Monday, February 16, 2009

Bank solvency and the "Geithner Plan"

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 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.

An observation

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.

John Hempton

*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…


Anonymous said...

Ooof. Tanta would be proud. I'll get around to reading it in the next few days.

Anonymous said...

A monster of a post, but good reading anyway.

One question, is your 1.5-2.0T expected loss for real estate related troubles only or for everything, including all consumer and corporate lending?

As t mark-to-market's faded popularity, it is highly procyclical and everybody loves procyclicality during the upturn of the cycle and hates it on the way back down. Especially when your bonus is assessed on it. Same with regulations and fiscal policy... Now how do we ensure proper countercyclical regulations, fiscal policy and accounting measures get enacted and survive the next upswing? It seems the only way to stabilize things.

By the way, when you write that a car crash might cause "industry" to others did you mean "injury" and if not, could you enlighten me as to how a crash can cause "industry"?

John Hempton said...

1.5 to 2 is everything. I have done several quantifications of that on the blog - I do not believe in the larger number.

I have corrected industry/injury.

There were about 6 trillion of mortgages outside Fannie and Freddie. If 30 percent default (an amazing number) and the loss given default is 50 percent then you get less than a trillion of mortgage losses.

Its pretty hard to get to 2 trillion.


Anonymous said...

this is great. how can i better understand the 1.5-2.0T estimate? any links anyone can provide that break this down?

M.G. said...

Actually I would not care if banks are solvent or insolvent after due process or test. What it matters is wether they lend money and do what they are supposed to do in the credit market. Since it appears that they are not allowing the normal functioning of credit markets, they need to be replaced in this main activity. As a matter of fact there is no point in making assumptions for pricing assets or mark to market if there is no market and no equilibrium price... That's why I advocate the creation of new "good banks" where "nationalization" is simply the wrong word because it suggests that the state will own them, when actually they will possibly belong to taxpayers and other private investors. Troubled assets will stay where they are until natural and gradual write-downs and/or "clearance".

Anonymous said...

Thank you for a very good post. Do not hesitate to write this long, or longer, in the future.

A couple of brief comments:

I believe that the reason why commentators like Paul Krugman and Yves Smith have been shouting “insolvent” from the roof tops is because the whole system was in such denial even about the possibility of the banking system being insolvent. Now, mainstream USA (when observed from the old continent, at least) appears to be prepared to consider insolvency/nationalisation without screaming communism. So now would be the time to refine the debate and your post is a step in the right direction.

You capture well the fact that the question of solvent or insolvent is not a matter of black and white, but a lot of grey. My own experience relates to the Swedish bailout which was all grey in the sense that it was clear that something had to be done to prevent the entire economy from choking but unclear exactly what and how far the state needed to go. The political class loathed the idea of having to nationalise (contrary to what some seem to believe, including President Obama, the Swedish Government at the time was centre right and considered nationalisation to be ideological heresy).

The Swedish bailout provided for a clear, transparent, comprehensive approach, that was run through Parliament to ensure public support (Do NOT forget this part if you consider nationalisation in the U.S.). The process of separating black from white in the banks’ books took time and different solutions were found the different institutions depending on their exposure.

The main point that I would like to make is that simply by having a comprehensive plan in place that included the possibility of nationalisation, the whole economy could breath easier and function somewhat normally. Without a comprehensive plan, the dominos in the economy as a whole would have kept falling.

I would thus argue that the question of whether banks are technically solvent or not at any given point in time is important, for obvious reason, but the decision to nationalise or not should be taken against the backdrop of the broader, general, interest.

John Hempton said...

My first post on this blog had a go at scoping the MORTGAGE losses for the US banking system - and that included the losses in the shadow system but not in Fannie Mae.

I could not get above a trillion. I still can't - but the situation is worse than I imagined.

The non-mortgage losses are going to be very large too - but they are also not entirely within the banking system.

My guess for losses WITHIN the US banking system on a yield to maturity basis is actually less than 1.5 trillion. But the Roubini number is also probably light.


Anonymous said...

Interesting post!
one comment:
To mkt-to-mkt at current mkt is equivalent to marking to the npv of the so called yield to maturity.
The current price, i.e the pv of the "yield to maturity" is the combined expectation of the current mkts expectations of the default rate and residual values on these securities/loans/ structured ( and sometime levered) instruments. In this "unprecendentad recession(depression?)", who is to know what default rate and residual values are to be? This uncertainty, not the lack of financing is what is keeping the mkt from bidding up these assets (imho). We know that are huge sideline funds parked in treasuries, and lots of vulture like funds who would love to pick up the "cheapest assets in this century".....the reason the do not, at least not yet, is because they are not sure they present value......which is why this is where the mkt is, despite the protestation of the banks ( who do not like the prce, because it would make them insolvent).

Anonymous said...

Great post. I think your conclusions on "Test 3" are problematic, but not for the reasons you cite. That's because subsidies distort the calculation.

What is the economic value of an unsubsidized banking system? Clearly negative. Imagine what deposit costs would look like without the FDIC guarantee. The NIM on new loans would likely not cover necessary provisions. Further, the discount rate, even with a positive income stream, would be punishingly high. What is the level of required return? Forget CAPM. What unlevered return would YOU require on bank equity? For me, the answer is well north of 20% even with FDIC guarantees. With that kind of discount rate, its hard to come up with positive NPV's unless the ROE skyrockets, and the only way to do that is to write down assets to a degree that no one envisions.

So I would argue that ANY economic value assigned to the banks results, today, from the FDIC guarantee. Since that guarantee is provided by taxpayers, then your "economic value" is really entirely a subsidy to shareholders. In return for what? A process of nationalization, asset write-downs, and privatization would at least capture part of that value from the risk takers in the equation: taxpayers.

Anonymous said...


In the absence of an FDIC guarantee, it is not clear that bank NIM's would cover provisions. Thus, any economic value you assign to banks is entirely a subsidy from taxpayers to equity holders. Does that mean the system is insolvent under "Test 3"? It depends on how you look at it. The guarantees are necessary from a public policy perspective. But if we define equity as a first-loss position, then the taxpayers effectively are providing that equity already. What do they get in return for the fantasy that shareholders are fulfilling that role?

Anonymous said...

Compliments to a wonderfully detailed and thought-out post. I find the blogsphere's demand for brevity peculiar when the issues are so complex. I vote for as many long-form posts as you have the energy to write.

A couple of thoughts FWTW:

Is there variability on the quality of capital for these institutions? My sense is Fannie & Freddie were more reliant on low-quality capital like tax-loss carryforwards it would never realize and thus required takeover. I viewed your bete noir WAMU and it's booking of negative amortization in its wretched option ARM book as revenue as similarly risky. Permissible under the rules, but likely to end in tears.

I'm also concerned that the securities held within these banks are so heterogeneous so as to defy any meaningful price discovery for entire books. The YTM of the highly-levered, derivative laden structures created in the tail-end of the credit bubble is a difficult puzzle indeed; I suspect some structures are so levered as to be binary in value (going from 50 cents to 0 with a 3% or so change in underlying collateral losses). I'm not sure cheap financing fosters a bid on those assets, and I'm not sure how big a chunk are sitting on the books of some of these banks. But Merrill's "surprise" $15b Q4 loss has me concerned.

Thanks again for your efforts.

Unknown said...

1) I think you're a little harsh on Sheila Bair. By all accounts I've read, she was the only one actually conducting vigorous "stress testing" late last year, which is one of the reasons that she deemed certain banks insolvent.

2) I think this was in some comment on another post, but another big issue here is the exposure of Citi and others to enormous amounts of off balance sheet assets. I think many US banks also have significant CDS exposure to shadow financial system participants, which could bite them in the arse.

