|
This
week, we will look at three examples of bank recapitalization using the
method advocated by John Hussman, and put in practice with the FDIC's
insta-bankruptcy and sale of Washington Mutual to JP Morgan/Chase.
Newcomers
may want to review my series on How Banks Work:
February 3, 2008: How Banks Work
February 10, 2008: How Banks Work 2:
Shitting Like an Elephant
February 17, 2008: How Banks Work 3: More
Elephant Poop
February 24, 2008: How Banks Work 4: Banks
and the Economy
March 9, 2008: How Banks Work 5: Selling
Loans
March 16, 2008: How Banks Work 6: Liquidity
Crises and Bank Runs
March 23, 2008: How Banks Work 7: the Lender
of Last Resornt
October 5, 2008: Effective Bank
Recapitalization
There
are a number of ways of recapitalizing banks. If the problem is not too
large, the government could make an investment in preferred shares, or common
shares. However, especially due to the fear of potential losses from
off-balance-sheet derivatives (whether or not they would actually turn into
real losses), we are perhaps beyond that point now. Nobody can be sure that
an institution is solvent. This method amounts to a sort of flash bankruptcy
and either government receivership or a debt/equity swap, to be applied to
those institutions which, due to funding issues, would otherwise go into
regular bankruptcy. In other words, it performs for larger institutions much
what the FDIC performs for smaller ones.
The
goals are twofold:
1)
Because the government is already liable for guaranteed deposits, it may as
well backstop the institution, which can then support the deposits, rather
than going through a liquidation.
2) The
government wants to avoid "systemic issues," related to runs on
uninsured deposits and availability of working capital to non-financial
entities.
We
also have, as goals:
1) To
avoid "socializing the losses." These are institutions that would
otherwise have gone into bankruptcy.
2) To
avoid theft via government sales of assets at super-cheap prices. Also, to
avoid dumping assets on distressed markets for broader systemic reasons.
First,
let's say something about bankruptcy. Bankruptcy doesn't mean that everyone
is fired and the laser printer is sold on eBay. It may get to that. All that
it means is that the company is unable to fulfill an obligation (typically a
payment of some kind), so then the courts get involved to see who gets paid
what, and who doesn't get paid. For example, depositors get paid, but
derivatives liabilities do not. Companies can operate in bankruptcy for many
years. People still show up for work, and the business continues. For
example, if GM went bankrupt, that doesn't mean the factories stop producing
cars. It may mean that GM stops making payments on its debt, and comes to a
new agreement with labor regarding medical expenses, but keeps selling cars.
Bankruptcy is a way to eliminate old obligations and establish new ones.
The
proposal here is to eliminate the junior portions of the capital structure,
mostly common equity and preferred equity. These would take a loss in a
bankruptcy anyway, and are very close to zero as it is, so this is no different.
The next rung on the capital chain, the present non-depositor debt holders,
would become the new equity holders via a debt/equity swap, which is a very
common method in bankruptcy reorganization. Also, other non-deposit
liabilities, notably derivatives liabilities, would be eliminated, as would
be the case in a regular bankruptcy. So, nobody gets "bailed out"
except the depositors, who would be bailed out anyway via the FDIC guarantee.
(Non-guaranteed deposits would also be protected, but that is probably
prudent at this pont.) This would leave a nice, clean, well-capitalized
balance sheet. Let's see how it works:
I.
Washington Mutual
WaMu
is a savings and loan, which means that it is funded almost entirely with deposits.
So, there isn't much of the capital structure besides equity to be wiped out.
Here's
WaMu's balance sheet as of June 30, 2008:
We see
that the liabilities are almost all deposits. There are some advances from
the FHLB, but since that is something like a government entity we might as
well "guarantee" that too. That leaves minority interests and the
shareholders' equity. The "other liabilities" could be things like
pensions, lease contracts, or an unpaid water cooler bill. They're small, so
let's assume they stay too. So, an abbreviated version:
Assets:
$314B
Liabilities: $283B
Shareholders' equity and minority interests: $31B
The
government recapitalizes this bank with $40 billion. This increases the
assets by $40 billion, so:
Assets:
$354B
Liabilities: $283B
Shareholders' equity (the minority interests get dropped): $71B
Now,
WaMu probably takes some writedowns of assets, to reflect the potential for
future losses. WaMu doesn't sell
assets, it merely says "this guy owes me $1000, but I think he might not
pay, so let's put the value at $800 to reflect the risk of nonpayment."
