Warning – a very long and wonky post - and possibly a little self indulgent. Don’t bother reading it unless you are really interested in banks and the crisis. More an essay than a blog post. If you are going to read it give me the courtesy of reading it to the end. If you are a direct report of Mr Geithner please read it now (the stuff you want is at the end).
It wasn’t the intention of this blog to become a public policy forum. It was just going to be a conventional investment blog. I used to be an (Australian and New Zealand) Treasury official and thought I gave up policy analysis when I ceased being a bureaucrat.
But the analysis of banks got intertwined with the analysis of politics. You can’t possibly decide what bank to invest (or for that matter short) without an understanding of where the politics is. If the government is going to keep giving money to banks (as per the Citigroup bailout) then you just have to own them. If the government is going to be harsh (as per the AIG bailout) then you want to run a mile. And they could be harsher than that. There are lots of possible outcomes – and the outcomes seem uncorrelated to the solvency of the institution. WaMu was probably solvent (subject to definitions below) and was confiscated – certainly – according to the FDIC – it had enough capital when it was confiscated. Wachovia was forced to sell itself when solvent (and when Wells happily purchased them later proving the point). AIG was shockingly insolvent and the shareholders were 80% diluted. Citigroup was in much bigger trouble than WaMu (it was actually illiquid) and the shareholders were given a big kiss (lots of very cheap government money and guarantees) and told to go on their way.
The government policy is very hard to determine. Under the Bush administration there was no policy. Each financial institution in crisis was handled a different way – think Bear, Lehman, AIG, Fannie and Freddie, WaMu, Wachovia, Citigroup. No two deals were even close to similar. Ad-hoc – thy name is Hank Paulson.
We have gone from an administration which demonstrated that it had no plan to the “Geithner Plan”. The “scare quotes” around “Geithner Plan” are because it is unfair to even call the “Geithner Plan” a “Plan”. As far as I can see there is no detail – and if you don’t have detail you don’t have a plan. I will remove the scare quotes when I think the Obama administration has a plan.
That said – lets put some framework around “the plan” – such as it is
First – let’s diagnose the problem – because I don’t even think the problem is well diagnosed.
We have a lot of pools of bank assets (pools of loans) which have the following properties:
- The assets sit on the bank’s balance sheet with a value of 90 – meaning they have either being marked down to 90 (say mark to mythical market or model) or they have 10 in provisions for losses against them.
- The same assets when they run off might actually make 75 – meaning if you run them to maturity or default the bank will – discounted at a low rate – recover 75 cents in the dollar on value.
- The same assets if sold in the market (which does exist if you wish to discover the price) trade at 50 cents in the dollar.
The banks are thus under-reserved on an “held to maturity” basis. Heavily under-reserved. If you were to take correct provisions – many banks – not all but many – would have negative net worth. Few banks would meet capital adequacy standards. Given the penalty for even appearing as if there was a chance that you would not meet capital adequacy standards is death (see WaMu and Wachovia) and this is a self-assessed exam, banks can be expected not to tell the truth.*
Before you go any further you might wonder why it is possible that loans that will recover 75 trade at 50? Well its sort of obvious – in that I said that they recover 75 if the recoveries are discounted at a low rate. If I am going to buy such a loan I probably want 15% per annum return on equity.The loan initially yielded say 5%. If I buy it at 50 I get a running yield of 10% - but say 15% of the loans are not actually paying that yield – so my running yield is 8.5%. I will get 75-80c on them in the end – and so there is another 25cents to be made – but that will be booked with an average duration of 5 years – so another 5% per year. At 50 cents in the dollar the yield to maturity on those bad assets is about 15% even though the assets are “bought cheap”. That is not enough for a hedge fund to be really interested – though if they could borrow to buy those assets they might be fun. The only problem is that the funding to buy the assets is either unavailable or if available with nasty covenants and a high price. Essentially the 75/50 difference is an artefact of the crisis and the unavailability of funding.
The problem with new loans
The difference between the yield to maturity value of a loan and its market value is extremely wide. The difference arises because you can’t eaily borrow to fund the loans – and my yield to maturity value is measured using traditional (low) costs of funds and market values loans based on their actual cost of funds (very high because of the crisis).
