Month: May 2009

GMAC Arithmetic

Calculated Risk has a table listing all of the leaked stress test figures so far. As a percentage of assets, the big banks need between 0% and 1.4% in additional capital. But there is one outlier: GMAC, with $189 billion in assets, needs $11.5 billion in capital.

This implies that GMAC is not just low on capital, it has negative capital. If you were to give GMAC $11.5 billion in new cash, it would have $200 billion in assets. The minimum tangible common equity requirement being used for the stress tests is probably in the 3-4% range. If it’s 4%, then the post-recapitalization GMAC would have $8 billion in tangible common equity – which means that right now it has negative $3.5 billion in tangible common equity. (The situation is slightly worse if you assume that it will be recapitalized through a preferred-to-common conversion, or if the threshold is 3%.)

The thing that confuses me is that, on paper, you can’t recapitalize a company with a negative net worth. No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion. (You can recapitalize a company that is under-capitalized: if it has $5 billion in capital and needs another $5 billion, then the new investors get 50% of the company.) This is why it is important (from the government perspective) for the stress tests to show that some banks are low on capital, but not that they have negative capital.

Maybe there’s some clever accounting mechanism or financial wizardry I’m missing.

Update: OK, now that I read the stress test document (I must be the last economics blogger to do so), I see there’s a mistake above. According to the stress test, GMAC is sufficiently capitalized now; the problem is that under the “more adverse” (realistic) scenario, its 2009-10 losses will be greater than its capital. So its expected capital at the end of 2010, absent recapitalization in the interim, would be negative.

It is not arithmetically impossible to recapitalize such a company, because we don’t know that this outcome will occur with certainty. I might pay $11.5 billion to own a company that, in the more adverse scenario, will be worth less than $11.5 billion at the end of two years – if I think that the possibility of a better outcome makes the bet worthwhile. Put another way, even if its end-2010 expected value is negative, its current value is still at least a little positive, because of option value. Still, though, it’s a pretty dodgy investment, so GMAC will probably have a difficult time raising new capital by selling common stock to the private sector.

The comment Nemo made below about the difference between market value and book value is true, but I also think my response is true: if anything, market values are below book values these days.

Finally, Felix Salmon also noticed that GMAC is the outlier on the bad end.

By James Kwak

Failure Is Good

Regular readers will know that we are fans of Thomas Hoenig, president of the Kansas City Fed (see here). I was catching up on the week’s news via Calculated Risk and came across Hoenig’s recent op-ed in the Financial Times, which I recommend as a follow-up to (or shorter version of) our previous post. Nor surprisingly, Hoenig argues that large bank holding companies should be allowed to fail, meaning:

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible.

Hoenig provides a list of arguments in support of this position. He starts with moral hazard, which would not have been at the top of my list. But I particularly like these:

So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role.

A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable.

Here’s a link to the whole thing again.

By James Kwak

Stress Tests and The Nationalization We Got

The post was co-authored by Simon Johnson and James Kwak.

When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.

What happened?

Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.

Continue reading “Stress Tests and The Nationalization We Got” →

Is Everyone Confused Yet? (Bank Stress Tests)

The public relations campaign packaging the bank stress tests is kicking into high gear and our professional information managers are really hitting their stride.  They face, of course, a classic spin problem: you need to get the information out there, but you don’t want to be too definitive on the first day or soon after – if you’re easy on the banks, that looks bad; if you’re tough on the banks, that might be dangerous.

The best way to handle this is by jamming your own signal – which they are starting to do in brilliant fashion.  To the WSJ you leak that BoA needs to raise a great deal of capital ($35bn); they run this story on the front page, next to a great frown on the face of Ken Lewis.  But you tell the FT that Citi will need “to raise less than $10bn” (note that the on-line FT version of this story, as of 8:30am Eastern, seems to have been adjusted downwards relative to the print edition that arrived at my house 4 hours ago.)  The NYT yesterday sounded quite upbeat.