Let's take a $30 billion writedown. This leaves:
Assets:
$324B
Liabilities: $283B
Shareholders' equity: $41 billion
Now,
the equity is 12.65% of the assets, which is a pretty cushy ratio. Also, the
assets have been written down already to reflect future credit losses, so of
course there is less risk of further accounting losses, because the losses
have already been taken in advance. If, unfortunately, WaMu's assets are so
bad that a further writedown is needed, then it is understood that the
government will provide more capital. Finally, and perhaps most importantly,
all of WaMu's off-balance sheet nasties get disappeared in the
flash-bankruptcy, so we don't have to worry about stuff that's in a desk
drawer somewhere.
Then,
the government sits on WaMu for a while. WaMu can continue to make new loans,
but of course they would be loans only to very good creditors, and thus not
likely to cause future problems. During this time, the old, bad assets, the
loans made to bad creditors, will eventually run off. They will either be
repaid, or they will go into default. Either way, they come to a resolution,
and disappear from the banks' books.
During
this time, WaMu is making money on its good assets. It can use these profits
to offset losses from bad assets. Let's look at their income statement:
From
this, we see that WaMu had a pretax loss of $5,534m in 2Q08. However, it had
provisions for loan losses of $5,913m, and losses on various securities
(probably mortgage-related) of $707m. So, it appears that WaMu's underlying
profitability on its good assets was in the neighborhood of $1,086m for the
quarter, or about $4,344m per year. That's right in line with the 2Q07 pretax
profit of $1,240m, before the bank started to make big losses. This $4,344m
could be used to offset further losses, just as happened in 2Q08. We see here
that WaMu's assets have already
been written down to a significant extent. So, any further writedowns after
nationalization would be on top of that. Remember how it works: "JoeBob
owes me $1000. However, JoeBob might not pay me back in full, so let's mark
his loan at $800." This is what happened in 1H08. Then, there's a
further writedown after the nationalization. "Wow, sure are a lot of
JoeBobs not paying their bills. Let's mark the loan down to $600."
However, it turns out that this is too conservative. The collective JoeBobs
actually pay back $700 out of every $1000 they were lent. So, there's
actually a latent profit here, as the loan goes from $600 on the books to
$700 in real-life recoveries. Or, the collective JoeBobs really roll over and
die. They only pay back $500 of every $1000 they were lent. However, the loan
is already written down to $600, so the bank only has to take another $100
loss, which it can do out of its underlying profitability (of $4,344m/year).
The
point is, the $30 billion in writedowns we assumed, on top of the
writedowns that WaMu did previous to nationalization, plus the big capital
injection of $40 billion, plus
the elimination of creepy off-balance sheet liabilities, plus the promise of
further government recapitalization if necessary, puts the bank in a very
conservative position. A bank people can trust. This eliminates all the
"systemic" issues.
After
a while, perhaps a few years, but possibly less than that, WaMu is a nice,
clean shiny bank with generally good assets and robust capitalization. Then,
the government IPOs the bank back to the market. A clean, well run bank will
typically get a price of about 2x book value, possibly as high as 3x. The
book value is $40B, the amount of the recapitalization, or more, if there
have been retained earnings while the government has held the company. Thus,
the IPO sale price might be around $80B. That's a profit of $40B for the
government.
II. Wachovia
Here's Wachovia's
1H08 balance sheet:
Wachovia
is a regular bank, as opposed to an S&L, so it's more complicated.
Deposits are only 61% of total liabilities. This gives us quite a bit more to
work with. In this case, with government oversight, a debt/equity conversion
could be organized. There is so much non-deposit debt (at least $55B in
short-term borrowings and $184B in long-term debt) that further government
recapitalization shouldn't be necessary. The shareholders' equity would
disappear, the debt would disappear, and the new equity holders would be the
old debtors. The "trading account liabilities" and "other
liabilities" may stay or be eliminated in bankruptcy, depending on their
nature. The new balance sheet could look something like this:
Assets:
$812B
Liabilities: $448B in deposits, $20B others for a total of $468B.