The spread between the origination value of a loan and its secondary value is huge. It simply makes no sense to originate new loans when you can buy old loans so cheap. Because it makes no sense to originate loans banks will not do it unless they are driven by an “institutional imperative” (they don’t know what else to do) or they are forced to by regulators or they are trying to prove their solvency by using capital (something I have accused Barclays of).
The irrationality of lending has dire economic consequences. At worst business just stops because they can’t get trade finance, working capital funding or any of the other basic services of modern banking.
Some reasonable numbers for the United States
Reasonable numbers are that:
- The system starting capital (ie pre-crisis) was 1.4 trillion dollars,
- Banks have raised about $500 billion along the way
- Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS (such as Norwegian local government authorities), indeed the whole point of securitisation was that it took the loans and losses out of the banking system,
- That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and
- That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion.
The hardest of these numbers to determine is the end cumulative losses. The reason is that it is a prediction.** You can’t possibly know the end losses until the loans have run their course. Moreover the government response to the system will – to a large part – determine this number. If the government handles it very poorly then end losses will be larger.
The starting capital, capital raised along the way, losses outside the financial system are all just hard facts (though my quantification is not fantastic and there are serious quantitative difficulties such as double counting). The mark-to-market loss is able to be estimated because the market prices are observable – but banks are not happy to tell you what is on their books – and – more importantly – they don’t want to find out the price for those assets because they know above all that this is a self assessed exam for which the penalty for failure is death. For what it is worth I suspect the end cumulative losses will be at the low end of my range and that the mark-to-market losses will be at the high end of my range (ie that Roubini is an optimist on mark-to-market losses).
The other observation is that the starting capital for the US banks was high. The regulators in the US by-and-large forced banks to have a lot of capital. They were more lax in Europe and totally lax in the UK. The UK problems arise in part because the banks started the cycle massively capital deficient.
Are the banks solvent?
It has been the blogosphere (and now commentator) meme-of-the-day that the US banking system is not solvent. See Paul Krugman, Yves Smith or Felix Salmon for examples. But I am not sure that anyone even defines solvent appropriately. So let's think about different definitions of solvency – and whether the banks meet them.
There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:
- Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
- Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
- Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
- Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
- Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?
Let’s look at the banking system against each of these definitions of solvency. That should clear the woolly thinking up on solvency.
Solvency against definition 1: does the banking system currently contain adequate regulatory capital.
To this definition the answer is not likely – and though if you ran for three or four years you might get there. The US banking system started with 1.4 trillion – which was quite near regulatory limits. In the great boom it was just assumed you wanted to run with as little capital as required because that got your return on equity up. So the starting capital was somewhere near required capital. As say 1.5-2 trillion has been lost (on the yield-to-maturity-definition) and only 500 billion or so raised so collectively the banks are likely to be short. Pre-tax, pre-provision operating profits (probably greater than 300 billion per annum with normalised funding costs) would not cover the difference.
There will be disparity amongst banks and some will actually have gone negative regulatory capital (including probably WaMu had it been left). The regulatory insolvency is far greater if you were to mark the assets to market but outside the brokerage area most banks don’t have to mark assets to market – and inside the brokerage area they really want the mark-to-market rules suspended.
Trading books (or loans originated for sale) are by accounting standard mark-to-market. This is a big problem because the market price is substantially lower than the yield to maturity value. If a bank did a lot of trading (eg Citigroup) or originated a lot of loans for sale but was stuck with them at the end (eg Royal Bank of Scotland on its private equity loan book) then it is likely to be deeply insolvent on a regulatory standard because it needs to mark those loans down to a the very low market price. These institutions are squealing for a suspension of mark-to-market rules – and I would have some sympathy if I could get them to account for it on a reasonable yield to maturity basis with reasonable reserves. I don’t trust them – after all – they are bankers and they lie.***
Nonetheless regulatory capital is not where it is at. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. It’s perfectly normal (and in my view acceptable) to have inadequate regulatory midway through a nasty downturn. Dividends should be cut, profit should be retained, even growth curtailed – all of which are how banks get back to normal regulatory capital – but confiscation or nationalisation of banks because the regulatory buffers have been removed is harsh – and unreasonable behaviour.
Solvency against definition 2: do the banks have positive net worth under GAAP?
This is a much less strict test than the regulatory capital test. It’s a test of whether there is capital there – not whether there are buffers there. You would not expect there to be broad buffers at this point in the cycle (after all the point of a buffer is that you use it when you have a crash) but soundness requires some buffer.