3) Given that the macroeconomy is plummeting, and that the recent stimulus package appears far too small (thanks in large part to Republican ideologues who seem to think that tax cuts once again are the answer to everything), why aren't Krugman et al. correct when we talk about insolvency? Even using the positive cash flow test that you posit, it's not clear to me that massively deleveraging banks, who will never again see the massive profits they saw in the earlier part of this decade, will make up the massive losses they seem likely to incur, particularly if those losses are revised upward (again) due to rising defaults in the US. Also, you seem to gloss over the opportunity cost of investing in banks. I mean, if we're talking about a $500b hole in Citi's balance sheet (let along $1T+), why would an investor put in any money, pre-liquidation, even if we were talking about a $50b positive cash flow (which seems highly optimistic)? Why wouldn't they rather stick them in Treasuries, where they're receiving immediate returns, and no risk of principal loss?

Anonymous said...

I notice that a large portion of your analysis focuses on the difference between mark-to-market and held-to-maturity values of assets. You differentiate those two on the basis of discount rate, and seem to imply that the main distinction between the two discount rates (market vs HTM) is uncertainty over default outcomes in this chaotic global downturn.

I may be over my head here, but it seems to me that the there is another component of debt pricing that is equally relevant and offsetting to default risk, namely inflation risk. Maybe the market is saying that the combination of inflation risk and default risk make the bank assets worth 50 cents on the dollar in every scenario, regardless of holding period or economic outcome.

If massive global fiscal and moonetary stimulus is effective, future inflation expectations will hurt bank asset values (including any low interest mortgage loans currently being written). If deflation is persistent, then default risk remains high. From this perspective, the HTM models may be ignoring the inflation expectations component of their asset valuations. I believe the current "risk free rate" will be viewed as ridiculously low in the not to distant future.

Anonymous said...

Up to the standards that I have come to expect of Mr Hempton.
An important addition is what future profit will solvent or insolvent banks make in the future,given a subsidized cost of funds.Even the incompetent Citigroup could make upwards of $100 billion in the next 5 years if their margins are high enough.

I have a feeling that hedge funds ( having seen the huge, almost riskless profits made during the S+L crisis) are behind this rabid nationalization push

Anonymous said...

Great post John.

I'm not by any means a banking expert, but I'm not following your imputations of banking earnings for the next few years. You are imputing potential bank earnings at about $300 billion/year, but this assumes a continuous glut of capital - I've heard statistics between $6.9 and $13 trillion in assets being wiped out in the past year and assume that it will work its way through the market in a pretty deflating way - and that their securitization and derivatives businesses have to be wildly downsized. It seems like between asset deflation, the continued credit crunch, and the loss of those two shops (or their significant downsizing), getting earnings all the way back up would be difficult.

How do you come to this estimation?

Clayton said...

Clever. instead of suspending mark to market, we just "tweak" (I hate to use the word "fabricate" or "create". maybe "supplement") the market to give a more sustainable mark. And if it works well then you gain control over the uncertainty about who is in danger and eliminate some of that inter-banking lending uncertainty. I don't know what kind of support a plan like this can muster, but judging from a memo out of Deutche Bank, they'd rather extort the government into overpaying for whatever they want to unload.

Although I have much more faith in the Obama administration to pull off a more coherent and fair plan, I can not forget there are alot of investment bank alumni at treasury, and that over 99% of americans(I'm being generous here) have no idea of what any of this even means, any hopes of a fair plan should be diminished.
But I agree with poster #2, how do we deal with good times regulations? What exactly is the end goal? Back to unsustained growth and stupid lending? Or is the plan only to stem job losses? Plus I don't know how much more economic growth and resource exploitation the earth's ecosystem can handle.
I'm a bit all over the place here but maybe there's a point in that there isn't a defined, agreed, goal yet with so many interests at stake, much less deciding how to get there.

Jonathan said...

I don't think it is hyperbole (although is is a sad indictment on some government officials) to say that writing like this may well turn out to be some of the most impactful individual contributions to ending this global economic crisis. Thank you very very much for your continued efforts.

Let's hope Tim has his reading glasses on this w/e.

A minor personal request to others readers: could anyone help me to understand this piece: "The mark to market 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."

Anonymous said...

Just printed your post out and will read it over coffee tomorrow. Keep posting more like this.



Anonymous said...


I think the author is saying that the market value of bank liabilities has decreased along with the value of their assets, because of increased perceived risk of that outstanding bank debt. Using mark to market accounting, the banks may carry some of that debt on their balance sheet at a lower value than par, making their liabilities seem lower. In reality, unless the bank is able to buy that debt on the market at current reduced levels, then they will have to repay the full principle at maturity.

Anonymous said...

I've only read part-way through so far - it is very interesting. But I have one comment so far: the penalty (for the folks managing these banks) for the "self-assessed exam for which the penalty for failure is death" is not "death" - their "penalty" is enormous bonuses and retirement to Montecito. We seem to have arrived at the point where there is a complete and total disconnect between the interests of the ownership of public corporations and the interests of the senior management of those corporations. Same thing we saw in the tech boom. No group has any commitment to the interests of any other group - the investors, the management, the employees/workers, the customers, the public-at-large.

JoshK said...

Basically you are saying that banks can ear enough on their new business to work their way out of their massive losses (as long as they get highly subsidized short funding rates).

Why not just let the banks go bankrupt in a very organized manner and then let the survivors pick up the new business? It seems like people have an almost religious attachment to Citi, Banc, et al.

Also, everyone ignores the utter failure of the FDIC. They charged Citi the same fee as a stable midwestern bank? We should start re-thinking that program. It would make more sense to have cash-management accounts that are SPIC insured and then let individuals take on risk in funds.

Anonymous said...

On Thursday September 25th 2008, Washington Mutual Inc aka WaMu Inc. or WaMu, common shares trading under the symbol WM, opened at $2.62, rose to $2.69 within the first hour, and then fell on average for the rest of the day and closed at $1.69. In after hours trading it fell to $0.16. Take note it fell 90.5% just in after hours. During the regular day it fell 35.5%. For the entire day it fell 93.89%. All these percentages are based on the open, and excluding the pre-market trading data, which I do not have. For the day, the DJIA rose 196.89 points, and closed at 11,022.06

Clearly anyone who held WaMu through the day experienced a financial wipeout in their position. What caused this wipeout? In a statement issued on the night of September 25th the Office of Thrift Supervision (OTS), an office of the US Treasury, said “An outflow of deposits began on September 15, 2008, totaling $16.7 billion. With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business. The OTS closed the institution and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC held the bidding process that resulted in the acquisition by JPMorgan Chase.” (link).

Washington Mutual Inc was a bank holding company and owned two banks, the Washington Mutual Bank, Henderson, NV and a subsidary of that bank, Washington Mutual Bank, FSB, Park City, UT. The first mentioned bank was the main banking operation, and the focus of everyone's attention. Both banks received the same treatment simultaneously on September 25th, and for brevity are usually referred to singularly as the Washington Mutual Bank or WMB or WaMu Bank or WaMu. For the rest of the text this convention will be followed and they will be referred to as one enterprise and principally referring to the vastly larger Henderson NV incorporated bank.

Just seventeen days earlier, on Monday September 8th, with the announcement of the placement of Alan Fishman as the new CEO for WaMu, WaMu simultaneously announced (link) that they and the OTS had negotiated a Memorandum of Understanding concerning aspects of the bank’s operations. It concluded with this sentence. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

WaMu suffered a rush of withdrawals and thus draw downs in its liquidity that the overseers at the OTS and FDIC felt justified a seizure of the bank. The accounts that withdrew were mostly large retail accounts of over $100,000 which at the time was the FDIC insurance maximum. These accounts were used primarily for payroll purposes. Mostly these accounts were in California, where the memory of the IndyMac bank seizure was likely on their minds. The speed and amounts withdrawn do not qualify as a bank run, as a bank run is a complete wipeout of deposits over a few days. At most it could be characterized as a walk on the bank. The withdrawals were done by electronic banking over the internet and by wired funds. It was not in the news, people were not lined up outside the bank. WaMu was the largest thrift in the nation, and the sixth largest bank by deposits. They had 2,239 branches in 15 states, concentrated in the west and south. They were large enough that the Federal Reserve assigned them onsite full time bank inspectors to monitor, among other things, liquidity levels. The Federal Reserve was witness from beginning to end of the liquidity draw down.

