Bailouts: catching a falling knife

Back in June before real panic struck, I outlined my thinking on the financial services sector in a post called “Financials: catching a falling knife.” My basic point at the time was that investors – especially sovereign wealth funds (SWFs) and hedge funds – were seriously underestimating future losses in the financial services. I suggested that buying financials was like catching a falling knife and that things would only improve when these investors gave up and went home.

Since that time, those investors have indeed given up after sustaining hundreds of billions in losses. Yet, their money is now being replaced by government money, which is propping up failing and bankrupt institutions. I see this as a problem, not a solution. However, it is unclear whether the new U.S. administration, the U.K. government, the German government, and the Irish government will continue this ill-fated policy response. If they do, you can expect things to get much worse.

Overlending and credit revulsion
Before I go into why these actions are not likely to succeed, I want to present a bit of background on financial crises.

What generally happens is this: many banks recklessly overlend as the economic cycle reaches a critical juncture. Soon thereafter, the banks start to incur losses which make plain the error in overlending. As a result, banks cut back on lending to the point that even solvent well-run businesses and individuals do not receive enough credit. This is called credit revulsion and is clearly where we are in the present business cycle.

The problem is this: banks made bad decisions that impaired their capital base. In a fractional reserve banking system (which actually has some similarities to a Ponzi scheme), a poor capital base creates distrust and, eventually, panic and insolvency for banks. Therefore, when credit revulsion occurs, banks must rein in lending to increase capital for fear of insolvency. It is futile to prod the banks into lending more. Credit revulsion has set in and their legitimate fiduciary responsibility lies with increasing capital to remain trustworthy and solvent. To be clear: those calling for banks to lend more fail to understand that banks do not lend when their capital base is compromised.

Re-capitalizing banks and pushing on a string
So, it is essential that banks be recapitalized in sustainable ways. There are a few ways this can be accomplished.

  1. Banks can earn their way into a greater capital base by making money on the spread between borrowing and lending.  Marshall Auerback wrote a post demonstrating that the Fed is secretly trying to accomplish this (see Bank of America: Bailout hides huge bank subsidy deep in press release text).
  2. Banks can sell assets – de-leverage.  The fewer assets they own, the smaller their balance sheet becomes and the less capital they need.  Banks are clearly doing this at present – particularly regarding exposure to the shadow banking system of hedge funds and other less regulated financial institutions.
  3. Banks can receive additional paid-in capital from investors, either from the public sector or from private investors.  This is what we saw SWFs doing in 2008 and what the government is doing in bailing out banks now.  In fact, I see this as policymakers’ preferred vehicle for re-capitalizing institutions.  I am skeptical as to whether this is the right policy prescription.

However — and this is important – given the psychology of credit revulsion and the true need for additional capital, lending can only be undertaken when capital levels have returned to secure levels and when banks are relatively certain that future losses will also not impair capital, risking insolvency.  Trying to prop up institutions with fresh capital when hundreds of billions of dollars have yet to be written down is a losing proposition. The hedge funds, private equity funds and SWFs found this out in 2008, suffering massive losses in the process.  I anticipate that government will learn the same lesson in 2009 – hopefully before too much damage is done.

What does that mean? It means that lowering interest rates, engaging in quantitative easing, bailing out banks with guarantees and capital infusions will not increase lending significantly until the losses from the previous credit binge are fully accounted for. We may see some increase at the margin. However, in general, policy makers are going to be pushing on a string — their efforts will not be successful. They are merely sowing the seeds of future inflation and another credit boom-bust cycle.

Writedowns are the key
Now, imagine that you are a bank executive and you have become quite familiar with your loan book and asset-backed security exposure. You are worried that you may experience tens of billions in writedowns due to the souring of these assets. Then, the government comes and hands you a check for $10 billion. What are you going to do?

  1. Go out and make tons of new loans hoping that the economy turns around so that they won’t go sour,
  2. use the money to backstop losses as you modify current loans that are likely to sour and for which adequate collateral is not available, or
  3. park some of the money as security against losses due to the economic meltdown and use some of the money to buy quality institutions that can bolster your capital.

I think you know the answer.  It is the same answer U.S. consumers gave when they received free money as tax rebates this past summer.  It would be irresponsible to take a flyer and start lending imprudently.  After all, isn’t that what got us here in the first place?

So, banks are waiting to figure out how many writedowns they will have to take on assets already on their books.  The level of those writedowns is key to increased borrowing. Having a reasonable hold on how many writedowns are to come gives an executive confidence as to how many new loans they can make and still have a strong balance sheet.

Question solvency because of the level of writedowns coming
Nouriel Roubini has just come out with an incredibly high figure of  $3.6 Trillion of expected total writedowns for the U.S. banking system alone.  If his estimate is even close to accurate,  then the U.S. banking system is effectively insolvent.  And we can reasonably expect this to be true elsewhere? What does this mean?  It means that government are injecting capital into many insolvent institutions. Is RBS solvent? Is Hypo Real Estate solvent?  Is Citigroup solvent?  is Allied Irish Bank solvent?  Should the governments of the U.K., Germany, the U.S., and Ireland be giving these companies money or liquidating them?  The answer to these questions is far from clear.

What is clear is that propping up insolvent institutions presents a moral hazard issue.  Moreover, it also lengthens and deepens recession.  How?  Say you are a bank executive at a well-run institution and another bank comes to you for a 30-day loan.  Do you give them the money?  How do you know they will be around in 30 days?  What about yourself – don’t you need the money?  How do you know you won’t need to go cap in hand to the government for a bailout at some point down the line?  You don’t.  That’s why you don’t lend.  That’s why some good companies might need to go bankrupt due to lack of funds.