My view – and it is open to debate – is that a reasonable sort of regulatory buffer is that a bank – properly provisioned when the disaster happens – should be forced to have about a third required regulatory capital – and should be restricted from reducing that capital (dividends, buybacks etc) until the buffers are fully restored. Forbearance is right at this point of the cycle – unlimited forbearance is not. And Test 2 here is too weak for most policy application.
Nonetheless on Test 2 the banks almost certainly collectively pass. The losses (yield to maturity basis) are unlikely to be more than 2 trillion. We started with 1.4 trillion of capital – will have made probably 400 billion on pre-tax-pre-provision profits and having raised more than 500 billion. Moreover – the whole point of securitisation and the “shadow banking system” was that it moved considerable losses outside the banking system. As losses were moved elsewhere – whether that be to dumb hedge funds (of which HF-Implode has a large list) or to Norwegian local government.
Now I have a metaphor for how you might think of Test 2. In the centre of the road are double lines. You are not allowed to cross them. Crossing them is dangerous (you might crash and you might cause injury to others). When you cross them you should get back to your own side of the road quickly. However there are times of driving stress when you would cross them and that crossing is considered normal and acceptable. A child runs out on the road – and under stress you swerve over the double lines. Nobody will confiscate your car and lock you up for that. However if you stayed over the double lines you would expect the government to come down on you. Breaching regulatory capital buffers is normal in times of stress – but staying at very low to zero levels of negative capital – that is suicidal.
If we consider a modified Test 2 – whether the banks have collecting a third of required regulatory capital right now (say 500 billion) then it is harder to determine collective pass or failure – but my guess is pass. The losses in the system are indeterminate – but on a yield to maturity system 1.5 to 2 trillion seems about right. Now there may be 500 billion losses outside the banks (that is the shadow banking system). We started with 1.4 trillion and have raised a bit along the way. If losses are 2 trillion total – 500 billion outside the system and you have some operating profits along the way you get a bare pass.
The situation of trading books under Test 2 however is much more dire. Trading books under GAAP are mark to market – and as noted above the market values of assets are considerably less than the yield to maturity values. (The Roubini number of 3.4 trillion in mark-to-market losses comes to mind.) If these insitutions are forced to account honestly according to GAAP – that is to mark their own book appropriately – then they are likely very insolvent indeed. The mark to market losses (which are in excess of yield to maturity losses) however are offset to some extent by the phoney mark-to-market gain resulting from reducing the value of their own liabilities because of reduced credit worthiness. The banks that are in this situation (insolvent under mark to market) include Citigroup, JP Morgan, possibly Bank of America now that it has swallowed Merrill, and possibly Goldman Sachs.
Solvency against test 3: positive economic value of the banking entity.
This test requires adequate ability to repay the debts of the banking system and have some value provided the banking system is able to function. Before I go any further I should mention the proviso is critical. At the moment the banking system (indeed anyone) has a hard time getting cheap funding. This test presumes that the banks can fund themselves more-or-less-normally (either because times are normal or because governments have guaranteed the funding making the funding problems go away).
Here I am counted as a radical. The system in my view clearly has positive economic value. I did that calculation in my voodoo maths post. To me the issue is unequivocal. The pre-tax, pre-provision income of the banking system normally funded is probably 300 billion. It is probably much larger if the funding costs were reduced to near Treasury levels. If you haven’t noticed interest rate spreads and hence pre-tax, pre-provision profits of the banking system should (presuming normalised funding) be way way up. 300 billion is an underestimate. So if there are 2 trillion of losses and 1.4 trillion of starting capital then four or five years and we are back to fully capitalised. We would get back there faster than that – because the banks have raised considerable capital on the way down and not all the 2 trillion of end losses are born within the banking system. Indeed against "Test 3" I think the system is brimming with solvency. Individual banks are possibly insolvent against this test – but the system is not and anyone that tells you otherwise is just not doing maths.
The usefulness of this test however is problematic. It presumes the system can continue to operate (a test falsified by the facts on the ground). It is however an indication of what would happen if the system were nationalised – the government would make a profit. It is also the test of what would happen if the system had credible government guarantees and were sensibly run. (If you are going to give it government guarantees then – in my view – you might as well nationalise it. However at the very minimum you need to control it to an enormous extent because government guarantees cause nasty moral hazard problems.)