A walk on the bank, is a mild form of a run on the bank. Bank runs were typical of the great depression which started in 1929. Customers want their cash in their hand, because if a bank dies and locks its doors, their cash will be forever beyond their reach. Bank runs have an effect on the public and the government that tends to snowball and be a self fulfilling prophecy. If a new bank has a problem, because a bank run has happened recently, it may be happening again now, so they do a run on that bank etc. Bank runs close banks down, and draw their cash down to zero. A slew of bank runs that closes banks is known as a bank panic.

In response to the bank panics of 1929 and the early 1930's, in 1933 the government created the Federal Deposit Insurance Corporation (FDIC). The FDIC is a government corporation that provides insurance on bank deposits. At the time of the WaMu seizure the insurance covered up to $100,000. In large part due to the WaMu fiasco the FDIC has implemented a temporary increase in the amount of insurance on deposits and it is now $250,000 until Dec 31, 2009, unless extended. The Chairman and four Board of Directors of the FDIC are all appointed by the President and confirmed by the Senate, with no more than three being from the same political party. The FDIC is self funded through its insurance premiums and it has an immediate $30 billion line of credit with the US Treasury, and procedures are in place if more credit is needed. The banks pay the insurance premiums. From 1996 - 2006 the FDIC waived the collection of these insurance premiums as it was at the upper limit of its legal reserves. The point of FDIC deposit insurance is so that even if a bank locks its doors, your deposits are covered up to the insurance maximum of $100,000, and for now $250,000. The idea was this would prevent the demand side, that being people, from doing bank runs.

The Federal Reserve system was created in 1913. The primary reason for creating the Federal Reserve was to prevent bank runs, from the supply side, the running out of cash at the bank, which had been a problem, causing bank runs, in the recession of 1907. The mechanisms to do this are by the banks loaning liquidity to each other in a process called Federal Funds, which is short for Federal Reserve Funds. Then there is a process of a bank borrowing straight from the Federal Reserve called the Discount Window. The Federal Reserve is a private corporation composed of the biggest banks in the country, who form the stockholders of the Federal Reserve. The Chairman and the six Board of Governors of the Federal Reserve are all appointed by the President and confirmed by the Senate. This is the legal extent of the Governments involvement with the Federal Reserve. Thus the government has weak control over the actions of the Federal Reserve. All banks in America are members of the Federal Reserve System and all paper money is printed by the Treasury per the amounts ordered by the Federal Reserve. All electronic money, wires, credit cards, debit cards etc and all check book money, is also under the monetary policies of the Federal Reserve. The Federal Reserve controls how much money, (cash, electronic, check book,) banks have on hand through its regulations and membership requirements. It maintains this flexibility so that it may meet the liquidity demands of banks.

WaMu was the largest thrift in America and part of the Federal Reserve System. WaMu had some no pay and slow pay mortgage loans, like many banks in America today. These loans were not an overwhelming problem for WaMu, as they had cash reserves enough on hand to last two years at the current bad loan rate.

After the Dot Com bubble burst in 2001, the Federal Reserve lowered interest rates to make borrowing more attractive, to stimulate the economy out of the crashing caused by Dot Com companies going out of business. Home loans became a primary source of lending customers. Competition was high and banks lowered requirements to receive loans, to make business and to get as big a share of the business as they could. The least stringent home loans were known as subprime loans, as they were made to other than prime customers. Often the loans were structured with low payments up front, and higher payments in the later years. Often these mortgages were sold to other lenders after they were written, and WaMu had purchased a lot of their mortgages. Over the years some subprime customers lost their ability to make their payments on time. As payments rose some borrows could not pay.

A bank’s assets are its loans, because loans are where people owe you money plus interest, an income stream. Deposits are a liability, because the bank owes the depositor the money, plus interest, and is liable for its payment on demand.

Insolvency is when a person or company can not meet the current obligations or payments on their debts, using whatever capital means they have available to them. WaMu borrowed money from citizens like all banks in many forms, Cds, secured bonds, unsecured bonds etc. to get money to do its business. WaMu was perfectly able to make the interest payments and redemption payments on its debts. WaMu was not an insolvent or bankrupt bank. WaMu held a lot of small deposit accounts, and depositors make withdrawals, thus liquidity, having funds available on hand for withdrawals was WaMu’s primary concern.

Bankruptcy is a courts legal recognition of a company's insolvency. There are three types of bankruptcy, Chapter 7 liquidation, Chapter 11 reorganization, and Chapter 13 which is a personal bankruptcy.

Liquidity is when your cash on hand and current income stream is able to meet or beat your current debt service and other liability requirements, without having to sell assets. As subprime loans fail to pay, a bank is losing its income stream, or it is losing its liquidity, as the monthly checks are not showing up. Less money coming in means less is available to pay the monthly interest to bond holders, Cds, savings deposits and also for customer withdrawals and redemptions etc. WaMu’s liquidity was shrinking due to its subprime loan failures, but it was not at a problem level, and WaMu was seeking solutions. In March 2008, JPMorgan Chase offered to buy WaMu for $8 a share, hoping the bank would accept it as a way out of its liquidity crunch. WaMu declined and instead on April 8th took a seven billion dollar cash infusion, two billion from an investment firm TPG Capital, in trade for 822,857 new common shares at $8.75, with the remainder preferred shares convertible to common shares, and five billion from other investors in trade for new common shares. Total new common shares issued at the onset of this deal being 176 million, and more created when the preferred shares converted. See Note 9 on the bottom of page 21 here. David Bonderman the CEO of TPG had been on the WaMu Board of Directors from 1997-2002. With this new deal he once again became a member of the Board of Directors. Another part of the deal was that WaMu had to accept an anti-dilution clause wherein if WaMu sold itself, or issued new shares worth over $500 million, for less than $8.75 a share, within the next eighteen months, TPG would be paid the difference against their shares. Shareholders disliked this whole deal, but they approved it to avoid stiff built in penalties. Although this cash infusion helped, there was a liquidity problem for WaMu in July 2008 when IndyMac failed. In September 2008 WaMu made the decision to find a buyout partner from a bank with better liquidity so the merged bank would have adequate liquidity in the face of a growing credit crunch. On September 8th they hired a new CEO Alan Fishman. On September 17th they announced they had chosen Goldman Sachs as a broker to find a buyer and work out a deal. On this same date TPG waived its anti-dilution clause to help facilitate the sale of WaMu. There were five to seven major banks interested, including Banco Santander, Citigroup, HSBC Holdings, Toronto-Dominion Bank, Wells Fargo and JPMorgan Chase again.

Other banks were in a similar situation. Congress under pressure from both the Federal Reserve and the Treasury was being urged to authorize government funds to bailout the banks with the subprime loan failures and thus the increasing liquidity problems. The idea at the time was the government would create new government obligations, bonds of various term lengths, and swap these for the banks’ subprime loans. As the government has the ability to control tax revenue by increasing taxes, its ability to pay its debt obligations is the highest you could have, because it can and does enforce the payment of taxes. If it needs money to pay a debt it increases taxes. The government would put itself in charge of collecting the subprime debts as well, and defaults are more easily absorbed by them as they are also offset by its tax collecting abilities.