Shareholders' equity: $344B (debt/equity conversion)
That
would be a very well capitalized bank indeed! Maybe, as part of the process,
some things like short-term debt with maturity under 90 days can be allowed
to mature regularly, to prevent market chaos. Wachovia could then take
massive losses (writedowns) on its loan portfolio -- things like goodwill and
tax loss assets probably need to be vaporized anyway -- so perhaps it would
look something like this:
Assets:
$712B (after $100B writedown)
Liabilities: $468B
Equity: $244B
Wachovia
is a big CDS dealer. To the extent possible, CDS should be
"netted," in other words, offsetting longs and shorts canceled out
against each other. Remaining CDS liabilities are toast.
Result:
Wachovia goes from a weak bank to one of the best capitalized on the planet.
The CDS problems go poof. The government oversees the process, to prevent
"systemic" issues and protect depositors, but doesn't invest a
dime. The debt holders become the new owners.
And
how about those debt holders, which got a pile of equity instead? There was
$239B of short- and long-term debt. Afterwards, there is shareholders' equity
of $244B. We can give a little franchise value, which I propose is 10% of
assets or $72B. So, that's a market cap of about $316B, or 1.3x book, which
is normal considering that the bank is rather overcapitalized and has a
lowish ROE. And, no more CDS nasties. So, the debt holders swapped $239B of
debt for $316B of equity. Not the worst thing ever.
Compare
this to Wachovia's merger with Wells Fargo:
1)
Wells Fargo doesn't bring any additional capital to the table, so the combo
is just as weakly capitalized as before.
2) The CDS problems remain.
3) The result is ... probably a lot like Wachovia's acquisition of Golden
West. (This is how Wachovia got into trouble in the first place.) The underlying
problems -- insufficient capitalization, inadequate asset writedowns, mystery
CDS liabilities -- remain.
III.
Citigroup
Here's
Citigroup's balance sheet:
Here
we have $114B in short-term borrowings and $420B in long-term debt. Let's
just say that the short-term debt with maturity under 90 days is allowed to
mature, and the long-term borrowings are converted into equity. The Fed funds
purchased will stay (not so good to stiff the Fed maybe). That would leave:
Assets:
$2,100B
Liabilities: About $1400B (after debt/equity conversion, elimination of some
junior liabilities)
Equity: $700B
Once
again, a very well capitalized bank. Then, the bank takes a massive
writedown, marking weak assets at a good estimate of their real value, so it
looks something like this:
Assets:
$1,800B
Liabilities: $1400B
Equity: $400B
Of
course, CDS liabilities and the like are either netted or disappear into the
ether.
It is
probably not necessary to have quite so much equity. After a while, maybe a
few years, when all the bad news has come out, the equity holders can arrange
what amounts to an equity/debt swap. The bank would issue debt, and use the
proceeds to buy back equity. Investment bankers and private equity guys do
this sort of thing all day.
Once
again, we achieve our goals:
1) A
nice clean balance sheet. This means that assets are marked down to their
real value, and there's plenty of capital.
2) No off-balance sheet nasties.
3) Depositors etc. are protected, thus solving "systemic" issues.
The
government, once again, serves as a facilitator. It invests nothing, but
makes sure the process runs smoothly.
* * *
Now,
there are some issues with this plan. The first is: there is bankruptcy
everywhere. That, of course, is the point -- a "flash-bankruptcy"
that allows financial institutions to reorganize and heal themselves in a way
that is possible only in bankruptcy. Normally, it is not such a good idea to
promote mass bankruptcy. For example, holders of Wachovia or Citi debt might
be quite surprised to find themselves with huge equity shareholdings.
However, things have gotten to the point that bankruptcy would have resulted
anyway, so we are not really causing any new problems here. If the problems
weren't so big, then the wave of private-market recapitalizations we saw in
the first half would have been effective. Well, we tried that, and it didn't
work so on to the next thing.
