Put this morning’s articles on Bank Rescue Plans in the Financial Times and the Washington Post next to each other, and you can see where we are heading. (Remember: policy announcements need to be bigger than what is leaked, so expect headline numbers larger than floated here – the FT suggests “total buying power” of the initiative will be $1trn; I expect closer to $2trn.)
The foreclosure mitigation steps seem reasonable, although on the small side – with perhaps $80bn of the available $320bn from TARP II being committed here. The heart of the matter is the banks’ balance sheets, including their toxic assets and presumably deficient capital. The principles at work seem to be:
1. Do not compel the banks to do anything. There seems to be a great deal of concern about bank manager sensitivities. Sounds like we will be overpaying for bad assets. I can’t believe there will really be no effective constraints on executive compensation; that would be political dynamite – and I’m sure Capitol Hill is expressing itself forcefully on this point as I write.
2. Buy some of the worst assets. Relatively little capital will be committed to this, as it is a nonessential and small part of the scheme – there is no way to sort out the valuation issue unless you are prepared to be tough with the banking system. Let’s say $50bn here, with credit from the Fed to scale up to $500bn or so.
3. Use a ring fencing/government insurance scheme for most of the bad assets; this is the Citi II/BoA-type deal but now available to all banks. The mark on assets used for the insurance payout is generous to the banks, the premium is low and any claims on the banks received by the government do not constitute a meaningful share of voting stock (which makes me think we’re going to more preferred or deferred stock and fewer warrants.) The deal will be quite untransparent, but a reasonable presumption should be that if it is more complex and harder to value, it is sweeter for the banks. The government will commit about $200bn in capital to this venture; based on the funding structure and ratios we saw in Citi II, this could allow the total amount insured to exceed $2trn (hence my headline expectation).
One problem, of course, is that this exhausts TARP II without substantially addressing bank capital (although there must be some window dressing in this regard). The Administration might like to see if their approach brings in new private capital, and come back to Congress for further recapitalization funds only if necessary. They may also still be open to negotiation on this issue over the next couple of days – remember the fiscal stimulus still needs to pass the Senate.
The bigger issue is much simpler. The banks made many bad decisions and now have assets worth much less than their liabilities. We have guaranteed their liabilities, because we had a look at the alternative and it was ghastly. So who pays for the losses and on what basis?
I would prefer something much simpler and more transparent: new capital in exchange for a change in control at the major banks – presumably leading to new private owners, wholesale managerial change, and the breakup of the big banks. Instead, we are looking at the mother of all Credit Default Swaps – if things go well, we get a small premium; if things go badly, we are on the hook for a huge and hard-to-quantify amount (ask AIG). Either way, the bankers get the greatest deal of this or any century, and they emerge more powerful than ever.