Tag: banks

Reader Questions: Nationalization

If I had infinite time, I would respond to all reader questions and suggestions. Unfortunately, I can’t. But I’m hoping to occasionally post some in-depth responses to some of the tougher questions we get.

Chris Uregian, one of our readers, sent us three questions by email. In summary, he thought that we were overlooking some of the problems with nationalization and the reasons why Treasury might be moving more slowly than we would like. I originally answered him in email but we later decided this would be good to post to everyone, and Chris gave us his permission. I am going to copy his questions here and add a response after each one.

Continue reading “Reader Questions: Nationalization”

This Time I’m Not the One Calling It a Subsidy

According to The New York Times and the The Wall Street Journal, the Treasury Department is set to announce its plan for troubled assets early next week. It will include three components. The details aren’t clear since these are anticipatory news stories, but it will be something like this (combining bits of information from the two stories):

  1. The FDIC will create a new entity to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide non-recourse loans* for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.
  2. Treasury will create multiple new investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.
  3. The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities** (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy “legacy” assets – those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Continue reading “This Time I’m Not the One Calling It a Subsidy”

Nationalization and Capitalism

This is my last post on nationalization for at least a week, and hopefully a lot longer than that. I’m tired of writing about it. But I was listening to Raghuram  Rajan on Planet Money, and things became a little more clear to me.

Rajan was saying that he had some concerns about nationalization and didn’t think it was necessary to fix the banking system. His concerns were sensible, I have counter-arguments for them, and I don’t want to get into a detailed debate here. More importantly, he agreed with the nationalizers that the system is broken, hasn’t been fixed, and needs to be fixed – he just thinks you could do it a different way.

Continue reading “Nationalization and Capitalism”

But Are They Buying It?

As Simon wrote this morning, the administration strategy is to wait and see if the economy turns around, lifting banks out of the mess they created. How can you tell if this is working? One way is to look at bank bonds.

If the administration is right and the banks are healthy (and to the extent they aren’t healthy, their capital will be topped up with convertible preferred shares), then bank bonds are safe. Even subordinated bonds (the ones that get paid off after senior bonds and insured deposits) are protected by the bank’s capital – both common and preferred shares. So if the administration is correct that the banking system is adequately capitalized, and will be even more adequately capitalized after the stress tests and capital infusions, then banks will be able to pay off all of their bonds.

Even if the administration is wrong and the banks are not adequately capitalized, bondholders are only in danger if the administration decides not to protect them. This could happen in one of two ways. First, the administration could request, as a condition of a future bailout, that bondholders exchange some of their debt for equity. There is no law that says that bondholders have to exchange their bonds for equity just because the government asks, so the threat would be that the government would not bail out the bank otherwise (forcing it into bankruptcy or conservatorship).* Second, the administration could take over the banks; in that case, the regulator might decide not to pay back all of the bondholders – but it certainly could decide to pay them back. It’s just a question of whether losses are borne by the bondholders or the taxpayer (assuing the equity holders have been wiped out).

So what does the bond market think?

Continue reading “But Are They Buying It?”

A Quick Note on Bank Liabilities

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

Continue reading “A Quick Note on Bank Liabilities”

Tangible Common Equity for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

You may have seen in the news that the government is thinking about exchanging its “preferred stock” in Citigroup for “common stock.” Here’s one of many articles. Which, if you are at all sensible and have any sense of proportion in your life, should be complete gobbledygook. The first part of this article will try to explain the gobbledygood; advanced readers can skim it. The second part will offer some of the usual commentary.

Continue reading “Tangible Common Equity for Beginners”

Bank Nationalization: A Viewer’s Guide

At the end of last week, Senators Dodd and Schumer signalled that financial elite solidarity has broken; “nationalization” is no longer taboo.  The consensus is dead (check with Barney Frank), crazy ideas abound, and long live what new policy approach?  Here’s five sets of issues to guide your viewing this week as we slip and slide sideways into our future. Continue reading “Bank Nationalization: A Viewer’s Guide”

Everyone Get in Line

For months now, Ricardo Caballero has been proposing yet another solution to the toxic-asset problem: universal, government-provided insurance for the assets. He recently let loose a double-barrelled volley in both the FT’s Economists’ Forum and the WSJ’s Real-Time Economics blogs. I believe he is correct that this would solve the problem: if the government is insuring any bank assets that the banks want them to insure, then the banks are protected from any further write-downs, and they are healthy by construction. However, there are other ways of getting to the same outcome. One would be for the government to pay face value (or current book value) for any assets that the banks would want to sell. Another would be to take over every single bank that fails Mr Geithner’s stress test, pull out all of their bad assets, and reprivatize them. All of these solutions will result in banks that are not encumbered by the fear of further writedowns on toxic assets.