The
other problem is the CDS world. Every time there is a bankruptcy, there is an
"event of default" that sets off big CDS payments. Also, at the
same time, these institutions would be absolved of their CDS liabilities,
these being junior in the event of bankruptcy. This will materialize the
Great CDS disaster, which is: a) huge defaults, and b) counterparties are
unable to pay. Well, that was going to happen anyway, so really what we are
doing here is allowing all those who fooled around in the CDS world to get
what was coming to them, while we resolve the "systemic" issues
that could cause problems (and are causing problems today) for the rest of
the economy.
When
Wells Fargo bought Wachovia, for example, that avoided an event-of-default on
Wachovia, so CDS on Wachovia was not set off. Many of the government's
actions can be interpreted as avoidance of where the CDS market is naturally
heading. The problem is, selling Wachovia to Wells Fargo, as noted
previously, doesn't solve the problem of insufficient capital, assets that
are not properly marked down, and too many black-box derivatives liabilities
at financial institutions.
* * *
Holding
up the mountain of shit: It is apparent that what Paulson
is trying to do is to support the mountain of derivatives liabilities. My
solution makes them disappear. Why do you think AIG got an $85 billion loan
from the Fed, to which has now been added another $37.8 billion (an oddly
precise number). Is it because of AIG's profitable insurance division? Or, is
it because of AIG's derivatives (CDS) insurance division, which is a
catastrophe? Well, that's real hard to answer. What could have happened is:
1) AIG
goes into bankruptcy and government receivership, which is basically what
happened.
2)
AIG's derivatives counterparties eat shit, which is what is supposed to happen in
a bankruptcy and receivership situation, but didn't.
3)
AIG's other creditors, such as those with insurance policies, are basically
fine -- indeed better than fine, because they don't have to worry about the
derivatives bomb anymore.
4) The
government recapitalizes (if necessary) AIG, then IPOs it back to the market
-- only the profitable, clean insurance division without the derivatives crap
or other balance-sheet nasties.
5) The
government makes a fat profit.
6) The
economy is saved.
However,
what would not be saved, in this scenario, are the derivatives
counterparties. Well, they shouldn't have entered agreements with entities
(AIG) that are unable to pay. Because, if AIG went into bankruptcy, those
derivatives claims would not be paid. Hey, AIG did go bust! So, the natural thing to
happen next is that those derivatives liabilities are not paid. Probably, this
would make people rather more cautious about such things in the future. That
might be a good thing.
The
problem here is that the Fed has already blown $122 billion down the black
hole of CDS derivatives, and AIG is
still not in good shape. If they had blown out the derivatives
liabilities, and other off-balance sheet nasties, and maybe some of the
junior portions of the capital structure, and kept the healthy insurance
division, they could have recapitalized the whole thing for maybe $50
billion, and IPOed it back to the market with a big profit.
What
happens next? AIG's derivatives counterparties -- wanna bet Goldman Sachs is
a biggie? And JP Morgan? -- take a big loss, which is exactly what they
should take. Then what? If GS can't take the hit, it goes into bankruptcy and
is liquidated, just like Lehman Brothers. And what happens to the bankers?
They go find a job somewhere else. Lehman's sales and trading is now part of
Barclays. Bankers change jobs all the time even during the good times. Big
deal. And what happens to Goldman's creditors? They get what they get in
regular bankruptcy liquidation. That should help keep them from loaning money
to entities levered 30+:1 in the future. Which might also be a good thing.
The
people who take a real big hit are Goldman Sachs' shareholders. Like the top
management. Or the former top management, like Hank Paulson. I bet the
general public would be real disappointed about that. Barney Frank would do
the hula. Something tells me Hanky Panky probably has a few bucks stuffed in
his sock drawer. He isn't going to suffer.
As it
is, AIG now has a big pile of debts. This $85+$37.8 billion business is not a
free giveaway, its a loan. That just replaces the derivatives liability with
a debt liability. This
doesn't bail out AIG, it bails out AIG's derivatives counterparties
-- Goldman, JP, etc -- who would have gotten a rotten apple otherwise,
instead of $122B. And, the Fed's loans are probably senior to other debt
liabilities. AIG's other creditors are now wondering if/when they would get
paid back, as AIG now has liabilities out the wazoo, and they have been
kicked into the junior position. AIG is not profitable, clean, etc. So,
people don't want to do business with AIG, thus continuing the credit crisis.
