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This week I
have just a few items related to our recent topics of the "debt/equity
swap" solution for banks, and also, what banks should look like after
this crisis.
The "debt/equity swap" idea is really a variant of "Chapter
11," the portion of our bankruptcy code that deals with organizations
that will continue operating during and after bankruptcy procedures. The
basic idea of "Chapter 11" is to reorganize the liabilities side of
the balance sheet, to redefine who owns what in the reformed going concern.
We've been discussing these topics recently:
November 13, 2011: Recapitalizing
Banks with a Debt/Equity Swap
October 24, 2011: Europe's
Economic Crisis Is Not A Euro Crisis
October 23, 2011: Are TBTF Banks
Unnecessary?
September 23, 2011: A Debt/Equity
Swap To Recapitalize European Banks: A Real World Example
September 1, 2011: How To Fix
Europe's Problems Without Taxpayer Money
October 12, 2008: Effective Bank
Recapitalization 2: Three Examples
October 5, 2008:
Effective Bank Recapitalization
Here's Steen Jacobsen, Chief Economist at Saxo Bank
in Denmark, who came to the same conclusion:
Is Europe set to
declare a Chapter 11 in early 2012?
Europe may need to pull a Chapter 11 – a
US-style bankruptcy, which would permit a market shutdown and Euro Zone
reorganization before reopening for business. ...
So what form might a Chapter 11 for the Euro Zone take? It is increasingly
likely that some kind of total “bank holiday” is enforced to put
a stop to market pressures – and then to reinforce and relaunch a stricter EU Growth and Stability Pact as a
price for cranking up the ECB printing presses to full speed.
Before accusing me of lunacy on my idea of a market holiday, it’s
important to point out that banking holidays are not without precedent. In
1933, President Roosevelt declared a bank holiday that ran for an entire week
in March of 1933, during which he passed the Emergency Banking Act and the
Federal Reserve moved to supply currency to banks. ...
Here's an extended item from John Hussman of Hussman Funds, who outlines bank debt restructuring and
some of the political implications.
Recession, Restructuring, and the Ring Fence
We are headed toward a new recession because our
policy makers never addressed the underlying problem in the first place,
which was, and remains, the need for debt restructuring. This is an issue
that I suspect will re-emerge to the forefront of public debate in the next
year. Hopefully, the response of our policymakers will be at different.
Think of restructuring this way. U.S. stocks just lost $2.5 trillion last
quarter. Why should the public bail out the bondholders of financial
institutions when the assets of these companies are far beyond what is needed
to cover their liabilities to depositors and customers? The problem for
banks, of course, is that they are leveraged, so even a drop of a few percent
in their assets wipes out much of their own capital and threatens to make
them insolvent. That should be a major concern for the lenders who have
allowed the managements of those banks to leverage their bets with increasing
lack of transparency (thanks to the FASB). But "failing"
institutions can be restructured without any loss to depositors or counterparties.
When banks become insolvent, my view is that receivership and restructuring
is exactly what should happen, and swiftly.
Look at Bank of America's balance sheet, for example. Reported assets are
$2.261 trillion. Against that, liabilities to depositors amount to less than
half that, at $1.038 trillion. Add in $239 billion for securities that they
are obligated to repurchase, $129 billion in trading account and derivative
liabilities, and $155 billion for accrued expenses. Now you've covered
counterparties, as well as vendors or others who might have invoices
outstanding. Even then, and you're still only up to $1.561 trillion of the
liabilities. The remaining 31% of Bank of America's liabilities represent
obligations to its own bondholders and equity of its own shareholders. This
is well beyond what is sufficient to buffer any loss that the company might
take on its assets, while still leaving customers and counterparties
completely whole. To say that Bank of America can't be allowed to
"fail" is really simply to say that Bank of America's bondholders
can't be allowed to experience a loss.
What "failure" really means is that bondholders lose money, and the
operating part of the institution is taken into receivership, sold for the
difference between assets and non-bondholder liabilities, and recapitalized
under different ownership. Often the only thing that customers and depositors
notice is that there is a new logo on top of their statements.
Now take a look at Citigroup's balance sheet. Reported assets are $1.956 trillion.