The bailout swap plan would insure the banks current income streams would increase as all payments would be made, and also be quite certain going forward as the government is not likely to go out of business. This plan is essentially the 700 billion dollar bailout plan that was being discussed in Congress at the time. This plan would strengthen WaMu considerably, and even to the point where some were speculating WaMu would not have to sell and could continue on as an independent bank. It also made WaMu and all the banks a much better investment or buyout candidate as much more of the portfolio value and income streams would be certain, and known. In the first week Goldman Sachs had been unable to find WaMu a buyer. The one huge obvious problem was the bailout talks and what their results would be, and the end effect that would have on the income value of WaMu' loan portfolio. There was another problem too though. Unknown to anyone the FDIC had already been offering WaMu secretly to the same potential customers that Goldman Sachs went to, but as a branches, deposits and loan portfolio only sale, free of all financial obligations to bond holders and of all claims of shareholders, to be done by private auction, and implemented by a WaMu bank seizure. This had killed WaMu's chance to find a buyer from another bank, and WaMu was now talking to two private equity firms, the Blackstone Group and the Carlyle Group, to see if they would be interested in buying the bank.

WaMu’s average account was only $5,200.00, well within the FDIC insurance range. In aggregate these FDIC insured accounts were much more in dollars then the FDIC had in cash to pay insured depositors. Since if it ever came down to it, the FDIC would be unable to make good on its insurance plan, without borrowing from the Treasury, the FDIC had offered outwardly to help Goldman Sachs in brokering a deal for a buyout of WaMu. As soon as the rates being received for the subprime loans in the bailout was known the banks could then establish a value and price for the bailed out WaMu. This makes sense, and this is what investors were told and thought, but the majority of the prime customers already knew WaMu was to be seized and auctioned, and for that to work it had to occur before the bailout. It was not WaMu that had the liquidity problem, it was the FDIC that had the liquidity problem, and the FDIC chose to protect what little liquidity they had by preemptively and unjustly seizing WaMu. The FDIC decided to avoid any chance of being caught short of cash, and used their regulatory powers to transfer their cash problem onto the WaMu shareholders and debt holders by wiping out their investment positions.

The White House and Congressional Finance Committee members began discussing the bailout together from my memory on Wednesday September 17th, the same day that WaMu announced that it was for sale. The actual Congressional hearings were started the next day, and were held everyday thereafter. The bailout, now known as The Emergency Economic Stabilization Action (EESA) of 2008, was passed Saturday October 2nd and made law on Sunday October 3, 2008. The first and only implementation of bailout funds so far was the purchase of preferred shares in twenty-five US banks. This was a bailout technique that England had recently used for their credit crisis.

Just previous to the initiation of the bailout proceedings, due to falling stock prices in financial issues, and most of the banks, for the entire year, thirty day bans on short selling were introduced. The first one announced Tuesday July 15th was on 19 finance stocks, and solely a ban on naked short selling. Kerry Killinger then CEO of WaMu had asked Treasury Secretary Henry Paulson to put WaMu on that List, but he was denied. On Wednesday September 17th naked short selling was banned on all stocks, and on Friday September 19th all short selling of any kind was banned on 799 finance stocks, and this was good until Thursday October 2nd, and has since been expanded and extended. WaMu was on the list of 799 finance stocks. All short positions on the 799 stocks had to be closed out within three days, and thus be covered by the market close of Wednesday September 24th. Shorts sell stocks at high prices and buy them at low prices and profit the difference. It works best in downtrends, which defines many bank stocks for the year. As this short selling ban relieved some of the selling supply at high prices, it was hoped with less supply, there would be dearer demand and prices would rise. There is though the other angle to this which is when stocks drop, shorts buy, creating demand at low levels and slowing and reversing descents. It is interesting to note that there was little short covering in WaMu, thereby disobeying a Presidential order, and that the bank was coincidently seized the day after all shorts should have been, but were not, covered. It has now been revealed that most shorts have covered since the crash and paying pennies a share to do so.

On Thursday September 11th WaMu provided an Update on Expectations for Third Quarter Performance (link), with the official results scheduled for Wednesday October 22nd. This is part of their release, The company expects its capital ratios at quarter-end to remain significantly above the levels for well-capitalized institutions and continues to be confident that it has sufficient liquidity and capital to support its operations while it returns to profitability. Net interest income is expected to be in line with the second quarter. The third quarter provision for loan losses is expected to be approximately $4.5 billion, down from $5.9 billion in the second quarter while reserves are expected to build, as described in greater detail below. Net charge-offs are expected to increase by less than 20 percent in the third quarter compared with a growth rate of nearly 60 percent during the second quarter. Non interest income is expected to be approximately $1.0 billion, up significantly from the second quarter, reflecting continued growth in depositor and retail banking fees (up 6% from the second quarter) as well as stronger MSR results due to slower prepayment speeds. Non interest expense is expected to be down approximately $200 million, reflecting expectations for lower resizing costs and lower foreclosed asset expense. It also had this to say about its Liquidity and Capital Retail deposit balances at the end of August of $143 billion were essentially unchanged from year-end 2007. In addition, the company continues to maintain a strong liquidity position with approximately $50 billion of liquidity from reliable funding sources. The company's tier 1 leverage and total risk-based capital ratios at June 30, 2008 were 7.76%, and 13.93%, respectively, which were significantly above the regulatory requirements for well capitalized institutions. The company expects both ratios to remain significantly above the levels for well-capitalized institutions at the end of the third quarter.

In general things were the same or better than the previous quarter. The worst thing was the small detail that deposit levels had not increased since the end of 2007, which was not a big deal, considering possible benefits from the bailout and also especially a buyout, once the bailout details were known. Note both capital and liquidity were well within acceptable limits.

On September 15th Standard & Poors issued a downgrade of some of WaMu's bonds, but made this positive statement about their liquidity. " WAMU's overall liquidity profile at the bank and the holding company is positioned to withstand this weak credit cycle through the end of 2010. During the past year, WAMU has conservatively and prudently managed its holding company liquidity position. It faces minimal debt maturities through the end of 2009. WAMU reaffirmed that its outstanding debt is not subject to rating triggers or other terms that would cause acceleration."

Also on September 15th, Lehman brothers, the fourth largest investment bank in the US, declared Chapter 11, bankruptcy reorganization. Lehman Bros was not a depository bank. It was though a first in a major Wall St firm declaring bankruptcy in recent memory. Bear Stearns another large investment bank had in March 2008, come close to bankruptcy, but a deal was worked out where JPMorgan Chase ended up purchasing Bear Stearns. The Lehman Bros bankruptcy may have contributed to subsequent events concerning WaMu by putting everyone on edge.

On September 18th Alan Fishman the new CEO released a letter (pdf link) to shareholders in which he stated "Capital ratios describe the financial strength of a bank. Our ratios continue to be well in excess of the levels that government regulators require of “well capitalized” institutions. We also have an ample supply of funds on hand to meet your needs and the needs of our other customers and our day-to-day operations." That the WaMu bank was well capitalized has never been disputed and the OTS in a Fact Sheet (pdf link) they issued on WaMu on September 25th 2008 said "WMB met the well capitalized standards through the date of receivership."

Thus going into the week of Thursday September 25th for WaMu there were expectations of large short positions covering and a possibly beneficial outcome to the bailout meetings, and regardless, shortly after a buyout merger. The total amount of outstanding shares short was 26% of the float, or about 420,000,000 shares. Who were these shorts? Did JPMorgan Chase have a large short position, did Citigroup? The three credit ratings services all gave WaMu debt downgrades during the week, first by Moody’s on Monday September 22nd, then Fitches on Wednesday September 24th and finally Standard & Poors on Wednesday evening September 24th. Essentially they were all downgrades from junk to junkier. Some people saw this as window dressing being done before the bailout was passed, and that it was being done so that whatever plans the bailout came up with, the debt would be freshly rated for carrying out that decision making. Many did not see it as a panic situation for this reason, and when one service down grades you, the others always automatically follow. WaMu issued a press release and pointed out the downgrades were due to market and economic factors that affected everyone, and that it was not a downgrade exclusive to their condition.

