The Obama Administration is captured. To understand why it has acted as it has, one doesn’t have to take the view that its efforts to save the banking industry were a deliberate attempt to line bankers’ pockets by transferring money from taxpayers to the banking industry. One need merely read the last post I wrote on this topic.

In their wildly optimistic view, the banking industry is solvent and always has been. All that was needed to ‘solve’ than banking crisis was a lot of liquidity, government backstops and, most importantly, time. This blinkered view sees a looting of taxpayer money to bailout the banking industry as necessary to save banks whose credit is the ‘lifeblood of our economy.’

They are wrong. The banks did not need to bailed out. The banking industry industry needed to made solvent again. There is a big difference between those two sentences (banks versus banking industry and liquidity versus solvency) that goes to the core of the captured and politically damaging world view we have seen on display by the Obama Administration.

Change you can believe in

Think back some 18 months when Senator Obama was in a horse race with Hillary Clinton to see who would go up against John McCain in the Presidential election. If you asked any reasonable individual who had the least experience and the thinnest political resume of the three, he or she would have said Barack Obama. If Americans wanted someone long on inside-the-beltway experience, they would have chosen John McCain – or, at a minimum, Hillary Clinton, not Barack Obama.

So, Barack Obama did not best both Hillary Clinton and John McCain and get to the White House because Americans felt him more qualified for the job.  Rather, Americans believed the U.S. was on the wrong path and wanted a qualified person to lead the country who would also change course. They believed that person was Barack Obama.

And when it came to the economy, the presence of two men, Paul Volcker and Warren Buffett, born some 80 years ago, gave one the sense that, despite Barack Obama’s perceived relative youth or inexperience, he had the ablest of wise old men who would be his and our counsel in resolving this crisis.

Bailing out the banks

So when Barack Obama took office, it came as a rude awakening for many that he chose to bail out the too big to fail institutions with little or no strings attached, allowing them to later make record profits and pay record bonuses, while the economy was in a deep slump and ordinary Americans were being bankrupted and losing their jobs and homes at record rates. This was not change you can believe in.

What could or should the Obama Administration have done?

If you had listened to the chatter inside the beltway early this year, you would realize that Obama’s team believed it was not politically feasible to ‘nationalize’ Citigroup or Bank of America and force top executives to resign as was done at RBS, Bradford and Bingley or Northern Rock in the UK. This was a blinkered view which can only be described as captured (if not outright disingenuous).  We need look no further than Fannie Mae and Freddie Mac to see that nationalization was an option.

But this is not the kind of solution we needed.  What we needed was a solution by the Administration to take prompt corrective action in seizing bankrupt institutions, dismissing management, punishing any misdeeds and setting up a timetable to sell off the institution’s assets. That is change you can believe in.

I laid this out fairly comprehensively in February in my post “America needs a pre-privatization plan.” So I am not going to cover that ground here except to quote the key relevant passage in that post:

To my mind, there are three ways to deal with an insolvent financial institution:

• Bankruptcy. Allow the  institution to collapse (like Lehman Brothers)
• Nationalization. Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae)
• Bailout. Inject capital into the institution in order to allow it breathing room until it can meet capital adequacy levels.

As you can see, governments have tried all three solutions.  However, there are vast differences between the three.

The bailout solution is the most ‘anti-free market’ choice and seems to be the favored solution of governments everywhere.  It props up organizations, giving them an unfair advantage at the expense of other more prudent institutions.  It also acts as a subsidy, which favors domestic institutions over foreign rivals.  Bailouts increase moral hazard by rewarding risky and reckless lending practices.  And they are often the result of crony capitalism due to the power of the financial services lobby. There are many other problems with bailouts. All around, bailouts are a poor solution.

So what we have here is a case of crony capitalism and kleptocracy, plain and simple – whether by design or not is immaterial. And the American people are on to this. That is why people are resistant to other changes this Administration has put forth.

Don’t let the media’s spin fool you: Washington insiders are on to this too. Politicians in Congress realize that Obama’s bailouts have cost him political capital  and they are challenging his policy agenda as a result. This is why the health care bill, which Obama wanted passed before the summer recess, may not see the light of day before year’s end.

