Congress' $850B "bailout" plan is not much
more than a giveaway to a handful of well-connected banks. So, what sort of
plan would work? I think we are quite close to a workable plan. John Hussman has been promoting a plan that is very, very
similar to what just happened with WaMu. Note that Hussman says: "you can't rescue the financial system
if you can't read a balance sheet." Do you understand now why I insisted
that you learn how banks work?
February 3, 2008: How Banks Work
If you understand how banks work, Hussman's plan makes sense. If you don't understand how
banks work, it's gobbledygook. How many Congresspeople
do you think understand how banks work? Probably less than one. They are
basically hopeless babes in these matters, so they stick to their core
competencies like stuffing legislation with unrelated chump-change giveaways
like a bicycle commuting deduction.
Let's look at the government's perspective. What are
the government's objectives?
1) The government is already on the hook for insured
deposits. So, the government might as well support the bank, which can then
pay the depositors, rather than having a messy liquidation.
2) The government would like to avoid turmoil from
bank liquidations, and would like to maintain basic banking services. This
means basic deposits, checking, money transfers etc. It also means not
defaulting on uninsured deposits, often deposits of corporations,
municipalities, etc. It means making loans to qualified borrowers, especially
working capital loans to corporations, the disappearance of which could cause
distress on the corporate level. In short, all the "systemic"
stuff.
This could be accomplished via the Washington Mutual
model, but instead of letting JP Morgan steal the goodies, the government
could take it over themselves and recapitalize it. As Hussman
suggests, the junior portions of the capital structure (common equity,
preferred equity, subordinated debt) would take a loss -- basically
everything below the deposits. There should probably be some provision for
recoveries -- thus, subordinated debt would get partially paid back depending
on how the assets of the company eventually perform to maturity. Then, if
necessary, the government would recapitalize the bank, perhaps by adding $40
billion in equity. The new bank would thus be well-capitalized, and thus safe
and reliable, and people could do business with it without fear of Friday
night surprises. The government could then IPO the bank back to the market at
some point, possibly quite quickly. This could actually lead to a profit for
the government, maybe quite a large profit! A nice, clean bank typically
sells for about 2x book. So, if the book value amounts to the government recapitalzation, of $40B, the government should eventually
be able to IPO WaMu for $80 billion, making a nice
profit.
As part of this plan, probably derivatives
liabilities should also be wiped out. Derivatives liabilities would be wiped
out anyway in a bankruptcy, so nothing new there. Poof -- the CDS problem
(for WaMu) disappears. This would also mean there
are no more off-balance-sheet nasties to worry
about.
These off-balance-sheet nasties,
especially derivatives liabilities, are one reason why banks are still in
trouble despite many recapitalizations to date. Losses from derivatives could
be in the trillions. Maybe they won't be -- but who wants to wait and find
out? Thus, it seems we need what amounts to a flash-bankruptcy process, as
was done with WaMu, in which liabilities outside of
deposits can be made to disappear.
This is also why foisting WaMu
off on JP Morgan/Chase doesn't solve the systemic problems. JP Morgan/Chase,
in my opinion, is the biggest potential derivatives disaster in the world.
Thus, if your local WaMu has its sign changed to
"Chase," that doesn't exactly make you want to keep your deposits
there, does it? Nor is JP Morgan/Chase bringing any new capital to the table,
as a government recapitalization would.
This plan would be easy, it would make investors
take a well-deserved haircut, it would be profitable for the government, it
would establish a new squeaky-clean amply capitalized bank that people can do
business with, and it would resolve broader "systemic" issues.
Well, sort of.
The problem with this is what happens next:
1) WaMu's equity,
preferred and subordinated debt investors get blown out, which causes
immediate losses elsewhere. Probably no avoiding this.
2) WaMu's CDS etc.
derivatives counterparties get a nasty surprise. Nothing different than if WaMu went kablooey, though.
Actually, this plan would be reserved for banks that already went kablooey (it is essentially a quick bankruptcy process),
as an alternative to liquidation.
3) WaMu then becomes
everybody's go-to bank. Why hold your deposits anywhere else? This creates
immediate stress on all the other weak banks.
These are not really new problems, they are more
like the resolution of pre-existing conditions. However, one aspect of this
solution is that it would probably be necessary to nationalize several
banks at once. Nothing in particular wrong with that. The other banks are
pretty much bust anyway, but the process would be accelerated. So, the
government should be prepared for system-wide resolution, not just a
bank here and a bank there. (Alas, at this stage "system-wide"
probably means worldwide!)
Fortunately, when you deal with things on a
system-wide basis, the problems tend to cancel each other out. Citibank's CDS
with WaMu becomes a non-issue, because Citi's CDS liabilities are also vaporized. All the
off-balance sheet stuff, system-wide, disappears at once. It's really the
off-balance sheet stuff that scares people, not the on-balance sheet loans
and mortgages, which are relatively easy to value and deal with. All kinds of
counterparty issues become irrelevant. The end result is that you have a
nice, clean, shiny banking system with boodles of capital. Common and
preferred equity, and subordinated debt, get blown out, but that was merely
what they deserved.
