The problem with comprehensive banking crisis solutions

I have come down on the side of sweeping change when it comes to the banking system in the United States. Basically, I fear a further downward spiral due to the fear and panic that the banking crisis has unleashed. In my view, this necessitates a comprehensive solution, one which we have yet to see. However, there is one problem with comprehensive solutions I would like to highlight: asset confiscation.

John Hempton at Bronte Capital is the one economic pundit on the blogosphere who has done the most to point out the problem of asset confiscation. In particular, John has strongly condemned FDIC actions with Washington Mutual and Wachovia. But, Chris Whalen has also contributed nicely here with a recent post at the Big Picture criticizing the seizure of Downey Savings & Loan in California.

Panics and the need for action

The crux of the debate revolves around the need for government action in a banking crisis. In a recent post, I pointed out that fractional reserve banking is a system that is heavily dependent on confidence in order to prevent panic and chaos because no bank ever has enough deposits to satisfy all depositors’ demand for cash simultaneously. What this effectively means is that entire banking systems are vulnerable to collapse due to fear and panic.

Therefore, during a panic, a critical state is often reached when a government must decide whether confidence in the banking system has been or could be lost. It will then have to step in and restore confidence in a heavy-handed way. This often means shutting down vulnerable institutions, forcing through bank mergers and engaging in other equally coercive state interventions. Let’s be clear: these measures may be necessary but this is not free-market capitalism.

The problem with all of this is asset confiscation. Do we want the government going around and shutting down banks, wiping out shareholders without any oversight? No. Does it not seem ‘socialist’ for the state to coerce institutions into mergers they would not normally do? Yes.

The need for comprehensive solutions

This is why a comprehensive process, made legal through legislative approval, is necessary. It certainly does not mean assets will not be confiscated. They will. But, it should give one greater confidence in the decision-making process behind that confiscation. Certainly, this is why the Swedish banking crisis resolution in the 1990s is a model for the future.  This is also what other Scandinavian countries when they bailed out their banking systems, and this is also what happened in the U.S. in the 1930s and again after the S&L crisis. Why are we waiting to implement such a plan here?

To my mind there are a few keys to a comprehensive solution that an ad-hoc solution does not provide:

1. An independent agency to shut down, merge and liquidate insolvent banks. The independent RTC-like agency will make the determination for every single bank. No institution will go unchecked. This means that no one can claim the process was arbitrary. The banks themselves and the executive branch will have zero say in the determination of the independent agency — mooting the possibility that individual actions could be seen as political in nature. The faster the liquidation process is complete, the sooner confidence will be restored.
2. Legislative approval of the minutia of the process. The U.S. Congress gave Hank Paulson a free check to do as he pleases. This was reckless and irresponsible.  Moreover, it exposes the process to suspicions that political animus is behind specific actions.  This is true for Sheila Bair and FDIC actions as much as it is for the Troubled Asset Relief Program (TARP). Congress must see fit to spell out in excruciating detail how the RTC-like entity will be formed, staffed, and made free from political interference.  It must further detail how decisions about solvency and mergers can be made.
3. Removal of the executive branch from regulatory oversight. Having Hank Paulson, Sheila Bair or any successors controlling the crisis resolution process is setting the United States up for a politicization of the process. The regulator must be an independent body free of all political influence.  This is what was done in Sweden and what was done earlier in the U.S.

The result will be a process everyone believes in.  The plan would be comprehensive and apolitical. Otherwise, every action taken can be seen as illegitimate and illegal.

Ad-hoc leads to illegitimacy and failure

Let me give you a few examples from John and Chris of what I mean here — without explicitly supporting their contentions or conclusions. And then I will wrap it up with a brief commentary.

First, Washington Mutual from John Hempton’s viewpoint in September:

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds to but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquidation rights – well established order-of-creditor rights – were denied by a swift U.S. Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made.

In essence, John believes Washington Mutual was not insolvent at all and that the FDIC panicked and closed it down, robbing investors of their money. This is called government confiscation.

