Searching for a Free Lunch

I don’t envy President Obama’s economic team. When it comes to fixing our banking system, there is no easy solution.

I’ve been sick the past few days, but someone pointed out this article in The New York Times a few days ago that has a concrete illustration of the problem: a bond that an unnamed bank is holding on its books at 97 cents, but that S&P thinks is worth 87 cents (based on current loan-default assumptions), and could fall to 53 cents under a more negative scenario . . . and that is currently trading at 38 cents. Assume for the sake of argument that all of our major banks are insolvent if they have to mark these assets down to market value. The crux of the issue is that any scheme in which the banks receive more than market value is a gift from taxpayers to bank shareholders, and any scheme in which they are forced to take market value is one that the banks will not participate in. Let’s look at a few possibilities:

  1. The government forces banks to write down their assets to reflect worst-case scenarios (unless they do this, no one will have confidence that the asset values won’t fall further), and then recapitalizes them to make them solvent. This is a desirable outcome, but bank shareholders won’t go for it because they will be mostly wiped out. This is roughly what Sweden did with two banks, but Sweden nationalized them first, so the shareholders didn’t matter.
  2. The government creates an aggregator bank to buy up toxic assets. If the aggregator pays market value, no bank will sell; if it pays above market value, it’s a gift. The current idea I’ve heard is that the aggregator will only buy assets that have already been significantly marked down, but that doesn’t really help the banks any.
  3. Another idea is having the government guarantee toxic assets, as it did for Citigroup and Bank of America so far. But this doesn’t solve the problem. There is already a market to insure toxic assets – it’s called the credit default swap market. If the government provides insurance at existing market prices, no bank will buy it, because the cost of the insurance would make it insolvent. If the government provides cut-rate insurance, as it almost certainly did for Citi and B of A, then it is a gift. The only “benefits” of an insurance arrangement are: (a) it’s much less obvious that the government is giving bank shareholders a gift; and (b) the way Citi and B of A were structured, it wouldn’t require a lot of cash from Treasury (and hence from Congress), because most of the guarantee was provided by the Fed.
  4. Meredith Whitney thinks that the banks should sell their “crown jewel” assets – presumably, businesses they have that are still in good shape – to private equity firms, and use the cash to repair their balance sheets. This would be a nice solution, but I don’t foresee it happening. Given the choice between selling the good operations and being left with barely-solvent portfolios of runoff businesses, or holding onto the good operations and hoping for a government bailout, I think all the Wall Street CEOs are betting on the latter.

I think there are two possible outcomes to all of this: (1) the government makes a gift to bank shareholders and justifies it on the grounds that there was no other choice; or (2) the government forces the banks to sell assets at market value and accept a government recapitalization program – either by exercising its regulatory authority (similar to an FDIC takeover) or by just buying out all the common shareholders at their current low prices. In option (2), the government would then re-privatize the banks at some point. But there’s no easy solution.

22 thoughts on “Searching for a Free Lunch

  1. My comment ‘it is sort of a screwed scenario.. piper has to get paid some how..’ not overly insight, my comment that is, but that’s where we are at. At the end of the day we are all in this together. The ‘making our way through this morass’ is the challenging part, but we’ll get there.

    Yes, I am an eternal optimist, how could you not be, we are blessed in so many ways, this is just another learning experience.

  2. Why is (2) not an easy solution? It sounds very easy, unless you are one of the insolvent bank. In fact, it is a pretty good description of what the FDIC does all the time to small banks when they fail. Why should the large ones get special treatment?

    The only thing that makes this “hard” is that a tiny number of wealthy and powerful interests oppose it.

  3. No easy solution, but perhaps there is a good solution. How many banker functions can be automated in a world in which everyone’s tax history can be known? Can we envision a financial world run by engineers instead of economists and lawyers? Engineers know a lot about stability and instability. A politically neutral way to inject liquidity into society is interest-free loans to taxpayers based on how much they have already paid in taxes. This solution can be rapidly implemented and is easily scalable.

  4. People are wising up, and the baloney isn’t going to work. The main reason the baloney isn’t going to work is because it hasn’t worked already. The markets are about to take another dive, and that should push over any banks that are now on the brink. If Geithner proposes plans that don’t include real accountability, the popular reaction will make Daschle’s tax problems look like a Sunday picnic. Furthermore, Americans have yet to realize that the rest of the world must hold us to account, just as we must hold our bankers to account. We still have a long way down to go. This is going to be rough.