This is a plan that would be easy to implement,
relatively cheap, include necessary losses for capital (no socializing the
losses), would probably be profitable for the government, and would resolve
all the systemic issues. Also, it would shut off the "cheap distressed
assets from the government" method of theft, because the government
would be selling its shiny, new non-distressed banks on the open market in
the form of an IPO.
So, what's the problem with this plan? The biggest
problem is the cost: it doesn't cost anything. If it doesn't cost
anything, then nobody gets any free goodies from the government. Probably
Congresspeople should just toss some money around
to friends. Briefcases full of twenties types stuff. Like a reverse bribe.
Here's some cash so you can get off my back and we can create some decent
solutions.
* * *
I actually support the move away from "mark to
market" accounting. This doesn't mean that banks don't have to take writedowns of bad assets. However, they can get a
reasonable estimate of asset impairment, from a third party if necessary, and
apply that. It wasn't that long ago when banks simply made loans, and kept
the loans on the books to maturity. There was no "market" because
people didn't trade loans. Actually, banks still do this to a large extent.
What I am suggesting here was, and is, common practice for these "held
to maturity" loans.
The problem is, basically, that markets are nuts.
This is true all the time. Have you ever wondered why brokers won't let you
lever up an S&P500 position more than 2:1, but a private equity investor
can lever up a company 5:1? The earnings of the S&P500 are actually quite
stable, more so than the vast majority of individual companies. The problem
is market volatility. Market volatility introduces risk (volatility anyway)
far in excess of the underlying economic risk. We looked at the case of
Thornburg Mortgage some months ago:
March 9, 2008: How Banks Work 5:
Selling Loans
This is supposedly the problem that is being fixed
by the $700 bailout package. But that is only a cover. After all, they could
just pass a rule that says banks can mark assets to a "reasonable
estimate of economic value," which is what they are supposedly (not on
your life!) going to sell them for to the government. No $700 billion, just a
rule change -- a rule change that is actually part of the final bill. I think
the package is merely a way to channel Treasury funds to certain "made
men" banks -- JP Morgan/Chase, Bank of America, Goldman Sachs, Morgan
Stanley, maybe Citibank -- which they will use to cover their own losses and
then to buy banking assets cheap. The FDIC seems ready to accommodate this
land grab, through its system (introduced with Washington Mutual's sale to JP
Morgan) of making the non-depositor liabilities and equity disappear. In
short, it is thievery plain and simple, and using just the model we've seen
so often all around the world: 1) Socialize the losses, and 2) Get the
government to sell you distressed assets cheaply.
July 1, 2008: Privatize the
Profits. Socialize the Losses.
* * *
Money market funds: yech! Thank goodness money market funds are now federally
insured! I took a look at a money market fund that I use, as a sweep account
in a brokerage account. The fund, which will remain nameless, holds $16.8
billion of assets, and yields 2.07%. This is a regular, plain-jane MMF, not an "enhanced" or other
bells-and-whistles fund.
US Government and Agency Obligations 26.19%
Federal Farm Credit Bank
Federal Home Loan Bank
Federal Home Loan Mortgage Corp (whoops!)
Federal National Mortgage Assoc. (whoops!)
Bank Notes 2.33%
Wachovia Bank (whoops!)
Wells Fargo Bank
Certificates of Deposit 16.81%
Abbey National Treasury Services
Bank of Montreal
Bank of Tokyo-Mitsubishi UFJ
Barclays Bank
Calyon
Credit Suisse First Boston
Deutsche Bank
Fortis Bank (whoops!)
HSBC Bank
Lloyds TSB Bank
Royal Bank of Scotland
Svenska Handelsbanken
American Express, Federal Savings Bank
Bank of America
Citibank
State Street Bank and Trust
US Bank
Wachovia (whoops!)
Commercial Paper 24.31%
Asset Backed Commercial Paper 12.22% (remember ABCP? mega-whoops!)
Automobile OEM 1.16%
Banking US 7.01%
Bank of America
Danske Corp.
Dexia Delaware LLC (whoops!)
Fortis Funding LLC (whoops!)
ING
Nordea
Rabobank
San Paolo
Consumer products nondurables 0.56%
Integrated Energy 0.12%
Finance, noncaptive diversified 1.27%
General Electric Capital Corp
Food/beverage 0.57%
Pharmaceuticals 0.81%
Telecom-wireless 0.59%
Short-term corporate obligations 11.54%
Banking, non-U.S. 8.87%
ANZ
Bank of Scotland
BNP Paribas
HSBC
La Caja de Ahorros y Pensiones de Barcelona
National Australia Bank
Rabobank
Totta Ireland
Westpac
Banking, US 0.77%
Bank of New York Mellon
Finance, captive automotive 1.90%
Toyota Motor Credit Corp.
Repurchase agreements 17.87%
includes:
Lehman Brothers (whoops!) collateralized by FHLB obligations and FNMA
obligations (whoops!)
Merrill Lynch (whoops!) collateralized by FFCB, FHLB, FHLMC (whoops!), FNMA
(whoops!)
Money Market Funds 9.00%
doesn't that cause Mad Cow disease?
I always thought MMFs were mostly t-bills and some
high-grade CP from non-financial entities. Maybe they were, in the past. I
don't think this MMF was any worse than many others. Probably above average. Makes you think, doesn't it?
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.
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