Against that, liabilities to depositors again amount to less than half of
that, at $866 billion. Add in $204 billion in repurchase obligations, $209
billion in trading and brokerage liabilities, and $73 billion in other
liabilities, and you're still only up to $1.352 trillion. The remaining 31%
of Citigroup's liabilities, again, represent obligations to its own
bondholders and equity of its own shareholders. And again, to say that
Citigroup can't be allowed to "fail" is really simply to say that
Citigroup's bondholders can't be allowed to experience a loss.
You can do the same calculations for nearly every major financial institution
in the world. The amount of bondholders and equity coverage varies somewhat,
but in virtually every case, bondholder and shareholder capital of these
institutions are more than sufficient to absorb any losses without the need
for public funds, provided that the objective of government policy is to
protect the people and the long-term viability of the economy, rather than
defending the existing owners, bondholders, and managements of these
institutions. Make no mistake - that choice is what the oncoming crisis is
going to be about (See An Imminent Downturn - Whom Will Our Leaders Defend? ).
But who are those bondholders? They include corporate investors, pension
funds, endowments, mutual funds and ordinary investors. And all of them
willingly take a risk in order to reach for return. As do stock market
investors. And if the risk doesn't work out, none of them should look to the
government to fire teachers, lay off social workers, underfund the National
Institutes of Health, cut Medicaid, and print money (because until the Fed
sells its Treasury and GSE holdings, it has indeed printed money), just
because they take their risk in a different type of security.
My impression is that the scare-mongering of self-serving financial
"experts" on Wall Street is shortly about to become deafening. It
would be catastrophe, utter catastrophe, no, Armageddon, to let the global
financial system collapse - collapse! - because the
world as we know it will indeed collapse, as day follows night, if
bondholders, who knowingly and voluntarily take risk and invest at a spread,
are actually allowed to lose anything! We cannot, in a thinking society,
allow losses to befall risk-takers who make reckless loans and bad
investments. We must, must at all costs, divert money away from health,
education, and welfare, in order to save these companies from failure,
because neither health, nor education, nor welfare are even possible unless
we save the financial system from unthinkable meltdown. We have no choice. No
choice at all. They are too big to fail, and we cannot hesitate - they must
be saved, for the sake of our children, for our children's children, for our
freedom, for the flag, and to honor the legacy of our forefathers, so that
these Champions of Disfigured Capitalism can continue to do their vital work
with impunity, unbound by any of the incentives or consequences that actually
allow capitalism to work in practice.
To reiterate the observations of Sheila Bair, the outgoing head of the FDIC,
in her discussion of the 2008-2009 crisis (see Sheila Bair's Exit Interview ): "'We were rarely consulted. They would
bring me in after they'd made their decision on what needed to be done, and
without giving me any information they would say, ‘You have to do this
or the system will go down.' If I heard that once, I heard it a thousand
times. ‘Citi is systemic, you have to do this.' No analysis, no
meaningful discussion. It was very frustrating.' ...
As she thinks back on it, Bair views her disagreements with her fellow
regulators as a kind of high-stakes philosophical debate about the role of
bondholders. Her perspective is that bondholders should take losses when an
institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured
bondholders always absorb some of the losses. That is the essence of market
discipline: if shareholders and bondholders know they are on the hook, they
are far more likely to keep a close watch on management's risk-taking."
I feel it is important to emphasize - as we move toward recession - that we
shouldn't blame what is happening here on capitalism or free markets. We
really have only a caricature of those here. We have a system that is
constantly eager to abandon the proper role of government in the markets -
which is effective regulation of risk - and to substitute it with the worst
role of government in the markets - which is absorbing losses for those whose
losses should not be absorbed, and pursuing policies tilted toward the
constant creation of speculative bubbles and the avoidance of required
economic adjustments, rather than the productive allocation of capital.
Free markets work - provided that they operate within a framework of
government policy that enforces property rights, provides reasonable
regulation, coordinates objectives that cannot be achieved privately (e.g.
certain infrastructure, insurance coverage for pre-existing conditions -
which otherwise creates an adverse selection problem even for companies that
would like to offer it), and maintains reasonable consumer protection
(because there is a huge "information problem" in requiring each
consumer to have all of the requisite facts to avoid abusive practices). To
blame our economic problems on the free market is an insult to what has
proved for centuries to be the most effective economic system for creating
prosperity and raising living standards. We would be wise to stomp out the
incessant policy of bailouts and monetary distortions if we hope for that to
continue.
