benefit.  New terms could be added to make small improvements to the program, such as prohibiting shareholder dividends or requiring specific lending commitments. Because the shares are non-convertible, this avoids the prospect of government control.

It is critical in this option that the program be made permanent; otherwise, it is only a stop-gap solution. For example, Treasury just gave Citigroup $20 billion. However, investors might plausibly believe that Citi is looking at $100 billion in future writedowns, and will have to come back again and again. If the market does not have confidence that the government will be willing to buy preferred shares on the same terms for as long as is necessary, it will continue to have doubts about Citigroup’s future.

Potential problems:

1.       Financial institutions which do not receive TARP funds are at a disadvantage, so by choosing who does and does not receive funds the Treasury is picking winners and losers.

2.       Some banks will need more funds than others to survive. Banks that require a large amount of funds may not be able to afford the 5% (or 8%) interest on the preferred shares; payments may have to be accrued but delayed for some period of time.

3.       Subsidized assistance to banks can distort incentives if the program lasts for a long time.

4.       Perhaps most importantly, taxpayers are effectively subsidizing the recipients since funds are at attractive terms, which weakens political support.

OPTION TWO:  PROVIDE COMMON EQUITY TO RECAPITALIZE BANKS

Another simple option is to continue with a version of TARP in which the government buys common equity at or below market prices. This approach prices the assistance appropriately, so taxpayers will be better remunerated. The government could then decide whether it wants to appoint independent directors to the board to represent its interests. In the UK the government will not appoint directors; however, there are clear signs that the Treasury aims to influence the decisions of state-controlled banks. It would make sense to create an independent institution that manages the shareholdings on behalf of the taxpayer, as an investor, with a mandate to sell all stakes within, say, ten years.  Based on European experience, this would provide confidence that the banks will be safe from default, and so reduce funding costs to banks.

Potential problems:

1.       While an independent institutional structure to manage shareholdings will reduce conflict with politicians, the structure of governance is not very attractive.

2.       There is a danger that credit will become politically directed and that this will lead to substantial new problems down the road.

3.       Given the current market values of major banks, this could quickly constitute effective nationalization, which may undermine political support. Creating an independent institution to manage the government’s stakes will help defuse this charge.

4.       Government support will ensure that share prices will not go to zero, which will put a floor under share prices. However, because this option does dilute existing shareholders – and because it is not especially generous – it could hurt the share price of participating banks.

OPTION THREE:  CREATE A NEW RESOLUTION TRUST CORP MANDATED TO PROVIDE EQUITY TO BANKS IN RETURN FOR ASSETS

A third option is to create a new Resolution Trust Corporation with a mandate to buy assets from banks; this would be similar to the original TARP concept. In order to protect taxpayers from mispricing (perhaps the biggest single gap in the original proposal), the RTC could demand contingent compensation through an equity issue.  For example, it could receive warrants to purchase shares in the banks, at 1 cent per share, equal in value to the assets purchased.  These warrants would be returned to the bank once the assets are sold by the RTC if the assets earn a minimum return (say 7% per year).  If the assets do not earn that return, the bank can pay in enough cash to reach the target return; if the bank does not pay the cash, the RTC sells the warrants to achieve that return. The RTC would appoint an independent asset manager to manage those assets, with a mandate to sell them after five years, but before ten years, from the purchase date.

For example, suppose the RTC buys 5% of Citigroup’s assets.  It would pay $100bn for these assets, and the RTC would receive warrants on 83% of Citigroup’s equity (based on the market value at Friday’s close).  In five years’ time it would be more clear what these assets are truly worth.  If the assets generate more than a 7% return, then Citigroup does not have to do anything.  If the assets generate less than a 7% return, Citigroup can pay enough cash to get the RTC to 7% and the RTC will return the warrants. If Citigroup does not make the payment, the RTC can sell the 83% stake to strategic investors.

The main advantage of this scheme is that it permits banks to remove toxic and illiquid assets from their portfolios, while providing taxpayers with substantial protection against losses with the contingent equity.  The equity also means there is less concern about pricing, since the government can always sell equity to cover losses after five years.  It also gives banks the opportunity to avoid large dilutions if the economic situation turns out well, while if the economy is weak they will have made share issues at current market prices to finance losses on the assets they sell to the RTC.

Potential problems:

1.        The asset purchases do less for capital ratios than direct capital injections, so more funding is needed.  In some case the equity needs are so large that it would only make sense to combine this with capital injections.

2.       The large contingent share issue which overhangs banks may make it more difficult to access equity markets, at least until there is greater clarity regarding the underlying asset values and solvency of banks’ balance sheets.

3.       This scheme is relatively complex and hard to explain.  Under today’s circumstances, it may not garner sufficient political support.

4. Our Recommendation

A large-scale, well-defined, rules-based recapitalization program for U.S. banks is urgently needed. However, repeating TARP on its original terms is unlikely to have political support, and the latest Citigroup bailout is too small, is too nontransparent, and has too little value for taxpayers to be scalable. A comprehensive asset purchase scheme with protection for taxpayers is promising on paper, but is too complex for the moment and will not get political support.

In order to create long-term confidence in the banking sector, major banks should be required to raise a substantial amount of equity, either from the private market or from the government. For banks that raise capital from the government, the taxpayer will need to put in so much money relative to the existing market value of banks that effective government control over banks will result. It would be better to be honest about this and immediately set up structures to limit political influence over credit. In addition, this recapitalization program will require the release of the second $350bn tranche of TARP money.