One issue of the bailout meetings was the rate at which the government would swap for the subprime loans in the plan then under discussion. Should it be the hold-to-maturity value, ie the full anticipated value when issued for its maturity or some reduced or discounted value, particularly the current market value, known as mark to the market, as determined in their distressed current condition and its effect on their current trading levels. Both Federal Reserve Chairman Ben Bernanke and Secretary of the Treasury Henry M. Paulson, Jr., were quite clear and stressful when speaking publicly about this that the subprime debt should be purchased at hold-to-maturity or full value to adequately capitalize the income streams and liquidity to the receiving banks so that they would be in a strong position to generate business at the local levels and keep the economy from slipping into a recession. They also stressed for similar reasons that the bailout should insure that no large banks fail, and that numerous small bank failures would not be acceptable either. WaMu was the largest thrift in the nation and all indications were that it was a prime candidate to succeed from the bailout. WaMu though made it clear that if a buyout was not completed before the bailout they would continue to look for a buyer in any case. As events unfolded the sincerity of those that made remarks concerning no large bank failures has to be questioned, and it has to be questioned if they were deliberately misleading the investing public. In general bank share prices drifted downward as the bailout meetings got underway. There was bickering, Pres. Bush invited both Senators McCain and Obama to a White House meeting that ended chaotically. I personally was unable to watch the hearings on TV, but those who did, did not seem inspired. The expected short squeeze in WaMu had not materialized. It should have taken seven days at recent typical daily volume levels for the number of known shorts to cover. Volume levels for the 22nd, 23rd and 24th do not show this short covering. There was higher volume on the 25th, but not enough for the shorts to have covered, and this volume was all related to the sell off. If JPMorgan Chase or Citigroup or their confidents had been a major shorter of WaMu they had not covered. Strangely the SEC and no one in government has had anything to say about this. Wednesday evening September 24th President Bush gave a televised speech to the nation on the economic problems and the bailout. One remarkable statement he made was that the subprime debt would be purchased at current market, very depressed, prices. This was the exact opposite of what the Federal Reserve and the Treasury had been saying. It also seemed to contradict the purpose of doing a bailout. Thursday September 25th was in general a day bank shares drifted down and the hearings produced no results. WaMu's stock began falling within the first hour, and this was attributed to the downgrades of the previous day and evening. I worked that morning, and was not at my computer until after the regular trading. I do not watch CNBC either, but during the day CNBC reported they had leaked information that WaMu would be seized by the FDIC as a bank failure. They did not report a source for this leak. This leak accelerated both the large retail online withdrawals of deposits from WaMu and the falling stock price for the day for WaMu. WaMu’s stock fell almost a whole dollar and 35% for the day. I remember getting home in the early afternoon west coast time, and the market had just closed. I was taken aback by the dollar drop for the day. Looking on the message boards I thought I understood the sellers concerns, but believed that the government would prevail. This was the mindset that week, in fact Warren Buffett considered one of the best investors going, had late Tuesday September 23rd bought $5 billion dollars of Goldman Sachs stocks for essentially the same reason. As by now all shorts were supposed to be covered and out of the market, even though there was no evidence this ever happened in WaMu, the steep fall in price was being partially understood as due to this normal braking mechanism to the market having been removed. I looked at an early after hours quote and it was a few pennies from the regular market close of $1.69. I surfed onto some nonfinance things. To me it was less than an hour later when I checked back again and the quote was $0.52. A drop of another dollar and two dollars for the day. I went to the Yahoo WM message board and began looking at posts. Some people were up in arms, some people said it was oversold panic selling etc. I stayed and watched the posting and began reading news sites for news. First there were posts on WaMu closing. This made no sense. I saw a post where the word seized was used. It only had one news source anyone could find backing it. I was unaware of CNBC’s earlier reporting in the day.

WaMu’s price by now was at about $0.16 where it would close, though it did go as low as $0.09 from my memory. It was discussed what they meant by seized. At about this time after hours trading ended. There was a strange spike in the final minutes of trading when someone bought 272,000 shares at $1.69, the regular market close and ten times the current price. This has never been explained, some suggested that someone on the inside had gotten trapped in the avalanche after hours and was rescued by his bank buddies at the end, others think someone just mistyped a buy at market order, leaving off the leading zero. Once after hours trading had closed there was suddenly a storm of news stories about the seizure and we learned the following. Most investors understood that Washington Mutual Inc was a holding company trading under the symbol WM and that the holding company was the owner of the Washington Mutual Bank. The shares were shares of the holding company, not the bank. Many banking companies are set up this way and here is a list of the top 50 bank holding companies. The OTS and FDIC recognized this as well and chose to exploit this corporate structure. Without a public word they realized that the WaMu bank could be seized and that the shareholders and debt holders of Washington Mutual Inc. would lose the primary asset of their company, but that their claims would not be directed at them for the possession of the asset, but rather would be directed at the holding co, who they owned shares in. Had everything been exactly the same for the WaMu Bank, but that the shares and debts been in the bank’s name and not the holding companies, it is likely the bank would not have been seized. That the corporate structure allowed a loophole to screw the shareholders and debt holders is really the reason the WaMu bank was seized. At about 7:00pm JPMorgan Chase announced they would be holding a Conference Call at 9:15pm. The conference call was used to announce to the world they now owned WaMu. JPMorgan Chase also released this press release that evening, and later this presentation (

JPMorgan Chase is one of the primary stockholders of the Federal Reserve which means they have the power to force favors from the Federal Reserve. The CEO of JPMorgan Chase, Jaime Dimon, sits on The Board of Directors of the Federal Reserve Bank of NY. Citigroup is also a stock holder of the Federal Reserve. It is the Federal Reserves job to insure that its member banks have the liquidity to transact business. The member banks borrow and lend among themselves electronically every night to keep each other liquid. This is called the Federal Funds. If need be a bank can also borrow directly from the Federal Reserve itself through a process known as the Discount Window. The FDIC was in a jam in that if WaMu was ever deprived of funds from the Federal Reserve, say for fear of not being paid back, and a bank run ensued, the FDIC would not be able to cover the insured deposits without borrowing from the Treasury. There is some slight differences in the amount the FDIC would have had to cover. Some estimates leave the FDIC with a nominal balance. Apparently the thought of having to borrow funds from the Treasury so early in the credit crisis was considered too much of a defeat for the FDIC to be comfortable with. Unknown to anyone in the public the FDIC was working on a secret solution deal. On one hand they were talking with WaMu about helping them find a buyer and the valuation of its loan portfolio, and secretly on the other hand they were allowing JPMorgan Chase and the other banks to have complete access to the books of WaMu and were offering to seize the bank and sell it to them in a private auction, which would free the purchaser from all liabilities to the debt holders, and all claims from shareholders. This would get the FDIC out of their jam. The words Toxic Paper, Toxic Debt, Toxic Loans etc suddenly were all over the newspapers and the internet. The idea that the FDIC’s cash balances could not make good on its insurance liabilities was being well advertised, but their credit line and credit abilities with the Treasury were seldom mentioned. Though borrowing from the Treasury would make the FDIC solvent, accounts over $100,000 would still lose everything above $100,000. These accounts read the writing on the wall and began silently electronically removing their funds from WaMu. As mentioned the Federal Reserve inspectors would be on hand to witness this day by day. WaMu’s cash on hand and hence liquidity was being drawn down. Did the Federal Reserve step in and loan them this liquidity as the system is set up to do for just these type of incidents. No they did not. Was the reason because WaMu still had plenty of liquidity left, or was there some cooperation going on between the Federal Reserve, the FDIC and the Treasury? This all occurred as the Congressional bailout meetings were underway.

