A few thoughts about the banking crisis response in the United States

This is a post I wrote last week on naked capitalism.

In any banking crisis, the central question always is: which financial institutions now operating are insolvent, how can we identify them and remove them from the system, and how can we recapitalize the remaining institutions in a way that restores confidence to the system generally? Therefore, any response by policy makers must address three separate issues:

1. Confidence in the system. This is the first question to be addressed because no fractional reserve banking system can function without confidence in its integrity. Is Citigroup going to be nationalized? Are the regionals sitting on massive commercial real estate time bombs? Does Wells Fargo have a fatally large exposure to California-based HELOCs? If BofA goes bust will I get my money back at the ATM? No one knows the answer to these questions definitively. As a result, each and every institution in America is subject to suspicion about its solvency by depositors, debt holders, commercial paper investors, and transaction counterparties. The whole system comes under a cloud. In short, doubt breeds fear and fear creates systemic risk.
2. Identification of insolvent institutions. This is the tricky bit for a number of reasons. First, I should note that Warren Buffett has said Wells Fargo has a pre-tax earnings power of $40 billion. That is enormous. While one should be suspicious whether Buffett is talking his own book, it points out the fact that any bank can ‘earn its way out of insolvency’ if given enough time. Nationalization is but one option. (John Hempton has noted that the Japanese banks actually did not have the benefit of time as their spread margin was so small due to the infamous zero-interest rate policy – you need a steep yield curve). But, ultimately, it is liquidity that is at issue for many bankrupt financial institutions – a loss of depositor or creditor faith. Their credit lines are pulled (Bear Stearns) or bank customers flee (Northern Rock). So, when we ask whether an institution is insolvent or bankrupt, it is a trick question because many failed financial institutions suffer a lack of liquidity — a circumstance which presages insolvency (see my take on this issue here). Identifying whether an institution is fundamentally insolvent depends crucially on the true value of its asset base as well as future loan losses and credit writedowns.
3. Recapitalization of solvent companies. Once one determines whether a financial institution is insolvent, the remaining solvent institutions might still be so fragile as to succumb to liquidity pressures. They must be adequately recapitalized in order to preserve confidence in the system as a whole. How one goes about doing so is less important than doing so. Moreover, it is crucial that government not recapitalize insolvent institutions lest they be confused with solvent entities, re-creating the loss of confidence which created the panic and crisis to begin with.

Set against these criteria, the response to date by U.S. regulators and government officials is thoroughly lacking. Let’s look a little more in depth at each step in the process to see why.

Confidence
I see confidence as the key to the entire problem. Think about it this way: one day you were walking around under the assumption that you could get money from the ATM, invest in your IRA, move money from account to account, and take out a mortgage pretty much at will. Then you woke up to news that your friend’s bank was bust and lines were forming. Then you hear that your friend can’t get his money back because he had ‘unsecured deposits.’ Suddenly, you think, “wait a minute, maybe my money is not so safe after all. How do I know that my bank isn’t next?”

The fact is you don’t know. And normally this does not matter because the integrity of the banking system is not in doubt. However, when a credit crisis emerges, psychology changes drastically and everyone — and every bank — comes under suspicion. People start yanking their money. Since banks borrow short and lend long, they don’t have all the deposits to hand. Any institution would be illiquid and forced into insolvency if enough creditors and depositors withdrew their support. This is why confidence must be restored at all costs. The question is: how do you do that?

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Bankrupt institutions
You shut down bankrupt institutions. If financial institution creditors and counterparties are reasonably sure that any institution which is potentially insolvent will be immediately shut down and liquidated, merged, sold, or nationalized by regulators and that they will be made whole, instantly confidence would be restored in the banking system as a whole. Yes, I am suggesting that senior debtholders receive substantially all funds in a re-organization

Now, the banking system is a cartel. That means the banking authority — state or national – excludes those it deems lacking in capital and credibility from sullying the system. As a result, banks operate in an environment of limited competition, garnering them larger profits. In return, they promise to uphold the rules set out by the regulator, the penalty being asset seizure and closure by the FDIC. This system operates because we all assume it has inherent integrity.