  5. Can anyone answer me this simple math.

    I think the total value of mortgages in the U.S. is like $10T. Every one of them is backed by a house sitting on land. If 30% of them (a huge number) went into total forclosure and were liquidated at 50% their value (again, conservative I think), then that would “only” be a $1.5T loss.

    Clearly the market cap of the banking sector has contracted by many times that.

    It seems like bank equity plus $700B of Tarp should fund this. I don’t get the source of the rest of the write downs.



  6. Eric,

    One word: leverage. I-banks were up in the 50’s. Fannie got over 100 at the top of the bubble. Easy to make a lot of money that way on the way up and, as we are finding out, easy to suck in a bunch of taxpayer money on the way down. See Spengler: ( and


    What about another option: providing inexpensive government funds for people to start new banks unencumbered by the foolish decisions of todays dinosaurs? Relax and streamline the bank founding process and smash the current cartel. (I’m looking at you, MS and GS.) With todays short term rates, only a true imbecile could fail to make money borrowing short and lending long. (Urp! Let’s not talk about a bond market crisis…)

    The old, bad banks fail, as they should. New banks eat their lunch and pay us back.

    So, what are the downsides of such a scheme? Too long to implement? Unrealistic? The way I see it, anything that avoids bailing the bums out deserves serious consideration.


  7. As you have clearly described, this is a very complex issue with no simple solution. We need to consider the basic restructuring objectives and then select the alternative that can best meet those objectives.
    The key objectives should include 1- isolating the bad assets now and disposing of them over time as conditions improve to minmise the negative impact on the taxpayer; 2 returning the “too big to fail” banks to positions of strength as soon as possible; and 3 – ensuring the current shareholders do not receive a benefit in the process (not “socialise the losses”) and time is of the essence.

    When assessing the alternatives that have been described, the “least worst” alternative to accomplish these objectives appears to be nationalising the key financial institutions, splitting out the bad assets from the good assets, recapitalising the banks, and then selling the banks to the private sector as soon as appropriate. The primary concerns with this approach seem to be a serious aversion to even contemplating the notion of “nationalization” and a belief that the government is not capable of effectively carrying out the process because the banks are simply too big and there is no one competent to lead or manage the process.

    We are in an evironment few, if any, have ever experienced. We are in uncharted waters. This is no time to narrowly follow traditional beliefs but to focus in a pragmatic fashion on what might work. It also makes little sense to assume there is no way the government can effectively take over the banks, clean them up and return them to the private sector. For example, an asset management company could be set up for each bank to take on their bad assets with an oversight organization set up to ensure they operate at arm’s length from the government, compete for resources and use incentives to ensure the process is done as effectively and efficently as possible. Certainly there are sufficient and experienced private sector leaders around to take on these roles if properly designed….creating, in effect, for as short a period of time as possible, a private sector banking sector segregated within the public sector.

    In summary, there is no obvious “best” solution that completely satisfies all reasonable objectives of restructuring and recapitalizing the banks. Consequently, the priority should be protecting the taxpayer while completing the process effectively which can best be accomplished through nationalization

  8. Why should the government have concern for the shareholders? Why does a private investment, or “well diversified” public investment group factor into a governments decision about the state of the bank? Seems to me they are catering to special interests and trying to balance that with the public good, when they should only consider satisfying the public good. That is IF Mr. Kwak’s analysis is correct.

  9. Karl,

    I think the concern is that the shareholders are not just small number of greedy rich people. 401Ks and Pension Plans are some of the largest holders of these stocks. Putting aside the stories of 60 year old grandmas who can’t retire because the government nationalized her bank and made her shares worthless, it is almost a case of robbing Peter to pay Paul. We’d fix the banking section for the public good, but do massive damage to the public’s retirement plans and probably end up having to bailout failed pension plans (which we’ll probably have to do anyways if valuations stay where they are for the next several years as the baby-boomer retirement wave hits full steam).

  10. I really like this blog and congratulate you on hosting an excellent dialogue here. However, I think you folks might consider taking a step back and looking at what you are really saying.

    If your solutions to the problems mean spending more money than the IMF and US government can raise, then they are not really solutions. If they mean rewarding the undeserving at the cost of the taxpayer, they are not solutions either.

    Fareed Zakaria’s Sunday GPS show on CNN from Davos began with an observation on Russia and China’s unusually direct criticism of America’s role in the creation of the global economic crisis.

    So let us pause a minute, what is going on here? Were all these financial and regulatory institutions so stupid, greedy and corrupt? If so, and seems to be the conventional view, then Russian and Chinese criticism is well deserved.