Continue reading “Everyone Get in Line”

Here’s an Idea . . .

. . . since the Geithner-Summers team seems to be looking for them.

Why not say that all bank compensation above a baseline amount – say, $150,000 in annual salary – has to be paid in toxic assets off the bank’s balance sheet? Instead of getting a check for $10,000, the employee would get $10,000 in toxic assets, at their current book value. A federal regulator can decide which assets to pay compensation in; if they were all fairly valued, then it wouldn’t matter which ones the regulator chose. That would get the assets off the bank’s balance sheet, and into the hands of the people responsible for putting them there – at the value that they insist they are worth. Of course, the average employee does not get to set the balance sheet value of the assets, and may not have been involved in creating or buying those particular assets. But think about the incentives: talented people will flow to the companies that are valuing their assets the most realistically (since inflated valuations translate directly into lower compensation), which will give companies the incentive to be realistic in their valuations. (Banks could inflate their nominal compensation amounts to compensate for their overvalued assets, but then they would have to take larger losses on their income statements.)

We can dream, can’t we?

Why Fiscal Stimulus Is Not Enough

Ben Bernanke gave a speech today that will be discussed for, well, at least a few days, outlining the Federal Reserve’s response to the financial crisis. We will probably devote a couple of posts to it (Simon already mentioned it below.)

Although the Obama team and Congress have been focusing on the politically popular fiscal stimulus plan, replete with hundreds of billions of dollars in tax cuts, Bernanke emphasized that stimulus will not be enough (something that Larry Summers seems to agree with, as Simon noted). Here’s the relevant passage:

with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions.  Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets.  A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets.  The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . . In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

In a nutshell: as the economy gets worse, more and more loans default, eating into banks’ capital cushions; investors are still nervous about all those toxic assets; and the continuing collapse of the housing market hurts all of those mortgages and mortgage-backed securities banks are holding. And as banks teeter toward insolvency, people stop lending them money, and they stop lending people money.

On the plus side, the famous TED spread dipped below 1 today, a sign that credit markets are doing much better than back in September. (The Calculated Risk article behind that link shows improvements in other parts of the credit markets, not just interbank lending.)

On the minus side, CDS spreads have shot up on Citigroup and Bank of America in the last week – here’s Bank of America:

Bank of America

The main peaks you see are the Lehman bankruptcy, the buildup to the bank recapitalization announcement, and the Citigroup crisis. So while there seems to be general improvement in the credit markets, the underlying problems have not been solved.

Overweight Fiscal? (The Obama Economic Plan)

Most of the current discussion regarding the Obama Economic Plan focuses on whether the fiscal stimulus should be somewhat larger or smaller ($650-800bn seems the current range) and the composition between spending and tax cuts.  President Obama stressed on Tuesday that trillion dollar deficits are here to stay for several years, and it looks like part of the arguing in the Senate will be about whether this is a good idea.

There is at least one key question currently missing from this debate.  Is this Plan too much about a fiscal stimulus and too little about the other pieces that would help – and might even be essential – for a sustained recovery?  The fiscal stimulus may be roughly the right size (and $100bn more or less is unlikely to make a critical difference), but perhaps we should also be looking for more detail on the following:

1. Recapitalizing banks.  Their losses to date have not been replaced by new capital and it is currently not possible to issue new equity in the private markets.  If you think we can get back to growth without fixing banks, check Japan’s record in the 1990s.

2. Directly addressing housing problems, including moving to limit foreclosures and reduce the forced sales that follow foreclosures.  There is apparently some form of the Hubbard-Mayer proposal waiting in the wings, but we don’t know exactly what – and this matters, among other things, for thinking about the debt sustainability implications of the overall Plan.

3.  Finding ways to push up inflation, presumably by being more aggressive with monetary policy.  Deflation is looming – according to the financial markets, despite all of the Fed’s moves and recent statements, prices will fall or be flat over the next 3 to 5 years.  This fall in inflation, from its previous expected level around 2 percent per year, constitutes a big transfer from borrowers/spenders to net lenders/savers.  The contractionary effect is likely to outweigh any fiscal stimulus that is politically feasible or economically sound.  (We have more detail on this point on WSJ.com today, linked here.)