Here's banking specialist Chris Whalen of Institutional Risk Analytics,
explaining the process of "converting debt to equity."
http://blogs.reuters.com/christopher-whalen/2011/08/09/uncertainty-and-indecision-threaten-bank-america-and-global-markets/
BAC is a too big to fail zombie created by the Obama
Administration and the Fed to protect US financial markets, but is now so
vast and unstable that it threatens the global economy. But more corrosive
and dangerous than the torrents of red ink inside BAC is the steady erosion
of public confidence. Uncertainty is the enemy now, both with respect to BAC
and to its large bank peers.
The only way to end the uncertainty and also accelerate the economic recovery
is to put BAC through a restructuring using the powers under the Dodd-Frank
legislation. While a restructuring by the FDIC may seem to be a horrible
prospect, in fact it offers the first real hope of definiteness in the
housing crisis, the multi-trillion dollar millstone around our collective
necks. Indeed, the BAC situation illustrates why the Founders of the US
embedded bankruptcy in the Constitution, namely the need for finality.
In mechanical terms, here is how it works. Let’s start the narrative
with a last, Hail Mary move by BAC CEO Brian Moynihan, who put the shell
corporation that is the legal successor to the Countrywide business into
bankruptcy after settlement efforts fail. This engraved message from Moynihan
to BAC’s creditors, litigants and even Treasury Secretary Timothy
Geithner — “foxtrot oscar”
— begins the real endgame.
Hopefully Secretary Geithner will know about the BAC filing before it occurs
and will have begun the process under Dodd-Frank to give regulators and
especially the FDIC the power to move immediately to protect BAC and its
subsidiary banks. In our narrative, FDIC enters the bankruptcy litigation for
Countrywide and asserts control of the entire BAC group. BAC becomes
effectively a subsidiary of the FDIC, with the full capital and assets of the
entire industry behind it.
Once the FDIC is in control of BAC, the process will then proceed like a
typical bankruptcy, with the operating units continuing to do business in the
normal course. For consumers and business customers, the situation at BAC
will be mostly the same. But for investors and especially creditors, the
situation will be far from normal.
In a Dodd-Frank resolution, the creditors of BAC will have an opportunity to
file claims, much as with any failed bank. Unlike a bankruptcy, however, the
FDIC will make all depositors of the subsidiary banks whole before considering
claims of creditors of the parent, a significant difference investors ought
to consider. Most important, however, will be the process of converting debt
to equity in the restructured BAC, providing the resources to absorb losses,
fund continuing operations and restructure.
The beauty of a restructuring is that it forces all parties with a claim on
the failed company to speak now or forever hold their peace. It also requires
the conversion of debt to equity, which increases capital dramatically and
also lowers the operating expenses of the enterprise. A super-capitalized BAC
with 2-3% asset returns, 30% tangible equity and gobs of cash flow will then
be ready to sell assets, modify mortgages and do whatever it takes to restore
the ability of the bank to support new leverage. That is why restructuring is
the key to US economic revival.
Here's Chris Whalen again (on video), explaining that "all major U.S.
banks will require restructuring, government receivership." In other
words, Chapter 11 and a debt/equity swap.
http://dailybail.com/home/chris-whalen-bank-bailouts-20-is-coming-all-major-us-banks-w.html
Finally, on our topic of what the financial system should look like
afterwards (much smaller and simpler, resembling 1960s banking with
computers), here's Boston University professor Laurence Kotlikoff.
He calls it "limited purpose banking."
“Larry Kotlikoff
grabs us by the collar, brilliantly unveiling the truth about our financial
system: ‘It’s a system virtually designed for hucksters.’
With scintillating arguments, vivid examples, and terrific wit, he shows us a
path of powerful reform that would stop banks from gambling and restrict them
to their legitimate purpose, ‘connecting borrowers to lenders and
savers to investors.’ This is economics at its very best: deeply
insightful and powerfully useful. It will change the global debate.”
-- Jeffrey Sachs, Director of The Earth Institute, Quetelet
Professor of Sustainable Development, and Professor of Health Policy and
Management at Columbia University
http://kotlikoff.net/
Nathan Lewis
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