    An alternative view is that the behaviors that lead to this catastrophe were largely unconscious and driven by some simple rules. First, as you noted, quoting Andrew Lo, if you were Chief Risk Officer of a bank and did not sanction these kinds of highly profitable transactions then you would not have held onto your job for long. The (UK) Times newspaper’s insider account of Dick Fuld and the last days of Lehman Brothers echoed this point. The second factor was the game of chicken: not owning up to a problem in the hope that a greater problem will quickly supersede it. These two rules lead to the suicidal, Lemming-like behavior that created this crisis. In the jargon of complexity science, the stock market is a complex adaptive system and this phenomenon is “emergent” behavior driven by a few simple rules.

    If the global economic crisis is indee the outcome of emergent behavior (not simply ubiquitous stupidity, greed and corruption) there are two important implications.

    First, that interventions top down and from the centre (like the bank bailouts and the Troubled Asset Recovery Programs) are unlikely to help but, on the contrary, are more than likely to have unintended and unwelcome consequences.

    Second, that the only effective way forward is to put the problems back in the community – who will have to solve them anyway when all these grandiose gestures have failed – encouraging collective mindfulness by making it safer to talk about the issues.

  11. It seems as though instead of admitting that there is no magic bullet, your list lays out three possible scenarios, but leaves the feeling that if we just thought a little bit harder we could all find a solution that will work for everyone.

    Unfortunately, there isn’t. Shareholders of banks who took (in hindsight) too much risk/leverage have to pay the piper and now have to feel the rest of the pain (on top of the pain they already felt). Unfortunately for all of the smart fixed income guys, so do the creditors, to some large degree. What scares me the most is the assumption that there is some magic bullet that if we think harder/wait longer the pain will go away. Sorry, but all we’re doing is delaying the inevitable.

    One final comment on Ms. Whitney’s suggestion. Sorry, but that’s like spitting in the ocean. Raising capital by selling crown jewels to private equity firms sounds like something that the bobbleheads on CNBC would say. There just aren’t enough crown jewels, or enough private equity, to make a dent in what really ails these banks (lack of capital). Juat as an example, say KKR decided it wanted to buy some division of Citibank for $10 billion. OK. Now Citibank has an additional $10 billion, but now it has sold the only part of the bank that is actually making money. And they still have a problem that was many many multiples more than $10b. It is a hollow suggestion, and shouldn’t have been included in your list.

  12. Carson,

    Leverage doesn’t explain how morgages that, in total, are $10T could be written down by more than $1.5T. U understand leverage. What I don’t understand is why we think the actually losses on mortgages will exceed a number like $1.5T in aggregate.

    Leverage would explain how people exposed to the secondary markets went under. What I don’t understand is how the loss on the mortgages themselves exceeds a number like $1.5T



  13. EW,

    Total mortgages outstanding, last I looked, was closer to 15T. 10% total loss on that, given that we are going to collapse by 50% or more in aggregate on the underlying asset value, seems like a low end estimate. Given the “walk away” culture we are currently inculcating, I wouldn’t be surprised to see 20% losses or more. Remember, the most likely to default mortgages are in bubble areas like CA and FL. These make up a very large percentage of the total value of that 15T, so thinking in terms of “30% of those mortgages” is misleading. You should think in terms of percentage of that total value. There were homes selling in the inland empire for 1M+ that are, by any rational accounting, worth ~200k. It’s these homes that are going to really blow holes in the banks balance sheets, with 70+% loss on million dollar loans (which are probably I/O and thus accounted for favorably on the banks balance sheet. Ooops.)

    That in mind, if the banks only did missionary-style mortgage finance, you would be correct and this wouldn’t be such a crisis. It’s the sucking chest wounds in highly leveraged secondary markets that are really killing them. That’s why I’m very much against just “recapitalizing” them and in favor of simply starting new banks: our existing banks made their beds on the way up, and should sleep in them on the way down.

    Caveat emptor: I’m an engineer with only a layman’s familiarity with economics and finance.


  14. The banks should be nationalized. Period. Afterwhich, the gov’t could slowly and rationally sell the “toxic” assets and recapitalize the banks. The new GSEs would them be spun off to the private sector. The FDIC approach has to be considered. Take over – clean up – and sell the pieces. It works and the systems and procedures are already in place. Sure the existing shareholders would be left with little or nothing; but that is investing. If a pension manager bought the wrong stocks and held on too long; then they should face the potential wrath; but again; that’s investing. We cannot socialize every loss – the buck has to stop somewhere.

  15. Carson,

    Thanks for engaging in the debate. I’m looking at the data now, and HH motgages are $10.5T. So, I get that some areas are crazy. But I just don’t buy that an number anywhere close to 30% of people are going to walk away completely from there mortgages and that the land and house will be liquidated for 50% of it’s value. In CA, sure. Pheonix, a wreck. Suburban Minneapolis or Chicago, no way.