You
can see why the government should be prepared for a systemic solution.
Because, this sort of thing would cause a chain of bankruptcies. So, the
method has to be in place to take these institutions into government
receivership, clean up their balance sheets by blowing out the derivatives
liabilities and junior capital elements, recapitalize them, make them clean
and shiny and beautiful (ample capital, ample reserves for losses, properly
marked assets and no derivatives nasties), and later sell them back to the
market at a profit. I suggest that the government better go this route while it still has time and
resources to do so, instead of squandering both in an effort to
uphold the Mountain of Shit.
This
might be their last weekend.
The
ultimate losers would be those investors who are taking losses on the junior
debt elements. (The equity guys have already taken their hits.) We're talking
about various investment funds that own the debt of Goldman Sachs, etc. So,
they take a loss, or are converted to equity. So what. Actually, the money is
already lost --
it was lost when the crappy housing loans were made to people who couldn't
pay them -- and what remains is the accounting of the losses.
* * *
I'll
say it again: the
derivatives liabilities need to disappear for banks to be considered healthy
again. In my opinion, the best way to accomplish this is with a
"flash bankruptcy" as described above. Some banks might not have
derivatives (CDS especially) liabilities, but who knows for sure? On Friday
it appeared that there were about $400 billion of CDS liabilities related to Lehman's bankruptcy
alone. You see that the government can't effectively recapitalize
the banking system without blowing out these liabilities, because the CDS liabilities
would chew up all the new capital. The choice is:
1) The
government recapitalizes the banks with $400 billion. The $400 billion is
immediately lost via one
single bankruptcy. What about GMAC? What about Morgan Stanley?
The end result: $400 billion up in smoke, and the systemic problems remain.
Let's
look at a specific example. The government invests $50 billion in Citibank,
because Citibank needs capital. Citibank then loses $50 billion in CDS
liabilities. End result: sqatsky.
2) The
government takes an institution through a "flash bankruptcy."
Derivatives liabilities are eliminated, and junior portions of the capital
structure take losses/are converted to equity. End result: the government
recapitalizes an institution with $50-$100 billion, or zero even, and it is
now healthy and whole. Later, the government IPOs the institution bank to the
market and gets its money back, and maybe makes a profit.
What
is the goal?: the goal is to produce a healthy, functioning
financial entitity, via government recapitalization. "Healthy and
functioning" means plenty of capital, ample loss provsions, and no nasty
surprises, especially derivatives liabilities. Do it over and over (or all at
once), and you have a healthy financial system.
As you
can see, the difference is the difference between effective recapitalization
and ineffective recapitalization. The government doesn't have many bullets
left. Once people stop buying Treasury bonds, it's all over for everyone, as we then
enter hyperinflationary collapse.
Probably,
this weekend governments are going to come up with a financial sector
recapitalization plan. It probably won't work. But, it could work, if it was
done correctly.
* * *
You
have to admit, this stuff is complicated. That's why -- I'll say it again -- you have to understand how banks
work. It's a hard thing to learn when you are already in a
crisis.
February 3, 2008: How Banks Work
February 10, 2008: How Banks Work 2:
Shitting Like an Elephant
February 17, 2008: How Banks Work 3: More
Elephant Poop
February 24, 2008: How Banks Work 4: Banks
and the Economy
March 9, 2008: How Banks Work 5: Selling
Loans
March 16, 2008: How Banks Work 6: Liquidity
Crises and Bank Runs
March 23, 2008: How Banks Work 7: the Lender
of Last Resort
During
these periods, journalists and other generalists tend to lapse into extreme
forms of "metaphor economics." The present metaphor is the
"bazooka." Everyone wants to know, "is the bazooka big
enough?" Because, if the "bazooka" is "big enough,"
we can "blow away the problem," presumably. From our discussion
above, it is not really a question of bigger or smaller, but rather exactly
what is done and does it address the problem. You can have a "big
bazooka" that is a complete waste of time, or you can have a small and
costless rule change, like Putin's 13% flat tax or a gold standard, that
radically alters the economic destiny of a nation, or the planet.