Once the bailout was completed, the plan being discussed, would have WaMu’s bad subprime loans swapped out for good government paper, maybe some at 100%, maybe some at a discounted level, maybe some at market level. WaMu’s improved condition in any case would make it a much more solid purchase after the bailout then before. WaMu was being set-up in a triangulation of cross fire, between the Federal Reserve, the Treasury Department's OTS, and the FDIC, to affect a seizure and a fire sale at auction. The beneficiary’s of this would be the FDIC, which would be removed of the potential problem of having to go into debt to the Treasury if it ever needed to pay the insurance on WaMu's deposits, the Treasury which would now not have to considering ever loaning the FDIC any money to cover the deposits, and the big winner the Federal Reserve/JPMorgan Chase which ended up owning WaMu, its loan portfolio, and deposits, and its jewel of branch networks, free of all debt holder obligations and claims of shareholders.
There is also the consideration that JPMorgan badly needed the deposit base of WaMu to help shore-up its very leveraged derivatives trading transactions. JPMorgan's acquisition of Bear Stearns, also done with the government's help, was said to be have been done for this same reason. If JPMorgan ever were to not be able to fulfill their ends of their derivatives trades, and collapse, they say it would bring down all of Wall St and the economy. Some of these trades were with WaMu and these trades would self cover and cancel, just as it was done with Bear Stearns. Thus the actions of the OTS, FDIC and Federal Reserve may not be entirely about money, but also about their reputation and their performance of duty, and that they chose to kill off WaMu to save their own necks by helping to save JPMorgan's neck. WaMu’s parent company Washington Mutual Inc shareholders and debt holders though were forced into taking an unjustified catastrophic and total loss.

Thus the Federal Reserve watched WaMu, while their own stockholders, JPMorgan Chase and Citigroup, participated in secret backroom discussions with the FDIC wherein it was decided the Treasury Department's OTS would seize WaMu for "lack of liquidity" and give it to the FDIC who would have it auctioned off in advance. Included would be the branches, deposits, and the loan portfolio including subprime mortgages, which were eligible to wash off as a write down to the amount finally paid, and what was not written down and washed off, would be eligible for swaps under the bailout plan. All for a fire sale private auction price, and leaving WaMu Inc the holdings company hanging onto all the obligations to the bond holders, as well as all the obligations to the preferred shareholders, and all claims by common shareholders. The winner, at 1.9 billion dollars was JPMorgan Chase. They got the WaMu bank branches throughout the west and south they had wanted so badly. JPMorgan Chase was able to take a $31 Billion write down on the subprime mortgage loans as part of the deal, even though WaMu had previously calculated $19 Billion as the bad loan amount. The unsecured mortgage loans JPMorgan took and could not write down are still eligible for the federal bailout plan. If JPMorgan Chase or any of the other banks in the secret dealings had major short positions, they had not covered. When WaMu’s stock price collapsed after the seizure, they could cover for cheap, or maybe just be able to hide the fact. When a company declares bankruptcy shorts do not have to cover - it is game over. That the shorts never covered in WaMu and that certain large banks were privy to the FDIC’s plan to seize and close the bank, would make it simple for these banks, their friends, confidants, and all their proxies, to never cover their shorts and keep a large profit. This would also help cover bad derivative trades and may be why it is not being discussed. That nothing has been said about this makes it even more likely this is what happened. This would be insider trading, an illegal act. As Congress discussed the bailout on Thursday September 25th, and after regular market hours, the OTS seized control of WaMu, and turned it over to the FDIC who immediately turned it over to the auction winner JP Morgan Chase. This was announced after all trading had ended simultaneously as one single packaged story. Bank seizures are traditionally done on Fridays so the weekend can be used to sort out the paperwork and details. The OTS/FDIC said they chose Thursday because of the leaked seizure report being circulated, and thus imply that a very real potential, a final agreement to the bailout meetings on Friday, was not a consideration. They say they feared the leak would increase the rate of withdrawals leaving WaMu that Friday. This has to have been one of the most valuable leaked reports in American history and one wonders if those who benefited so handsomely from it may have also been those who started it. As a further deflection, although a loan swap had been sold to everyone as the bailout all along, the Treasury pulled a surprise on everyone after the bailout was passed and did a preferred stock purchasing plan. Was this to distance themselves from the WaMu take down and modus operandi behind it?

JP Morgan Chase had at least three weeks to prepare their bid, during which time they had at least seventy-five of their own people crunching numbers and working forecasts, using the data WaMu had supplied to the FDIC under the understanding that the FDIC would help them facilitate a buy-out transaction. Bids were submitted on the 23rd and the FDIC notified JPMorgan Chase they had the winning bid on the same day. The 1.9 billion dollars was paid to the FDIC, who say it will be used to toward paying off the debt holders.

J.P. Morgan becomes the country’s largest bank by deposits, with more than $900 billion in deposits, and second largest overall. They added WaMu's 2,239 branches in 15 states, many in key states where they had little or no presence, like California, Oregon, Washington and Florida and becoming stronger in states where they were low and mid level players, like Texas, Colorado, Utah and Illinois.

J.P. Morgan acquired all of the assets, all of the bank branches, and all of the deposits of Washington Mutual Bank and nothing of the holding company’s Washington Mutual Inc. The senior unsecured debt, subordinated unsecured debt, and preferred and common stock of Washington Mutual Inc remained with them. Due to the seizure, the next day Friday September 26th Washington Mutual Inc filed for Chapter 11 bankruptcy, a reorganization, and listed assets of $32.9 billion, and total debt of $8.2 billion. Much of the assets are shares of the seized bank.

A little needs to be said about bank deposits. To a bank, bank deposits are a liability because the bank owes the money, plus the interest promised, back to the depositor. This is obviously true. What needs to be considered is that the banking system is based on fractional reserves. When a bank receives a thousand dollars in deposits it gets to lend out, most of the money, at a higher interest rate than it pays depositors. In the USA the reserve requirement is about 10% (10.3 actually). The bank receives say a thousand dollars, promises 2.5% on it, loans out $900 and receives 7.5% on it, and keeps the difference. If money the bank has loaned out, is redeposited back into the bank, they can repeat the process with that deposit. Banks make good money off of the deposits. Banks do a lot of advertising and customer service benefits to get people to deposit money at their bank. It is a slow trudging process to build up a banks depository base. When JPMorgan Chase received $188 billion in WaMu deposits, the amount of deposits on the date of seizure, for a $1.9 billion payment, it was a huge steal of a deal. Now consider that to build deposits a bank has to be located in areas convenient to entice depositors to deposit with them. The bank needs a branch network. This is a costly, slow to build, trial and error system that generally takes years and decades to create. It is a highly valuable asset. JPMorgan Chase also got all of the WaMu bank branch system as part of the deal. Also as part of the deal they got to write off all the bad loans they felt WaMu had on its books, $30.7 billion was the figure they agreed to. So their risks were washed away and their benefits were enormous, and they paid a measly $1.9 billion for the deal. It was the WaMu investors who paid for this deal, by receiving nothing for their bank, a total robbery.

The mortgage assets JP Morgan acquired were $176 billion of WaMu’s home loans. Those assets were immediately written down by 19%, or $30.7 billion. Leaving JPMorgan with a cool $145 billion dollars of good assets, some that are eligible for the bailout plan, for which they paid less than $2 billion dollars, and this does not include the real estate assets. The only liabilities they took were the deposits. A few weeks later after the dust settled it was revealed that WaMu Inc., the holding company, had a $4.4 billion dollar account in the WaMu bank. The FDIC is claiming this money in court as part of their receivership. If WaMu Inc, the holding company, had been invited to the secret private auction, and bid the balance of just this account, as most people think they gladly would have, they would have won and beaten JPMorgan's bid by more than two times.