    How many people do you know personally, who are going to walk away from their homes.

    I really struggle to get to the losses that we are talking about. I’m sure that it lies somewhere in the derivatives exposure, but I’m just not sure how.



  16. On the question of why the losses could be so big, I don’t have a quick answer, but here are some factors.

    (First, the relevant number to look at isn’t the drop in banks’ market capitalizations, because that is a reflection of expected future cash flows, not current asset values.)

    The derivatives markets are a possibility. If you were selling insurance on bonds that are likely to default, you are now looking at large losses. Over the system as a whole that is a zero-sum game, but it’s not necessarily zero-sum for any particular portion of the system.

    With the entire economy in recession, banks will take loan losses on many assets beyond home mortgages and mortgage-backed securities. The worst-case scenarios include severe losses on credit cards, auto loans, commercial loans, corporate bonds, some government bonds, etc.

    There were housing bubbles that have since collapsed all over the world, so global losses will far exceed losses on U.S. assets. U.S. banks will suffer some of those global losses; of course, some of the U.S. losses will be suffered by overseas banks.

  17. Eric,

    I’m getting my data from here:

    Roughly 12 trillion in vanilla residences and 2.5 trillion in “other.” Perhaps I’m not understanding the data correctly though.

    Again, I think you are making a statistical mistake in thinking about “30% of mortgages defaulting.” Housing prices in CA are 5-10x what they are in other parts of the nation and, thus, CA makes up a disproportionate amount of the total outstanding residential debt. Just as a simple thought experiment, consider if CA and OH had the same number of houses, but CA houses were on average 5x the cost of OH houses. CA houses would account for 83% of total mortgage debt if all homes were mortgaged 100%. If the 30% of all defaults is concentrated in 100% in CA, this means that 60% of all mortgages in CA default. At a total loss of 50% on them, you get 83% * 60% * 50% = 25% total losses. If only 20% of total mortgages fail, again all concentrated in CA, it would give you 83% * 40% * 50% = 16%

    So, to do the real loss analysis, you have to know where loans are, what amount they are and what the realistic prices will be. I’m in no position to do that, but given a few simple assumptions regarding I can see how we get well above the 10-15% figure you sited earlier. I’d also encourage you to take a look at some of the places with run ups in CA, places like the flood plain north of Sacramento, the outer inland empire, and the central valley. It is possible to envision total devastation in many of these areas, with houses cratering 70% in value or more and damned near everyone just packing up, if they ever moved in in the first place.

    In any event, I agree with you that, were this only a US residential collapse, the banks would only need a “minor” (say, 2T) bailout to continue on business as usual. But, as I said in my first post, they all levered up obscenely on the way up and took their bonuses and payouts, and now, on the way down, the piper must be paid. (We can thank our recently retired Treasury Secretary for lobbying congress to relax leverage restrictions on ibanks in 2004. Way to go Hank!)

    Taxpayers, start your checkbooks…


  18. An interesting article and discussion. But I think some critical points are getting overlooked and one point is getting overstated.
    Three points which need emphasis are:
    (1) Banks really are important because they leverage. Some greatly over-extended their exposure through securitisation,. but any modern economy needs the leveraging activity of banks. From the point of view of government, if $1bn help to a bank leads to $7bn new lending (but please not $70bn), that is a very good deal at this stage in the economic bust.
    (2) Apart from the public management problem, governments don’t want to nationalise banks because ownership could mess up the government’s balance sheets – which have enough problems already.
    (3) Banks are highly exposed to each other through counter-party risk, which is why the collapse of Lehmans caused such a shock. They need confidence in their counter-parties (and their counter-parties’ counter-parties etc)to do business. In short, its a system wide issue.
    So, something has to be done for banks.
    On the over-stated side:
    Share-holders (whether 85 year olds or pension funds) don’t complain when they get strong capital gains, which has been pretty much the situation for five years (though not for Citi or Bank of America wheer shares have been pretty flat until the big tumble). Shareholding is risky and there is no cause for those who took the risk to be bailed out by those who didn’t. If government rescues banks only by equity injection, then it dilutes the value of existing shares and obtains a stake for the tax-payer in the business concerned. This is exactly as it should be. Government need not exercise its control rights as a major shareholder, except to protect its basic position through exercise of veto power.
    So, the core solution is equity injection without assuming outright ownership or control.