By the way, I would argue that a large part of why this system broke down has to do with de-regulation and its introduction of competition from unregulated sources, which pressured banks into seeking more risk in order to earn a decent return, fatally undermining the system’s integrity (but that is a topic for a different post).

The problem in the United States today is that it is unclear that all insolvent institutions are, in fact being shut down in a timely fashion. Is Citi insolvent? Is BofA bankrupt? How about Fifth Third or Zions? Moreover, as a creditor, you have no idea whether you are going to get paid in full. Remember what happened to the holders of preferred at Fannie and Freddie? Why would you lend to any financial institution if you are not sure that you are going to get your money back? The same is true for depositors, which is why WaMu was seized by the FDIC in my opinion — there was a run on deposits at the bank. Equity holders are a different situation as they should bear all the risk.

This is disastrous for the economy because banks must then deleverage and cut credit as their funding sources disappear, further weakening the economy and banking system until somebody fails and then we have another panic. We have had six months since the last panic began. One would think the Obama Administration might have a solution in hand.

The vague and delayed plan presented by Tim Geithner is not going to get it done. It has been widely panned and has not instilled confidence in the system. Moreover, as originally proposed it allowed the banks themselves to value their assets in order to meet the tangible common equity stress test criteria. This is self regulation in the extreme. And as Willem Buiter has said, “Self-regulation is to regulation as self-importance is to importance.”

I have come up with a number of proposals in the last few months, as have any number of pundits from Willem Buiter to Nouriel Roubini. In fact, I pointed out the Swedish model as a potential framework for the U.S. as far back as August – 7 months ago (and this has been dismissed out of hand by the Obama Administration for, what I believe, are ideological — and not substantive — reasons). Yet, the Obama Administration continues to dither. Certainly, the mechanics (FDIC seizure, merger, break up and sale, pre-privatization) are daunting given the size and scope of America’s larger institutions. And we have some frightening examples in government ownership (AIG and Fannie and Freddie), in bankruptcy (Lehman Brothers), and in merger (Bear Stearns, Merrill Lynch). However, putting off the problem is not an effective solution, as doubt grows in such an environment and this increases the need for both deleveraging and restricting credit.

Recapitalization
And that brings us to the last of the three pillars here – recapitalization. If and when Geithner and Summers decide who is insolvent and how to deal with them, they will need to present a model for recapitalizing the remaining solvent institutions. Now, for a moment, let’s assume Citigroup is in fact solvent, and that this is why it is being propped up. Even in such a circumstance, it is not a very good model for further recapitalization. The Citigroup solution has been — in a word – ad-hoc. And ad-hoc is poison because it creates doubt about how the same solution will be re-applied for other institutions. And when creditors and borrowers doubt that they will be paid in full, they do not lend or deposit their funds.

And I should point out is far from clear that Citigroup is in fact solvent at all. The propping up of potentially insolvent institutions that may eventually be seized undermines confidence in the entire system.

Now, my own site is called “Credit Writedowns” in large part because I see writedowns as the key to finance and this banking crisis. Basically, any solution for recapitalization must address future writedowns and loan losses of assets already on the books if it is to be successful. One reason that this crisis has been so protracted is because there has been a painful drip, drip of writedowns after each and every capital injection into America’s financial institutions. Clearly, investors and policy makers alike have seriously underestimated the scale of writedowns. So, Job 1 is to get a grip on the future losses, write those assets down and recapitalize institutions accordingly. Getting this done quickly is important. The mechanics, while tricky, are less important.

In my view, much of this seems axiomatic. For months, various credible economists have offered this advice and I have been puzzled as to why Paulson, Bernanke and now Geithner and Summers have not moved in this direction. I can only assume it is because they still believe the U.S. banking system can be salvaged with a minimum of invasive surgery. However, a prudent approach, a cautious approach, would recognize the need for swifter and bolder action lest the patient die on the operating table.

My advice is to pick a credible comprehensive solution quickly (there are many). Garner legislative approval and set up a bi-partisan, non-politicized process. And then stick to your game plan in each and every case – regardless of size or influence of the institution.