Test 4: do the banks have positive liquidation value?
This one is easy – no way. There is nothing wrong with the Nouriel Roubini number about 3.4 trillion in total losses if all assets on bank balance sheets are marked-to-market. Indeed if anything Roubini’s number is light. Bluntly speaking if you liquidated the banks now the losses would be huge – and they would be huge for almost all banks including those that met regulatory tests in "Test 1". The losses would be huge for the same reason that the banks are having trouble – nobody could lever up to buy the assets at anything that looks like a reasonable “yield to maturity” value. Incidentally it should be noticed that a bank which has adequate regulatory capital and has been well run will be profitable in run-off but have negative liquidation value. It is rough in the extreme to use liquidation value as the test - though in the event of widespread confiscation liquidation value is the test that will wind up being used.
Test 5: do the banks have enough liquidity?
Well this is hard – and critically dependent on government policy. Solvent banks (even "Test 1 Solvent Banks") will be "liquidity insolvent" if there is a run. And when people who provide funding lose in a run then any thought of runs will be self-fulfilling. So far several banks have failed "Test 5" – notably various brokers and Citigroup (which is a broker). The ability to pass or fail "Test 5" however comes mostly from the faith that people have that you will pass "Test 5". If you pass "Test 3" above (and the US banking system does) and people have sufficient faith then you should continuously pass Test 5.
Government policy however has been arbitrary and capricious. The Hank Paulson plan was no plan. It was ad-hoc. The “Geithner plan” is so vague as to be meaningless. WaMu which was adequately capitalised but had a minor run (induced by leaked rumours of a government takeover) was confiscated. Citigroup – which – being a broker – is almost certainly insolvent from a GAAP perspective – and which had a major liquidity squeeze was given a big-fat-sloppy-kiss (lots of cheap government capital). In the WaMu case the intermediate funders had any rights confiscated. That I thought at the time was reckless and irresponsible. I still think that.
If the government doesn’t get a consistent plan – and that consistent plan does not appease intermediate creditors of banks (as argued in the “reckless and irresponsible” post) then we might as well nationalise the entire US banking system now – because almost all banks are dependent on intermediate funding – and that funding has fear-of-government.
If you believe these numbers – and I do – then there is no need to nationalise the banking system in the US provided that you can get confidence back into the system. Now that is a big proviso – I have some methods of getting confidence back into the system – but they are harsh. Mostly it can’t be done with the current tier of executive management (who are utterly discredited). It also can’t be done unless government policy becomes consistent and appears to be consistent. A strong plan is necessary.
Nationalisation will work though as a way of bringing confidence back. I first mentioned nationalisation (as something that would work) in June 2008. One big name Wall Street journalist (who now thinks I was prescient) thought that I was mad then. I thought nationalisation might happen if government policy were badly executed. So far government policy has been badly executed - and the takeover of WaMu (which kicked the intermediate debt holders and hence put the fear-of-government into people that fund banks) is exhibit A. (I thought the end consequence of Sheila Bair’s action would be the nationalisation of the whole US banking system though I still harboured hope for better. I hoped that Hank Paulson – and later the Obama administration would be better than that. So far I am very disappointed.)
Anyway – there would not be a crisis if people trusted – even if the banks were marginally insolvent. However banks have told lies – blatant lies – for so long that nobody believes them. Certainly the blogosphere has decided that banks are insolvent no matter what they say – though the evidence for insolvency (other than mark-to-market insolvency as per Nouriel Roubini) is thin to non-existent. Mark-to-market insolvency is the norm.
Nationalisation, insolvency and process
Now when a blogger or an analyst tells you a bank or the system is insolvent then ask them what definition of insolvency they are using and test them against that definition. Then test them against others – and work out – in the context given – whether the institution is solvent against the definition appropriate for the circumstances. People who do not think clearly as to definition of insolvent are being sloppy – and that includes most the bloggers I most admire including Paul Krugman. The context in which the banking system is insolvent is that (a) it is illiquid because people don’t trust it and (b) it can’t get enough liquidity because it has to sell assets into a market in which they are trading considerably below their “yield to maturity or GAAP price” and if you sell it at that price you reveal “mark-to-market” insolvency as per Roubini. However provided the banking system could remain liquid it is unlikely it will actually be insolvent though individual banks might be. [I should note that this is a US conclusion. The UK banks started much more thinly capitalised and I think they are insolvent.]