So perhaps the issue is not the absolute size or composition of the fiscal stimulus, but rather the role of the fiscal stimulus relative to other parts of the Plan.  Hopefully, it’s a more evenly weighted package, and just we haven’t yet seen the details.  Still, it’s odd that the presence and general contours of these other important elements have not yet been clearly flagged.

What About Bank Capital?

The Obama team’s plans are big and bold on key dimensions.  The fiscal stimulus will be one of the largest ever in peacetime.  We don’t yet know how much support there will be for a housing refinance initiative, but there is no question that the proposal will be huge.

But in this mix the lack of serious discussion (yet) of the need for new capital in the banking system is striking.  It could be, of course, that reports on the lack of capital have been greatly exaggerated.  And it could also be that a detailed assessment of the capital injections so far might indicate they have had less effect than previously expected – although you have to think about the counterfactual, what would the situation be now without these capital injections?

Most likely, the strategic thinking is along three possible lines here.

1) No more capital is needed because the fiscal stimulus will be large enough to turnaround the economy, bringing back growth and gradually steepening the yield curve (so banks can go back to making money the good old-fashioned way; borrow short, lend longer).  This is a plausible approach, but  risky.  There is a great deal that can go wrong or at least delay the positive effects of a big fiscal push, particularly in the current global economic environment – see my piece on Forbes.com today.

2) If more capital is needed at any point, it can be provided on the same sort of terms that Citigroup received in November.  This seems dubious because I would expect a political backlash if there is an attempt to repeat or scale up this deal.  The terms were simply too unfavorable to the taxpayer.  And we should probably now move beyond relying on weekend rescues of major financial institutions; too much can go wrong under that kind of pressure.

3) If more capital is needed, there is a plan but it is secret for now.  This might have some appeal, in the sense that any plan would be controversial and could distort incentives.  But Congress would surely appreciate knowing at least the potential scale and strategic direction for bank recapitalization in advance – after all, Mr. Paulson’s surprise request to them in September did not go down well initially and did not work out well later.  Any sensible plan would presumably involve the commitment of some hundreds of billions of dollars.  This would be an investment on which the government can earn a good return, but more details in advance on potential deal structures could help us understand exactly the value proposition for the taxpayer.

Some proposals – after we saw what happened at Citigroup – for recapitalizing the banking system are here.  Our approach may not be the answer, and I understand why many on Wall Street would prefer to do things differently.  But I do think we need more debate around a plan for recapitalization contingencies, and this should be done sooner rather than later.

To Lend or Not To Lend, Fed Edition

This is so brilliant I’m going to just copy Mark Thoma’s entire post right here:

Tim Duy emails:

Discordant headlines in Bloomberg:

Fed’s Kohn Says Regulators Should Encourage More Bank Lending Amid Turmoil: U.S. regulators should rise to the “challenge” of encouraging an expansion in bank lending amid a weakening economy and continuing financial-market turmoil, Federal Reserve Vice Chairman Donald Kohn said.

Fed’s Kroszner Urges Banks to Increase Capital Reserves to Buffer Losses: Federal Reserve Governor Randall Kroszner urged banks to hold more reserve capital to protect themselves from future “cascading losses,” as potential market fixes are “no guarantee” against another credit crisis.

It’s nice to see the Fed getting its communication problems under control.

This is the inconsistency I pointed out in the goals of the financial sector bailout. Banks need new capital to protect themselves against falling values of their existing assets. But if they use the new capital to make new loans, you defeat the purpose of the new capital, because that new capital is no longer helping support the existing assets. These are two separate and somewhat contradictory goals. Note that, according to Bloomberg (see the second link above), financial institutions have taken $978 billion in writedowns – so far – and raised only $872 billion in new capital. So while politicians rail against banks that took TARP money but haven’t expanded lending, the banks at least have logic on their side. I’ve been surprised that no one in Washington that I’m aware of has been willing to point this out.

(And do visit Mark’s blog – it’s a great place to get a variety of perspectives, updated throughout the day.)

Banks At Serious and Immediate Risk, Again

Despite the shot of confidence provided by the recapitalization program in mid-October, equity prices and CDS spreads indicate investors are getting nervous about banks again – and some may even be betting that they will fail, or at that equity holders will be wiped out. As the recession deepens, banks’ assets (not only mortgage-backed securities, but loans in all forms) are falling in value, increasing the chance that the government will need to step in again with more capital. Peter and Simon have a guest post at Real Time Economics (WSJ) on the options – none of them pretty – that the government has.