JP Morgan expects the deal to generate $12 billion dollars over the next three years, or $4 billion dollars a year, making them a 100% profit on the deal in the first year, and an additional 200% profit every year from then on. Thus the increase in earnings per share will be immediate and is expected to be between $0.50 and $0.70 a year, starting in 2009 and every year thereafter. The owners of the company, the Washington Mutual Inc shareholders, received zero dollars on their shares, and they now trade at around six cents. They had their primary asset preemptively confiscated and sold, for less than two cents on the dollar, which they do not even receive, for the so called reason that it suffered occasional short term liquidity problems and those whose duty it was to help them out with liquidity problems didn’t want to, and the FDIC that guaranteed some of its liabilities didn’t want to take the extremely unlikely and extremely short-term and extremely slight risk that they may need to pay on their guarantees should WaMu actually not be able meet withdrawals before possible benefits from the bailout began and/or a buyer was found and the bank sold off at a fair value. Though simply giving WaMu depositors a temporary increase in FDIC insurance coverage would have been all that was needed to remove this one highly unlikely potential problem. Unless of course they felt some extremely powerful outside force could precipitate this problem. The bailout which at the time was about to be passed in the forth coming week, maybe even the next day, would have possibly eliminated this problem, and the mere completion of the bailout would have cleared away the final unknowns in the way of a buyout merger. Although in reality the buyout option had already been secretly sabotaged and ruined by the FDIC's secret auction agreements, leaving them no choice but to finish with seizing the bank and it would look a lot better done before the bailout was passed. The liquidity problem would have taken weeks or even months to occur even without a bailout and only if the worst happened or a media campaign was done. Yet because of a news "leak" the OTS justified seizing WaMu immediately before the bailout passed. The seizure and its timing also hugely benefited the brazen uncovered shorts, whomever they were. Washington Mutual Inc and its shareholders were set-up by WaMu's family and friends and then robbed and murdered by them. The whole WaMu take down was accomplished by subterfuge, sabotage, deceit, propaganda, illegitimate seizure, done irregularly, on the sly, in secret, in darkness, under camouflage of smoke and mirrors, on leaked news, and ended solely to the financial advantage of the FDIC, the Treasury Dept, the Federal Reserve/JPMorgan Chase and the uncovered shorts. WaMu shareholders were totally wiped out. It is one of, if not the, greatest theft in American history.

To add insult to injury after EESA 2008 was made law on October 3rd 2008 JPMorgan Chase became one of nine banks to receive money from the EESA funds in exchange for preferred shares created especially for this purpose. On October 14th JPMorgan Chase received $25 billion from the EESA funds. In effect the government paid for JPMorgan Chase to take over WaMu and then received a $23 billion bonus for doing so. WaMu would not have even needed $23 billion in mortgage guarantees to be effortlessly merged and preserving the shareholders and bond holders investments and the soundness and thus confidence in the US financial system. It was a tragic move by the FDIC.

For those who say WaMu made bad loans and so the deserved to be taken down, it isn't true. WaMu's bad loan rate was 3.62%, that is not enough to justify the trillions of dollars sucked out of the economy by the WaMu fiasco. Further more JPMorgan Chase is drowning in bad derivative trades, far more than WaMu's bad home loans. It is more moral to make a bad home loan, which leaves a house and a place for someone to live, then it is to lose more millions in bad derivitive trades which leave nothing but worthless paper. WaMu deserved government assistance more than JPMorgan Chase.

Unknown said...

My sense is that basing the "Geithner Plan”: module 1 on the principles of Test 3 is the only feasible path. I disagree that applying Test 3 calculations is the same as cleaning up an accounting mess. Test 3 is all about cash flows. If you think that it can not be done then forget about the participation of private capital for module 2. Private capital is all about cash flows not accounting standards which are exceedingly more complicated and expensive from an information management perspective.
Further, I find it impossible to believe that private capital will participate without some dramatic changes in the political environment. It is impossible to determine whether Congress will decide to confiscate "excess returns" after the fact.
The article overall is excellent and a public service. Thanks.

Jonathan said...

Many thanks to the reader that answered my question. Regards, Jonathan.

CouldMarxBeRight said...

It's always delightful to read your musings and I think as always you put things in such clarity that really shows your genius. But here is a fundamental question I'd like to pose to you, which happens to be one of the key assumption you made that drives your conclusion about banking system's solvency.
Why does your severity assumption on non-conforming mortgages look optimistic to me? It is clear to me that when subprime, Alt-A loans and HELOCs has so little equity cushion that their loss-given-default would be substantially worse than the home price depreciation (due to the costs of recovery). Peak-to-trough home price might only drop 35% when the dust settles. But it is the home price drop of the defaulting homes that matter. The defaulting loans are skewed toward markets that dropped more than the national average. Home prices in these neighborhoods have dropped 50%+ and will drop some more. Put collecting/administrative costs on top you can have pretty bad loss-given-default. Have you taken that into consideration in coming up with the severity assumption?
And then what about auto loans, student loans, credit card loans, CRE and construction loans? What about C&I? These credit losses can be spread over several years but we should be careful not to count their pre-provision earnings and ignore their ultimate cum. losses.

Anonymous said...

Isn't a loss given default of 50% not
a bit too good? I think 60-70% is closer
to reality,considering all those servicing
fees and selling into a depressed

Anonymous said...

Great post - very inciteful. One comment: The £300bn of pre tax, pre provision income assumes a level of household indebtedness and bank leverage that is not sustainable. Bank balance sheets need to shrink, and that will shrink your £300bn

lewy14 said...

John, great explanation.

One point which you hit on tangentially, but which (I don't think) folks have commented on: the willingness of the banks to lend.

When you say that the cost to originate new loans exceeds the cost to buy old loans, you're on to something big.

It seems from your analysis that banks can be solvent (and thus in a just world, safe from confiscation by the FDIC) while at the same time being zombies - unwilling to lend.

Is this how you would describe the current state of the system?

What blunt instrument then would the earnest policy maker grasp for, wanting to save the economy from the mother of all credit crunches, while bank capital and funding is tied up with banks which are moribund, yet also (technically) sacrosanct?

Could this dilemma be a motivation for the drumbeat of nationalization?

If the Geithner plan's blanks get filled in correctly, and it works, then, well, some people are going to become very rich as a result.

This inconvenient fact will create new political problems.

Anonymous said...

Great post, very information read - you're doing your bit to help people understand the rights and wrongs of Government policy.

babar ganesh said...

> When you say that the cost to originate new loans exceeds the cost to buy old loans, you're on to something big.

yes, that's a point that's obvious once you think of it, which i hadn't. i have learned a lot from this blog so far -- thanks.

Anonymous said...

>>>If you can sell those loans... we can believe your assumptions and stress test using the bank’s existing assumptions.

Unfortunately, this plan might not work for the following reason: if I were a banker forced to test. I would get one of my banker mates in another financial institution to buy these assets at a reasonable rate.

In exchange, I would do him the same favour when his institution gets tested.

A lot of this post is predicated on held to maturity valuation of 75%. Where do you get this number from?

Anonymous said...

Thank you for your thoughtful post.

My hope is that the U.S. government buys assets for less than they are worth. I know that everyone is up in arms about this - but it is a relatively inexpensive to deal with the banking problems. The consequences of Huge banks going into receivership are not pretty. A lot of other financial institutions hold the bonds for C, BAC, WFC, and JPM. The ripple effect of letting any (let alone more than one) of these companies default on their bonds would be disastrous.

I also agree with you that many of the banks, and the system as a whole, are quite capable of rebuilding capital through operating earnings. What is going on with BAC makes sense. The can only pay 1 cent per quarter in dividends. Ideally, a block of large banks would all do the same thing "voluntarily" right now. Banks don't want to do such a thing individually because it will make them look weak - which becomes a self-fulfilling prophesy. However, collectively this would add meaningful capital to the system and most banks are going to end up cutting or eliminating their dividends anyway.

Anonymous said...

most excellent, thank you.