Of course, deliberately or inadvertently confusing people is made much easier by the fact that the experts are in sharp disagreement.  Goldman’s Jan Hatzius says that the worst is now behind us in terms of loss recognition and pre-provision earnings will be much higher in the US than they were in Japan during the 1990s – here he and others are taking on the IMF’s Global Financial Stability Report.  And he has two good points in this regard, Continue reading “Is Everyone Confused Yet? (Bank Stress Tests)” →

Pollution, Race, and Poverty

Under a common conception of free-market capitalism, firms should do whatever they can – legally – to maximize value for shareholders, which often means maximizing profits. As long as firms do not bear the costs of the externalities they create – like air pollution – they will continue to create them. That’s all taken as a given.

What is a little more sinister, yet still completely legal, is where they will create them. Even in the absence of cash costs per ton of pollution, the effective costs to polluters will vary from place to place; those costs show up in the political difficulty of getting permits to build and operate facilities, the degree of environmental regulation, the likelihood of local muckraking journalists writing unpleasant exposes, the ability of the local populace to bring political pressure to bear, and so on. The net effect is that the low-cost places to put pollution tend to be communities with relatively less political power – in this country, communities of minorities and the poor. 

A team of researchers from the University of Massachusetts-Amherst and USC recently released a new report, “Justice in the Air,” that quantifies the disparate environmental impact of toxic air pollution on minorities and the poor, by firm and by facility. Michael Ash and Jim Boyce also have a working paper that describes the data sources and the methodology.

Continue reading “Pollution, Race, and Poverty” →

All About Optics (Predicting Stress Test Outcomes)

The bank stress tests are beginning to create a perception problem, but not – as you might think – for banks.  Rather the issue is top level Administration officials’ own optics (spin jargon for how we think about our rulers).

At one level, the government’s approach to banks – delay doing anything until the economy stabilizes – is working out nicely.  This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. “Don’t just do something, stand there,” is great advice in any crisis – eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.)

But American bankers apparently just cannot cooperate by lying low, keeping their mouths shut, and refraining from anything that looks like picking other people’s pockets. Continue reading “All About Optics (Predicting Stress Test Outcomes)” →

Comment Etiquette

I am surprised and a little impressed, but not happy, about the lengths some people will go to to promote their views in our comments. I’ve noticed two disturbing bits of behavior recently. One is “replying” to the first comment on a long comment stream in order to boost your own comment up to the top of the page, when you are not responding to that first comment substantively. The second is posting comments under multiple identities in order to agree with yourself or, worse, to insult or attack other commenters. On one recent post, one person posted eight comments under five different names, only two of which were substantive.

There are various measures I could take to try to solve this problem, but all of them will create overhead for the community as a whole. So please stop.

Guest Post: Size Really Does Matter

This guest post was contributed by Lawrence Baxter, a member of the faculty at Duke Law School and formerly a divisional executive in a large banking organization. He takes a look inside the large mergers that created the behemoth financial institutions we know today, and the assumptions that encouraged and allowed those mergers.

A friend recently observed to me that he had maintained zero interest in banks and banking all his life—until the past year.  Now everyone is engaged in a swirl of emotions and punditry as we focus as experts, taxpayers or consumers on almost every dimension of the financial crisis, from bailouts to complex executive compensation schemes.  Yet throughout the commotion we have not lost our faith in one quintessential American value:  bigger is better.  How quickly we forget such disasters as Daimler Chrysler and Travelers-Citicorp, even as we hail Chrysler-Fiat.

True, a consequence of great scale has informed the public policy debate on banks:  what do we do with a financial institutions that is “too big to fail”?  Yet answers to this question have, for the most part, turned on whether a particular company should be allowed to fail, or be propped up by government action.  The underlying pathology receives only passing attention.   Why do we let these institutions get so large in the first place?  Is it not likely that many of the institutions requiring massive injections of public capital and other forms of subsidization and public assistance are, and have been for some time, simply too big to manage?