Bank recapitalization will not solve the larger economic and financial problems, and even a massive fiscal stimulus will, at this point, only have limited effects.  (A more coordinated fiscal stimulus within the G7 would be better, but there is little sign that Europe is moving in this direction.) Only a substantial further easing of monetary policy, with the explicit goal of creating inflation, offers a reasonable prospect of avoiding a deep and long recession, or worse.

If comprehensive bank recapitalization cannot work in the current political environment, another TARP round (on tougher terms compared with October, but still fairly generous terms to existing equity holders) could serve as a stop-gap measure until the new administration takes office. But it should not be confused with a real solution.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

Of course, the government still has the power of regulation, which most people expect (and hope) will be greatly strengthened.

Let us know if there are other topics that you think need an introductory treatment.

• $250 billion of TARP money will go to the program, with about $125 billion already allotted to 8 banks (9 including Merrill) who were given take-it-or-leave-it offers yesterday.
• The government will generally put in between 1% and 3% of assets held by a participating bank.
• Most if not all banks will be eligible; it’s not clear what happens if the $250 billion is oversubscribed.
• The government gets non-voting perpetual preferred shares (no conversion to common), callable after 3 years, with a 5% dividend, increasing to 9% after 5 years.
• The government also gets warrants to buy common shares up to 15% of the preferred investment.
• Although the shares are non-voting, participating companies have to follow Treasury guidelines on executive compensation and corporate governance.

In addition, the government announced  a blanket deposit guarantee on non-interest-bearing deposits and a 3-year guarantee of new senior debt issued by banks.

This is definitely at least two steps in the right direction. Nevertheless, some concerns to think about are:

1. Is it enough money? 1-3% of assets isn’t much if we are worried about additional writedowns. Besides the writedowns we expect on mortgage-backed securities, a recession will increase losses on all types of loans. Fortunately I don’t see any reason why more of the $700 billion couldn’t go into this program if warranted.
2. Couldn’t we have gotten a better deal? Buffett got a 10% dividend and more warrants at a cheaper price on his Goldman investment. However, this plan was structured to protect the interests of existing shareholders to maximize the chances that banks would participate, which may have been the right tradeoff.
3. How do we make sure the banks behave sensibly in the future? By getting non-voting shares – as opposed to the UK plan, which will allow the government to appoint bank directors – Treasury has given up one form of control, presumably to avoid charges that the government is meddling in bank operations. This just means that regulation will be especially important.

Although the stock market is moving sideways, the credit market seems to be mildly positive: yields on 3-month T-bills are up 20 basis points (meaning that less money is fleeing to quality) and the TED spread is down 33 basis points (meaning banks are more willing to lend to each other).

4) Equity purchase program: We are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

However, a couple things should be pointed out. First, this was #4 out of 7 initiatives that Kashkari’s team is working on, including buying mortgage-backed securities, buying whole mortgages, insuring MBS, etc. So as I said on WNYC this afternoon (clip may not be up yet), this isn’t really new information. Second, the program is voluntary. This means that bank shareholders can take it or leave it; if they don’t like the terms the government is offering, they can choose to stay out on the thin ice and hope it doesn’t break. I’m not saying the government should be forcibly nationalizing banks, but this does raise a potential issue. Third, it is designed only for “healthy institutions,” which raises the question of who is healthy today. Perhaps the idea is to shore up a few major banks and let them buy up assets from the others – a plausible strategy – but it isn’t clear.

Luckily, word is that something will be announced tomorrow, so we won’t have long to wait. If you get any early leaks, please share.

1. The UK announced specific plans to recapitalize three of its largest banks – RBS, HBOC, and Lloyds TSB – with up to 37 billion pounds of government money. Separately, Barclays announced plans to raise money independent of the government. This seems to be the implementation of a plan that was announced last week.
2. Mitsubishi finally closed its deal to invest $9 billion in Morgan Stanley, gaining a 10% dividend on its shares (similar to Buffett’s investment in Goldman). This deal, which had been pending for weeks and some had given up for dead, will help boost confidence in Morgan Stanley. Note that unidentified sources have claimed that the US government promised to protect Mitsubishi’s investment; it’s not clear if that’s part of the final deal.
3. The Federal Reserve and several of its counterparts announced an expansion in the supply of credit to banks around the world in US dollars. The Fed said it will make available as many dollars as the other participating central banks need. They will then lend the money out to their banks against whatever collateral is appropriate under their rules. This is another move to increase liquidity in the financial system; however, for several weeks now it’s been apparent that liquidity alone is not enough to solve the problem.
4. Following yesterday’s agreement in principle, major Eurozone countries are announcing their rescue plans today, including both bank guarantees and recapitalization. Germany announced 400 billion euros to guarantee bank loans and 80 billion euros for recapitalization; France announced 320 billion for loan guarantees and 40 billion for recapitalization; Spain passed legislation providing 100 billion for loan guarantees and allowing the government to recapitalize banks by buying shares. I believe Italy is expected to make an announcement soon.

In summary, governments are taking the kind of steps that are necessary to halt the crisis. Loan guarantees and bank recapitalization are two of the steps we have been advocating. However, the jury is still out on whether they are coordinated and decisive enough. The much-followed TED spread (a measure of banks’ willingness to lend to each other) is only down by 7 basis points, although that may in part be due to the fact that the bond market is closed in the US today due to a holiday. All eyes are now on Washington, where a more definitive bank recapitalization plan is widely expected. Neel Kashkari, Paulson’s point man on the crisis, said today only that “We are designing a standardized program to purchase equity in a broad array of financial institutions.” (He said a lot of other things on a broad range of other topics.) Finally, this burst of support for wealthy countries’ banks could have unintended effects on emerging markets, as we discussed previously.

Update: Austria, the Netherlands, and Italy are also on board.