When I can understand > 50% of what you're writing I'll consider myself on the way :)

But notwithstanding my limited comprehension, a very enjoyable read.

bmkj said...

Most excellent post. Thanks! I'm a non-financial type that found your post eminently readable and very enlightening.

One question (likely to be naive) is when you talk about establishing a secondary market and creating a market-price based determination of bank solvency:

"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."

What would prevent a bank from participating in the private market, bidding for its own assets at some extravagant price (say 90 cents on the dollar, in your example), buying few select assets, and then happily declaring itself well-capitalized?

You could consider more sophisticated versions of this, where C buys BACs assets, in return for the same favor from JPMC ...

John Hempton said...

I keep getting asked the same question - what would stop the companies rigging the auctions for their assets - either by bidding on each other's or by bidding on their own through surrogates.

1). It is criminal fraud and it is price fixing. Don't think it doesn't happen though - some energy traders went to prison for reporting false prices - they were price fixing.

2). I had it that the bidders would be the non-bank funds. They would all be shown - and all be required to set some bids. However they would also have a funding advantage giving them an incentive to bid high.

That said - the price fixing lies are easier to detect than most lies banks tell.

And if you think the banks would lie (and I tend to) just imagine the alternatives of the government buying the assets from them...


bmkj said...

Thanks for responding quickly, John.

I agree when you say:

"It is criminal fraud and it is price fixing."

But here is an alternative strategy that would not be fraud, and would perhaps get the capital markets to recapitalize the banks.

Let us assume your solution of creating 10 secondary markets is implemented.

Let's take BAC for example -- trading at $4 per share.

I (or some other outsider) buy $1 Billion worth of BAC shares, and another $1 Billion to bid up assets of BAC.

Given that the pre-scare value of BAC was about $30 per share, and that the market will certainly rebound if it knows that BAC has been declared safe by the authorities, I could keep taking money out of the capital markets as the shares go from $4 to $28 to keep buying up their assets on the secondary market.

If I employed leverage (e.g. trade BAC calls) I might actually get quite rich doing this. (i.e. I lose less money over-paying for assets, than I gain from the increase in stock price. Given that Geithner is paying for most of the losses, it is hard to lose!)

And this would not be illegal, would it?

Assuming not, I could get rich, and presumably at some point during this price increase, BAC would issue more common stock and recapitalize itself adequately ... so everyone is happy.

Only problem I see is that I don't have that kind of money ;)

I know! I could borrow it from GS!

To your second point, I certainly do agree that the Treasury buying assets is also fraught with peril. Your current proposal is superior. This mess is a great technical/policy problem with many solutions and pitfalls; no right or wrong answer, but definitely better and worse answers -- gladdens my inner nerd. It is kind of too late to treat it as a moral problem (bad bankers! stupid homebuyers! blah!).

Thanks for being patient with the questions. I have been avidly reading all the usual blogs -- CR, NC, PK -- but for the first time found a great post parsing the solvency issue in depth. Keep writing and don't worry about length or complexity! Wikipedia is our friend!

Finally, also thanks for treating Geithner seriously as a professional - he may be right or wrong, but he doesn't deserve to be treated like an idiot child by every blogging stranger just 1 month into his job.

John Hempton said...

Ah, I wish I could dismiss your conspiracy theories that nicely.

The accounting rule is only that you need to have 3% outside interest to be called a "sale". That was the rule in the Enron accounting mischief anyway.

The rule I have here is 15% of genuine third party loss interest.

The amounts of money you would need to pull a fraud like the one you are describing is huge - and my view is that it is very hard to keep a big secret involving lots of people.

But yes - if there are scams on Wall Street someone often has a go at them.

The only defence I have is a very public auction process and WITH QUANTITY of assets - so you need to buy billions of dollars worth of assets. You can't fiddle a stock for hundreds of millions by buying 20 billion of dodgy assets - and in this case the assets are larger than the equity of the banks - much larger.


Anonymous said...

Waiting for the "zombie" banks to recover is what Japan did. We know how that turned out and it was NOT 5 years.

The big zombie banks' shareholders have to be wiped out, bondholders have to take a haircut, incompetent and corrupt management has to be replaced and the bad assets have to be written down.

There's no point in throwing public money down a rathole just to keep zombie banks on life support.

Anonymous said...

John, very interesting analysis. Could you provide your actual data source for 9.5 trillion of mortage debt outstanding you use as the starting point in your May 2008 post calculation, which seems to be the source for your continuing comments that losses will be under a trillion? All the information I can find, including section L.217 in the Federal Reserve Flow of Funds report, implies something more like 14-15 trillion in mortgages outstanding. Thanks.

Dataman said...

John, I very much appreciate your post. Thank you.

Unknown said...

You say that the managements of the zombie banks [not all big banks, by the way] have been discredited, but how else do you get rid of them besides by nationalization or receivorship? These guys are now routinely called oligarchs and Summers and Geithner their errand-boys. There needs to be some meaningful triage.

Anonymous said...

I haven't read comments. John, your definition #3 assumption is delusional. If banks were certain to return to a normal $300B/yr pre-tax profit in the next few years no one would have an issue trending towards porkier public expenditures.
I'm using the $2.7T uninsured deposit figure as a proposal cost cutoff. Economy wide finance industry triggered losses could be much more or less. Here, the difference between MTM valuation and cash-flow valuation is huge. Nouriel says the former yields $3.4T, while you say the latter yields 1/2 this. If losses are over $2.7T it is cheaper just to writeoff deposits and print deposits for temporary Crown banks. If only $1.7T, there may be cheaper salvage options. I'd lean towards using MTM accounting for the simple reason it kills off the crappiest actors, even if they happen to be most of them (in USA); a bank that is only solvent in bull markets is a moral hazard, is always a next time.

"...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."

This is just a direct subsidy, AKA TRAP 1.1, of risky assets. If you make the funds bigger you will inflate the assets, if you make them buy the assets over a certain time period you will induce a certain temperal premium. I don't have to add anything to original TRAP criticism.
I like that your proposals are specific, as many are afraid to be.

Anonymous said...

“Here I am counted as a radical. The system in my view clearly has positive economic value ... 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.”

I am also a radical, in the specific sense of this approach of sensible conservatism.

Your test 3 is extremely important for two reasons:

a) It takes into account ongoing franchise earnings and therefore franchise value

b) It obviates the relevance of MTM accounting for this purpose, because it deploys HTM accounting for problem assets over the same time period over which franchise earnings are also taken into account; therefore, it appropriately destroys the Rubini illusion of the relevance of full MTM.

I think Geithner is going to employ a back of the envelope Test 3, bootstrapping onto existing proprietary simulation models, bank by bank.

I attempted to tackle the problem of policy response from an MTM perspective rather than directly from a solvency perspective, at a guest post here:

BELSS: Bocconi Experimental Laboratory for the Social Sciences said...

um, Citi has had negative earnings for 5+ quarters in a row. I do not believe all those quarters were write-down quarters. Do their assets really generate more revenues then the costs their liabilities incur? If not, how do we expect them to recapitalize themselves?

John Hempton said...

In response to JB - no the trading revenue can go negative - but negative yield to maturity revenue is rare - but try Corus bank.

Anonymous said...

I read it!

Anonymous said...

The "overstated purchase prices" by banks has already started. And they are effectively buying assets from themselves. Here's how......

Many of the big banks own large quantities of the super senior tranches of CDO^2 (either on their own balance sheets or off balance sheet through SIVs).

These CDO^2 are being put through forced liquidation and all of the underlying assets are being auctioned off.

Guess who is buying all those securities in the auctions? The banks, as holders of the super senior tranches, are outbidding everyone else in the market and buying the underlying securities that made up the CDO^2.

But the money they bid just comes back to them when the CDO^2 gets liquidated. So, they pay whatever they feel like marking the securities for, get all the money right back, and get to keep up the appearance of having enough capital.

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