America’s obsession with bigness has led us to assume glibly that organizational growth, vertical and lateral, is a natural consequence of business success and must be respected, even celebrated.  Armies of consultants, lawyers and investment bankers devote their businesses to the science of corporate enlargement, encouraged by economists who celebrate not only economies of scale, but even “economies of super scale.”  Ken Thompson, then CEO of one of the most venerated banks in the United States, Wachovia, spoke for an industry when he declared in 2006, at the very moment the company was making its fatal acquisition of Golden West Financial, that ““[c]onsolidation continues to make economic sense.  Done right, size enhances competitive power.  With economies of scale, a company can better afford the technology and longer branch hours that customers demand.”*

Continue reading “Guest Post: Size Really Does Matter” →

Stress Tests for Beginners

The big news on the banking front this week will be the public release of the stress test results, currently scheduled for Thursday (originally it was supposed to be today). Over at The Hearing, I wrote an overview post recapping the context for the stress tests and the current dilemma the administration faces: whether to keep quiet about the details, and risk undermining the credibility of the exercise, or whether to release signficant bank-specific information, and risk undermining the reputation of certain weak banks. 

There is nothing wrong with the concept of the stress tests, and arguably regulators should have been doing them constantly as the crisis worsened, so that this particular iteration would not create such a political challenge. The idea is that not only do you want to know how much capital a bank has right now, but you want to know how much capital it will have left if the economy continues to get worse. If you did this analysis in a way that was credible with the market, it would go a long way toward restoring confidence in the financial system, since the current lack of confidence is based on people’s not trusting the information they are getting.

Continue reading “Stress Tests for Beginners” →

The Need for New Antitrust Laws

The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.

Theodore Roosevelt, “Address at Providence,” 1902 (emphasis added)

By “creatures of the State,” Roosevelt meant not that corporations were created by the state, but that their existence and power existed because of and in concert with the state. A few years ago, someone reading this quotation would have probably thought first of Halliburton; today, it evokes the large banks that are too big to fail.

That quotation was pointed out to us by Zephyr Teachout, a law professor at Duke, who has been proposing new antitrust laws aimed at reducing the political power of large firms.

Continue reading “The Need for New Antitrust Laws” →

Ponzi Schemes Of The Caribbean (A Weekend Comment Competition)

The IMF has just released a new working paper, with more detail than you likely ever wanted to know about how Ponzi schemes work – particularly in and around the Caribbean.

Ponzi schemes are everywhere and, at least in some environments, new versions arrive frequently.  But why are they so hard to prevent and shut down once they appear?  The paper contains some strong hints, albeit couched in very diplomatic language.

The comment competition is: what, if anything, does the failure of governments to shut down blatant Ponzi schemes imply about the prospects for a potential “macro-prudential” system/market-stability regulator implementing cycle-proof rules in the United States?  Is there a better way to prevent the kind of behavior that led to our current financial crisis?

Zombie Oligarchs

At this stage in any economic stabilization process, the state-sponsored lifeboat for oligarchs starts to get a little crowded.  Governments don’t have enough resources to save everyone, and not all major borrowers can have their debts rolled over.  In emerging markets, it’s usually the shortage of foreign exchange that sets a limit on government largesse (see the start of our Atlantic article for more detail on this cycle); in the US and other industrial countries, it’s more complicated – mostly about constraints around bailout politics (Lorenzo Bini Smaghi made this point effectively in the fall).

The survival-failure decision is taken at the highest level.  In April 2008, after the failure of Bear Stearns, Dick Fuld had dinner with Hank Paulson and reportedly concluded, “We [Lehman] have a huge brand with Treasury.” As the broader problems within the financial system worsened, this proved worth less than he thought.

Fuld is still in shock, and seething. How could Paulson let Lehman go? “Until the day they put me in the ground, I will wonder [why we weren’t saved],” he told Congress.

This week, Daniel Bouton resigned from running SocGen, in the face of what he called “incessant” verbal attacks – a reference presumably to lack of support from Mr. Sarkozy; it’s not good when the President of France calls your proposed pay package “a scandal”.  And Ken Lewis may take a further battering – due in part to not being the best-connected with top people in Washington. Continue reading “Zombie Oligarchs” →