Tuesday, November 25, 2008

The Brad DeLong question - and how to design a bailout that works

Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.  


Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

Citigroup had poor risk controls.
As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
They weren't.
And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.
I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage.  It is simply about the question “do we trust them to repay their debts”.  You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay.  Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed.  All estimates are a shot in the dark.  In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout.  It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts.  I can not understand them and I am a pretty sophisticated bank analyst.  I know people I think are better than me – and they can’t understand Citigroup either.  So Citigroup was always a “trust us” thing and now we do not trust.  

The long answer has to be a replay of the various themes of this blog.  So lets do it in pieces.

1).  The losses in the banking system in America are not unmanageably large.  Anyone that tells you otherwise just hasn’t done the maths (and that is most people).  I have written this idea uphere…  and nobody yet has an adequate response though Mark Thoma has tried and even Kevin Drum on the Mother Jones blog has commented on it.

One offender not doing the maths is (very surprisingly) Paul Krugman - although his last post in which he blamed lack of capital for the crisis was March  - so maybe he has done some maths since.  Krugman usually does the maths and is spot-on in his analysis of Fannie and Freddie.   I am usually an unabashed fan of the Shrill Professor – so his various diagonoses  leave me perplexed.

2).  The problem with the banking system is that it is structurally short of stable funding.  America has a loan to deposit ratio that is collectively well above 100.  So does the UK, Iceland, the Baltics and most of Eastern Europe, Australia and New Zealand.  This means that collectively the banks need an awful lot of wholesale funding.

Japanese banks fizzle, they make no profit – but they do not collapse.  Why?  Because they are structurally long finance.  Agricultural Bank of China (the notorious ABC) is deeply desperately insolvent – but it is still here.  Why?  Because it is long funding.  Generally it is banks in current account deficit countries that are vulnerable.  The main German bank that collapsed (Hypo Realestate) had two large businesses with no deposit base.  It was the bank in a current account surplus country that collapsed – the exception that proved the rule.  [There is an issue with banks with life insurance subsidiaries in current account surplus countries.  They are vulnerable but for completely different reasons – the subject of another blog post – a long time into the future...]

3).  The crisis will end when people are convinced to roll the wholesale funding.  Government policy that brings us closer to that point is probably effective.  Government policy that does not bring us closer to that point is almost certainly ineffective.  Policy that takes us further from that point is counter-productive.  My case examples of counter-productive policies are the confiscation of the rights of the debt holders of Washington Mutual, and the pointed refusal to issue government guarantees even when it is utterly obvious that the government is on the line (as in Fannie Mae and Feddie Mac).  The confiscation of Washington Mutual convinced bond holders that their positions would be compromised by government fiat and with little notice.  As I have posted many times I thought that was reckless and that Sheila Bair should resign.  The refusal to guarantee Fannie Mae and Freddie Mac at this point looks like sheer stubbornness but I think is driven as much as anything by government accounting concerns – a full guarantee means the assets and (more importantly) liabilities get bought onto the government balance sheet.  

The cause of the crisis

This is a wholesale funding crisis and the cause of the crisis is plain.  It is lies told by financial institutions.  Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap.  They sold it to people who provide wholesale funding.  

Now they need to roll their own debt.  The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs.  They no longer believe.  It is “fool me once, shame on me, fool me twice, shame on you”.  As I have put it the lies that destroyed Bear Stearns were not told by short sellers.  They were told by Bear Stearns.

Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him.  In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold.  The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them.  When they tell the truth now, nobody will listen.  

Robert Rubin racks his brain about how he would have done things differently.  Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth.  The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup.  Even Robert Rubin.  In a world where Berkshire credit default swaps are going skyward because people do not believe that Warren Buffett has no collateral requirement Robert Rubin’s reputation ain’t going to count for much.  

Anyway given that the crisis is a wholesale funding crisis we need to do something to make the people who provide wholesale funds happy.  

What of course would make the people who provide the funding happy is a plausible government guarantee.  Iceland couldn’t provide one because its banking sector was ten times GDP.  But the US probably could. 

The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt.  The problem of course is that is hugely risky for the taxpayer.  My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside.  That is full nationalisation.  The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it.  That is fine.  Take the risk – make a profit – it’s the capitalist way.  Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario.  Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government.  In a full nationalisation I see no reason for Sheila Bair to resign.  (Her tenure in that position would not threaten the financial system.)  

I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis.  But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc).  Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit.  It would not be the first time – Norway made such a profit.

But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system.  Indeed they are determined it seems not to control financial institutions.  If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG.

A cost effective TARP

What however is required is something that convinces the funders that the banks are solvent at the least possible cost to the Treasury.  Now my view is that if the treasury guarantees (and hence takes the risk) it should own.  That is a view in favour of nationalisation, but as that is not on the table let’s do the next best thing.  Suppose the Treasury takes the “fat tail only”.  Then the banks are solvent.  Imagine for instance if the treasury agreed to capture the losses at Citigroup above say $90billion.  Why did I chose 90 billion – well – it is the stated capital of Citigroup.  

As Citigroup has at least its net worth guaranteed then Citgroup is solvent.  Funding should come back.  

Note that excess of loss insurance policies are almost certainly the cheapest way in which to guarantee banks.  The reason of course is that you take on only the losses you need to take on.  However you leave the upside with the banks.  