This is one specific way that doubt and uncertainty create a downward spiral.  Fear creates an environment in which it is extremely difficult to discern the difference between illiquidity and insolvency.  Propping up bankrupt institutions only increases doubt and fear, adding to the economic death spiral.

What needs to be done is to comprehensively review financial institutions in a way that makes clear which are insolvent and which are not. Once this issue is taken care of, solvent institutions can be induced to lend if they are infused with enough capital to reasonably cover capital needs for future writedowns of assets already on the books.

As we move forward, you should be watching to see if policy makers understand these facts. If they do not, they will be bailing out insolvent institutions – and taxpayers will be catching a falling knife. We would expect writedowns to increase further from unnecessary dead weight economic loss, lengthening and worsening the recession. While this recession will be deep, it is not too late to keep it from becoming catastrophically so.

Roubini Predicts U.S. Losses May Reach $3.6 Trillion –

  1. John Creighton says

    I remember reading your past comments when I was watching squeezeplay last night:

    And so many of your comments::
    Pushing on a string:
    Insolvent banks:

    today your post remind me of some points I saw on the show. Another point that Kevin made on squeeze play is that the recapitalization of banks dilutes shareholders earnings and for that reason he would rather buy debt the equities. The prospect of banks being insolvent after considering future loan loses is scary is scary. However, is there a chance that future inflation could inflate the value of assets and help counteract loan losses?

    1. Edward Harrison says

      That's a good question. My take: first the deflation and deleveraging and then the inflation. That means that for the foreseeable future the financial services sector will be in a shrinking mode — shrinking assets and credit growth along with them. Inflation is not going to be a factor in that environment. So inflation cannot inflate away the real burden of banks' own problems. Down the line, it may help debtor consumers, but it won't help the banks.

      In my view, banks need to get a handle on how much they have coming in writedowns first and foremost. Then they need to find a way to get adequate capital to deal with those writedowns. On some level, who cares where this capital comes from, because when they have it: we can return to some sense of normalcy. However, if we keep propping up these zombie institutions, the writedowns are going to increase and that will put us further away from our goal.

  2. Wag the Dog says

    Wouldn't letting bad banks fail increase the risk of bank runs? There may be FDIC in the US and FSCS in the UK, but there is still the psychological fear of losing access to your funds, if only temporarily. The fact that Icesave took on average two months to sort out scared a lot of depositors that lots of savers began spreading their money around. 7 bank accounts and more was not unheard of in the MoneySavingExpert forum. So much so many people were familiarising themselves with password management software – something they never thought they needed.

    By all means, let investors who made bad decisions lose their shirts, but are savers to be counted among these investors? Will savers have to pay as close attention to their bank's health as do the shareholders? Savers and consumers will be waking up to a risk they weren't even aware of before – counterparty risk – and that by itself can make them hoard cash and withdraw their spending.

    Who funds the FDIC scheme? In the UK it's the taxpayers who have to foot the FSCS bill.

    1. Edward Harrison says

      I am not suggesting a Lehman-style approach is the way forward. I think a comprehensive review followed by an FDIC-style seizure or forced meger will be the best way in 90% of the cases. Sometimes, liquidation or nationalization will be best, but ultimately it needs to be a well-crafted and orderly process. Savers have been given guarantees and the FDIC-like process of letting another bank take over the deposits is the right approach so that there is no effect on large savings deposits. The banks fund the FDIC scheme in the U.S.

      In the U.K. the Lloyds-HBOS link up was botched because HBOS turned out to be in considerably worse shape than anticipated. Now, Lloyds customers and shareholders are feeling the pain. This is the kind of thing that needs to be avoided.

  3. Stevie b. says

    Ed – "first the deflation and deleveraging and then the inflation…etc".

    I'd be really interested to get your views on the following and the implication that inflation may not be as easy to -create- as I had thought:

    The whole thread including responses is a bit long but hopefully really thought-provoking?

  4. Anarchus says

    Insightful post.

    One interesting datapoint to watch going forward will be the results posted by FRE and FNM. As you clearly point out, it's just not feasible to ask financial institutions to lend (or guarantee) aggressively when the capital base is impaired and the trend in asset quality is going south rapidly – in part because it doesn't make economic sense. So. I think anyone who expects that the financial results of FRE and FNM are going to be improved by government stewardship is living on the same la-la side of town as Stanley O'Neal and dancing CEO Charles Percy.

  5. Anarchus says

    The fundamental problem as I see it is that on a national basis, the home prices underlying trillions of dollars in mortgages and derivatives got wildly inflated relative to income levels. and now the value of said mortgages and derivatives is going down, down, down until home prices fall to a solid, sustainable level relative to incomes. Based on my back-of-the-envelope calculations that's another 20%-to-40% down from here, and the issue is complicated by the facts that (a) markets have a tendency to overshoot fair value when prices are moving with a lot of momentum, and (b) incomes themselves are likely to be under dramatic pressure and move downward for a while.

    In any case, the reason that bank capital continues under assault is that financial institutions only have about $1 in equity for every $20 in assets and the value of mortgage-related assets still has considerably further to decline. As an aside, the government would do better to encourage home prices to fall quickly to sustainable levels rather than attempting to keep home prices up at valuations that make no sense. The pain would be immediate and harsh, but there's no avoiding that regardless. Watch FNM and FRE . . . . . .

  6. Anderson says

    Very good post. Another consequence of the bad banks buying good banks to shore up their balance sheet, is that after they fail, their will be less good banks left to help the economy recover, further prolonging the depression.

  7. John Creighton says

    Anarchus, I hope the house prices don't have another 20-40% to go. However, if they do then maybe they are trying to use currency devaluation to cover the remaining gap.

Comments are closed.

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