When I
was in Japan, the popular "bazooka" of the time was public works
spending. Once or twice a year, the government would come out with some
preposterous plan to build more bridges to nowhere. People would always ask:
"Is it enough?" Nobody asked: "Is it relevant?" Was the
economic problem really a shortage of bridges? Or was the problem something
else? Thus, a great number of bridges were built, which accomplished almost
nothing except to create a new problem, namely radical government indebtedness.
That's
why I talk about Identifying the Problem.
January 27, 2008: Crisis Management
Some
people, like Bill Gross of Pimco, have started to talk about large-scale
public works stimulus in the U.S. I would feel bad if I had to tell them how
little this accomplishes.
* * *
Debt/Equity
swap: Why a debt/equity swap? This is to be fair to the
debt holders. Once the equity gets wiped out, then the debt takes a loss of
some sort. How much of a loss? In the case of a liquidation, this is easy to
answer. In a going concern, however, it is a lot cloudier.
For
example, let's say someone bought a house for $500,000 with $100,000 down.
There's a mortgage for $400,000. The house goes into foreclosure and is sold
for $350,000. The "equity holder" (owner) is completely wiped out.
Then, the debt holder gets $350,000, which is less than $400,000. So, the debt
holder takes a loss of $50,000. Pretty simple.
Now,
let's say you're a bank. You have 1000 mortgages for a total of $400m. Of
these, 40 mortgages are in default, and 80 are delinquent. The equity holders
are effectively wiped out, because, due to poor capitalization (potential
losses in excess of equity), the bank can't continue as a going concern
(nobody will lend to it) without recapitalization. So, how much of a hit does
the debt take? We have no idea. What will be the recovery on the defaulted
loans? How many delinquent loans will go into default? How many performing
loans will become delinquent? What will be the performance of new loans that
haven't even been made yet? It will be ten years before these questions have
a definitive answer. So, you can't really say, in advance: "The debt
holders need to take a 10%/50%/100% loss."
By
making the debt holders the new equity holders, the debt holders become
entitled to the cashflow from the loans -- whatever it happens to be -- over
the next ten years or in perpetuity. In short: the debt holders (now equity
holders) own the loan. Literally. So, if the loan pays out $0.50, then the
debt holders get $0.50. If it pays out $0.70 or $0.20, then the debt holders
get that. This is how capitalism works. These sorts of situations are fairly
common in a distressed debt (bankruptcy restructuring) situation.
The
important role for the goverment would be to make this conversion process
very quick, with no messy loose ends. It could happen overnight. Afterwards,
the bank is no longer in bankruptcy. It is a normal going concern, with a
new, much healthier balance sheet, and a new stock listed on the exchange.
The debt holders (now equity holders) can then choose to exit via the stock
market if they wish.
* * *
The Washington Post reported
on Friday that the Treasury was working on a plan to take a 10%-15% stake in
banks.
1) The
recapitalization is totally insufficient. They need to take a 100% stake in
banks (except for the strongest, like Wells Fargo wishes it was), and
recapitalize them in full, as described above.
2) It
appears that the banks don't go through the flash-bankruptcy process, by
which they can be recapitalized through the elimination of junior capital
positions and stripped of derivatives liabilities
It
won't work.
* * *
Lehman
CDS settled Friday, at $0.08625. That means, out of $400 billion of CDS,
someone has to pay someone else $365 billion. $365 billion! Hahahahahaha! Do
you see why these liabilities need to disappear?
The $700 billion TARP facility (which can apparently be used to recapitalize
banks) doesn't mean much when banks (and other liabilities holders) can lose
$365 billion on a single bankruptcy, when there will be many, many more
bankruptcies to come. Thus, LIBOR remains bid-only.
Citadel
and Pimco named as major liability holders. Expect mass carnage.
Nathan
Lewis
Nathan
Lewis was formerly the chief international economist of a leading economic
forecasting firm. He now works in asset management. Lewis has written for the
Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and
other publications. He has appeared on financial television in the United
States, Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada, call
800-567-4797.
|
|