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.

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