This is what the stakes are in the (so far incompetent) government policy as to how the banking crisis is to be dealt with. What is a marginal solvency crisis (and that is all it is on a yield to maturity basis) is being turned into the mother-of-all-liquidity-and-solvency crises. Sure the banks bought in on themselves by telling so many lies in the good times (so they are never believed now). But now the problem is beyond their ability to control.
Anyway wholesale nationalisation is not the right policy per-se. It will the inevitable result of following the wrong policies. The right policies will involve selective nationalisation – what I have described in other posts as “nationalisation after due process”.
The “Geithner Plan”: module 1 – stress testing
The first element of the “Geithner Plan” is a stress testing of banks. This is so vague as to defy description. That hasn’t stopped Calculated Risk from thinking that this should start quickly and will be quick – though Yves at Naked Capitalism has it right.
Fannie Mae (according to its 2006 10K) spent almost a billion dollars in 2006 alone trying to remedy its accounting from its 2004 accounting scandal. Hey – that was just Fannie Mae. If you want to do a proper stress testing with qualified people across the banking system then your accounting bills will be in excess of $3 billion dollars. At the end of one post I jokingly called this “stimulus” – but it is – lots of work for underemployed business accountants.
At Fannie Mae I do not need to remind my readers the money wasn’t well spent.
Anyway the words “stress testing” in Geithner’s speech do not constitute a plan. Not close.
There is one stress test that it doesn’t cost a billion in accounting bills to do – and that is to say – hey – you got only 8 percent reserves against that pool of loans – why don’t you test that in the market. If you can sell those loans – even a few of them – at 92 cents in the dollar then we will think your reserves are sensible. Having done that we can believe your assumptions and stress test using the bank’s existing assumptions. The only problem – and it is a big problem – is that the secondary market price of the loans is way below the yield to maturity price – and if that is the test that you are going to have then you will reveal Nouriel Roubini type insolvency – because the whole system is grotesquely insolvent on a mark-to-market basis. A market based stress test can’t be done unless you fix the secondary market up.
The “Geithner Plan”: module 2 – private money involvement in purchasing assets from banks
Again the word “plan” is a misnomer here. More a statement of hopeful intent. I jokingly put some figures around it with a blog post that suggests that Geithner get the US Treasury to lend Bronte Capital a trillion dollars under favourable terms. I figured with such a loan that I could start making substantial money.
But the idea deserves more consideration than I gave it. If instead of one fund with 150 billion of private money and say 1050 billion of public money you established ten funds of one thirtieth that size then you could produce a functioning secondary market for the dross that banks are taking off their balance sheet. And this leads to what I think is the obvious meld of “module 1 and module 2”. That is (a) establish the funds – but with a rule that they are expected to – and only allowed to bid on the assets sold by banks on their stress test, and (b) having established the market for the secondary assets (admittedly supported by cheap money) you can get the banks to redo their reserves by selling sample assets into that market. This allows you a market redo of the accounts – and hence to avoid the problems that caused Fannie Mae to waste a billion dollars redoing their accounts.
If they have inadequate capital after testing in that market then you have the basis for forcing them to raise more capital or putting them into receivership – you have a functioning due process.
When the banks are illiquid rather than offer guarantees you beef up the secondary market by establishing more funds (with private money at risk in those funds). You have the banks sell their assets to gain liquidity.
This is a workable plan along Geithner lines. It won’t necessarily result in wholesale nationalisation – and I hope that I have convinced you that nationalisation is the end result of failure of policy rather than a policy goal in itself.
At worst it gets maybe a hundred billion of private money into the fray. It has all the requirements of due process. It should be a good plan.
Thanks for reading this far.
*It was Warren Buffett who first – at least to my hearing – described financial accounts as a self-assessed exam for which the penalty for failure is death. I think he was talking about insurance companies – but the idea is the same. Truth is not expected.
**Estimating the end losses for loans is always problematic. The modal outcome is near to zero (most loans pay) but the tails are fat. We live in a time of fat tails – and getting a handle on this number requires that we pretend we as much about the future as we do about the present. (And we know the present fairly poorly because – as I have pointed out – bankers almost always lie.)
***Note also it was acceptable to pay bonuses to traders based on mark-to-market profits. Now they want those rules suspended. Cynical comments are allowed…