What about Wachovia? Here’s what John presciently had to say in September:

Many of my regular and some of my more perceptive readers have asked about Wachovia. To date I have studiously avoided stating my position.

Besides – as is now clear – my views are worth little. I thought WaMu was ultimately better than Wachovia and preferred the preferreds of WaMu to many less risky bets. I did not (and would not) own the common of either institution. I would not – as I think at best they wind up diluting themselves massively. I am fond of shorting commons against preferreds – but that trade is difficult to do these days.

Anway I was wrong. WaMu was confiscated first.

In the past Wachovia has looked worse than WaMu. Does anyone other than me remember the Money Store?

It will not be long before Wachovia’s numbers are as bad as WaMu was last quarter.

I have no position in Wachovia but if I could I would short the common now. The way the FDIC acted makes me think Wachovia is toast too.

If you were the CEO of Wachovia you would be looking for a bride-groom or suitor now. You would take a bid at a discount to market so the common is just awful.

The prefs in Wachovia would just be a bet on a willingness of someone to pay 50c a share for the common – and now the FDIC appears willing to confiscate the bank and even wipe out the senior debt there appears no reason to do that.

The FDIC decision might be right – but the public information needed to justify it is simply not there. The FDIC has some explaining to do.

We all know what happened here: the FDIC forced Wachovia into Citi’s arms, only for Citi to be trumped by Wells Fargo, a better run institution — explaining much of Citi’s problems today.

And then, we have I trifecta of alleged confiscation coming from Chris Whalen earlier today:

On Friday, the FDIC closed and facilitated the sale of two CA savings banks, Downey Savings and Loan, the bank unit of Downey Financial Corp (NYSE:DSL) and PFF Bank and Trust, Pomona, CA. All deposit accounts and all loans of both banks have been transferred to U.S. Bank, NA, lead bank unit of U.S. Bancorp (NYSE:USB). All former Downey and PFF Bank branches reopen for business today as branches of U.S. Bank.

Earlier this year we wrote positively about Downey and the funding advantages it had over larger thrifts such as Washington Mutual due to the solid deposit base and strong capital. Indeed, as of Q3 2008, the bank’s Tier One leverage ratio was over 7.5%, more than two points over the minimum, and its charge offs had actually fallen compared with the gruesome 400 basis points of default reported in the previous period.

But since the September resolution of WaMu and Wachovia, the FDIC, it seems, is not willing to wait to resolve institutions, even banks that are apparently solvent and not below any of the traditional regulatory triggers for closure. The visible public metrics indicating soundness did not dissuade the Office of Thrift Supervision and FDIC from seizing both banks and selling them to USB.

The purchase of Downey and PFF is good news for the depositors and borrowers, who will all be offered the FDIC’s prepackaged IndyMac mortgage modification program as a condition of the USB acquisition. Bad news for the investors and creditors, who now see their already impaired investments wiped out.

The resolution of Downey illustrates both the best and the worst aspects of the government’s remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well – when politics does not intervene.

In the case of Downey and PFF, it appears that the OTS and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG (NYSE:AIG) are granted salvation by the Federal Reserve Board and the U.S. Treasury, but other investors are not?

I hope Chris and John’s commentary demonstrates why an ad-hoc approach only serves to further undermine confidence in the administration of regulatory oversight and, by association, the entire banking system. Looking at the Citi solution, the fact is we should still wonder whether Citigroup will make the grade because we still have zero idea as to what the toxic assets on its balance sheet are worth.

I still harbor deep misgivings about the U.S. banking system’s integrity as do most Americans. This is a clear signal that the TARP, the Citigroup deal and other similar remedies have been a failure.

Sources
What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup Chris Whalen, The Big Picture
Wachovia next – Bronte Capital
The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC – Bronte Capital
Citigroup, Whachovia, Sheila Bair and a post I didn’t make… – Bronte Capital