The Federal Government should logically charge for the excess of loss policy.  There will be some banks with very big losses that will claim on it – and so there will be losses recognised even if the system is solvent.  My rule – which is a little arbitrary – the government should take 20% of the equity of all institutions that want to buy an excess of loss policy.  I figure in five years time selling the equity should pay most government losses.

To be precise the excess of loss policies should not be for 100% of losses beyond an attachment.  In reality the government should guarantee only 90% of the losses beyond the attachment.  The reason for that is when the attachment point is hit you want the bank in question to have an incentive (be it 10% of recoveries) to actively mitigate the losses.  A better incentive is also to have the losses covered by the government – but with the government receiving equity in the institution dollar for dollar for the losses covered.  This will still mean that institutions are nationalised – precisely those with the biggest losses.  [The equity grant to the government for covering the losses will punish institutions that have to claim and will help mitigate government losses from the scheme…]

Mr Paulson seems however to be wanting to give government money inefficiently to financial way too cheap.  The bailout of Citigroup is a case in point.  They gave a capital injection (subordinated debt) for which they charged the princely sum of 8 percent.  Hey – that was what bank preferred stock yielded in 2006 – and way below the fair value of such money now.  Then they just guarantee 300 billion of assets – admittedly subject to an excess of loss rule (above 40 billion).  This excess of loss threshhold is way too low.  It could be 80 billion and Citigroup would remain solvent.  Then the government also did not take anything like a large enough equity stake in Citigroup even though Citigroup would have willingly handed one over.  Why not?  Because they play fast-and-loose with taxpayer resources.  

That said – the excess of loss policy is the right idea and for that (and for once) I applaud Mr Paulson.  This is the first bailout I have seen with a decent design.

Now as for Sheila Bair.  Her takeover of Washington Mutual and the subsequent collapse in Wachovia is perhaps the most glaring example of abusing the bank intermediate creditors this cycle.  She should resign for it – and the intermediate creditors will not be comfortable until she takes the fall.  But, and you will sense me relenting a little here, if the deal is that the government writes excess of loss policies on a grand scale her continued tenure in the job doesn’t actually threaten the financial system.  But until then she is the symbol of the risks faced by the providers of intermediate finance.  Absent a comprehensive solution as outlined here she should resign.  With a comprehensive solution her position is neutered – and she can stay in it without risk.  If she is driver for a comprehensive solution then I will forgive her staying around - but at the moment she seems far more concerned with modifying mortgage terms - that is about first loss.  An efficient comprehensive solution is about excess of loss - and she isn't playing that ballgame.  





John Hempton

7 comments:

Anonymous said...

I can understand one thing about Citi financials.

Year Dividends Paid
2007 10.7bn
2006 9.8bn
2005 9.1bn
2004 8.3bn

Maybe they should have kept a bit of that $38bn they paid out. I dont even look or want to calculate 2008 because the stupidity of that may make me puke. Talk about full-steam ahead as your are sinking. I cannot believe in that.

Bakken BEx said...

Excellent post. Though I agree with your assessment that the WaMu takeover was designed and executed poorly, I think you may owe more praise to Bair than just "possibly benign".

First however, congrats on recognizing the initial WB-Citi deal as a back-door bailout. Today's Citi bailout pretty well proves your thesis correct in how similar this deal is to the original Citi WB takeover, especially the asset loss guarantee.

I'm going off this post but I believe the details are accurate, http://blogs.wsj.com/economics/2008/09/29/fdic-citi-to-buy-wachovias-banking-operations/

In the original Wachovia Citi deal, the FDIC agreed to guarantee losses on a $312 billion pool of assets, with Citi taking the first $42 billion in losses.

In the current bailout, the USG entered into a loss share agreement on $306 billion, with Citi taking 100% of the first $29 billion, and then taking 10% thereafter. This 10%, if the pool of assets showed a total loss, would be equal to an additional $27.7 billion, for a maximum possible loss to Citi on the assets of $56.7 billion though their actual loss won't be nearly that large, and in fact this deal is likely a bit more generous than the WB one.

You applaud Paulson for the first bail-out decently designed, yet this one appears to have the FDIC's fingerprints all over it. I suppose it would come down to whose idea the 10% post-threshold loss-share was.

Jonathan said...

truly excellent post. Thanks again.

Anonymous said...

Where did you get the figures to indicate that Australian bank lending is 100 times bank deposits. Bank balance sheets look nothing like that, and even adding RBA rmbs figures gets nowhere near?

Anonymous said...

really good stuff...but isn't it "fool me once, shame on you, fool me twice, shame on me..."?

Anonymous said...

"This is a wholesale funding crisis and the cause of the crisis is plain. It is lies told by financial institutions. Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap."

So isn't this the definition of "fraud"? And shouldn't everyone now just shut up about "moral hazard" and start talking about "criminal culpability"? And won't behavior start improving a whole lot when a few BSD's find themselves sharing quarters with a 300 lb. African-American fellow citizen with a big scar down his face? And will Fox News stop extolling the virtues of "retributive justice" when that begins to happen?

epicaricacy said...

Don't know if you've seen this. May be moderately relieved.

http://www.bloomberg.com/apps/news?pid=washingtonstory&sid=aTFflUwD.Qbg

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.