  19. Couple of follow on points to the unbelievable percentages being thrown around in some of the above responses, such as “60% of all mortgages defaulting in California.”

    Firstly, if anything approaching 60% of mortgages default in CA, there won’t be a civilization left and this whole discussion is moot. I recommend that instead of throwing around blunt percentages, we actually go to some reference points that understand the historical default rates over the past recessions and even during the great depression (which we are no where near). I strongly recommend that people go read some research reports written by Mike Mayo, the FIG analyst at DB for some very good historical vs. today analysis. You will see, that yes indeed we are in a terrible position, but we are not talking about such a huge number of defaults. So to answer the original question, how can all this be happening if total mortgages are “only” $10-$15T? Two answers: 1) Leverage and 2) Derivatives. No need to rehash both of those topics.

    My last comment on this thread is that you can’t be so myopic on mortgages. Yes that is a big deal and asset devaluation is making every feel extremely uncomfortable and maybe the main cause of the recession (or it is certainly an easy thing to grab on to — but lets not forget the business cycle is actually a good thing). However, if, as this thread started, you want to talk about recapitalizing the bank, you have to look down the pike and look at CRE (commercial real estate), credit cards, and C&I (commercial and industrial). Again, take a look at the hard data. Banks are now projecting total credit card losses to exceed 10% at the through vs. typical 7-8% at the trough. Banks are now projecting CRE defaults to go to 4% at the trough vs. 2.5 historically at the trough (NOTE THIS IS NOT 50-60%!). So this is really what the problem for the government is in recapitalizing the banks. Not only do they have to figure out how to value the “toxic” assets…they have to figure out what toxic means!

    Anyways, keep up the great posts and comments, but lets start looking at both source data and compare that to historical vs. making wild claims to fan the fire. Leave that job to the jokers on TV.

  20. Mike h,

    The 60% default rate above is via an obviously unrealistic thought experiment using simplistic aggregates, meant only to point out that thinking in terms of, er, simplistic aggregates can be misleading. As I said, I’m in no position to do the actual loss analysis myself since, sadly, I program computers for a living. The though experiment does show, however, how the concentration of bad loans in CA and other bubble areas makes the mortgage problem worse than it might otherwise appear. A significant percentage of total mortgage value outstanding is concentrated in precisely the areas that will suffer the highest default rates and largest losses.

    Can you post a link to Mayo’s analysis? I’d be interested in reading it.

    Regardless of our opinions on what the total losses on mortgages (and CRE, CC, etc.) will be, we all agree the core problem is the leverage employed by the banking system.

    That’s what it comes down to. Leverage made them an incredible amount of money on the way up and now, in the inevitable credit collapse, they are transferring wealth from the taxpayer (and future taxpayers) to themselves. It is as infuriatingly simple as that. You can understand why, when people realize that that’s what our banking system has done, they become less interested in saving it.


  21. I’m not smart enough to see all the angles and implications, but why isn’t this the right thing to do:

    Buiter’s suggestion is to establish new ‘good banks’ and force the existing banks (the ‘bad banks’) to sell off their good assets to the good banks while they hold on to the bad assets (presumably in the hope of selling them off as time goes on. The leverage the government has over the existing (bad) banks is to revoke their banking licences, thus preventing them from taking on new deposits.

    Some of the pluses of this plan: (1) It eliminates the oft-cited problem of having to set a value on the toxic assets — we only need to put a price on the banks’ good assets; and (2) Technically, it’s not nationalization and thus might be more palatable to the American public. Of course, the government would likely have to step in and offer support for loans to the new ‘good’ banks, but they wouldn’t have to take any banks over.

    I don’t know, seems like an option that’s worth discussing.

  22. Steve Forbes and other commentators are screaming get rid of mark to market. Why don’t we? Among the options you listed, you didn’t say just let banks sit on their bonds until maturity instead of trying to make them liquidate. If S&P thinks they’re worth 87c and the market is paying 38c at the moment, why can’t they value them at 87c and move on?

    Didn’t the government accounting rules in fact drive companies off the cliff and into collapse, even though they were actually healthy in terms of cash flow right up until the day they were killed? They were compelled to realize paper losses unnecessarily, right?

    The analogy I read was this: Suppose you paid $500,000 for a house. And you still owe $400,000. The house has dropped in (presumed) market value to $350,000. Even though you have no trouble making the mortgage payments and expect to live there another 15 years, the bank declares you to be in default if you can’t immediately cough up $50,000 cash to ‘cover’ the paper loss. They turn a paper loss in to a real loss. That’s crazy. Mortgages don’t work that way in real life (thank goodness), so why make banks follow such destructive rules?

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