Are we home safe?

I would advise the Obama Administration not to run any victory laps about having slayed the beast. The lingering effects of crisis are still there. The Fed’s liquidity is still liquid. Impaired assets are still impaired. And zombie banks are still zombies. As I indicated in my depression piece:

In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized.

Since I covered this ground in that article, I will leave you to read my further thoughts there. What I want to turn to now is the ‘why.’

The Cheney-Rumsfeld replay

Now, I am not writing off Barack Obama’s presidency. I do worry he still could see a recessionary relapse which would cause him to seem more Herbert Hoover than Franklin Roosevelt.  But, despite his Nobel Prize, it is much to early to know what his legacy will be.

Nonetheless, I believe he has wasted a lot of political capital and this will make ushering through a meaningful legislative agenda very difficult.

Why did Obama throw it all away?

Here’s my answer: I call it the Cheney-Rumsfeld replay.

When historians look back at the Bush 42 presidency, it will be defined by 9/11 and the wars in Iraq and Afghanistan.  While George W. Bush was politically pre-disposed to the Neo-con world view, it was really advice from Dick Cheney and Don Rumsfeld which made Afghanistan and Iraq possible. George W. Bush was famously not well-versed in foreign affairs, having almost never travelled abroad.  He was completely dependent on Dick Cheney and Donald Rumsfeld to make foreign policy (although he could have listened more to Colin Powell, his actual Secretary of State; again it goes to predisposition).

So, I see George W. Bush’s presidency as having been defined by foreign policy and the War on Terror and, by extension, on Rumsfeld and Cheney.

Fast-forward to Barack Obama’s presidency and you have an almost identical situation, this time with the economy instead of foreign policy and Tim Geithner and Larry Summers instead of Donald Rumsfeld and Dick Cheney.

But, as with George W. Bush, it goes to pre-disposition. Paul Volcker was a critical member of the Obama 2008 campaign. He also was a key member of Obama’s economic policy team. But, he has been speaking a very discordant message that is not in sync with team Obama. So, as with Bush and his marginalization of Powell, one has to believe Barack Obama has chosen to side with Geithner and Summers over Volcker. Why anyone would do so given Volcker’s experience is beyond my comprehension.

The obvious conclusion, therefore, is that Barack Obama shares the blinkered and captured view of his policy makers and that this is why he has decided to go down this chosen path. And when it comes to Obama’s other ‘change’ decisions on the Guantanamo closure, torture, rendition, state secrets, and health care, the same logic also applies.

Is this change we can believe in? I will leave that for you to decide.

Related posts:

• The wildly optimistic view of Treasury’s handling of the crisis
• Bush Administration turns the TARP over to Obama
• The 3 a.m. moment – McCain blows it
• Greenspan: “If they’re too big to fail, they’re too big”
• Automakers likely to be bailed out

Lloyds are looking to avoid the embrace of government by going to existing shareholders to raise capital and sidestep the draconian break-up solution foisted upon RBS by Neelie Kroes. According to Bloomberg, this is the largest rights issue ever for a British company and equates to $34 billion.

All of this must be excruciating for Lloyds shareholders, as Lloyds was not a reckless lender during the bubble years. It was HBOS which nearly went to the wall and was subsequently foisted onto Lloyds.  At the time (late September 2008), I certainly thought the deal was in the best interest of all concerned given how little Lloyds was paying for HBOS:

The fact that government were so involved in the negotiations makes clear how important it was that this deal get done. It appears to have been the best outcome for all parties concerned: HBOS, Lloyds and Labour. The British Government has been pilloried for having squandered the good times and leading the UK into a major downturn with no room for fiscal stimulus. Both Gordon Brown and Alistair Darling should be worried about getting the sack. The last thing either they or the Labour Party needed was a failure of an institution like HBOS. HBOS was too big to fail.

The HBOS crisis was a perfect example of how liquidity concerns become intertwined with solvency issues in a time of panic. With the HBOS crisis now at an end, one wonders whether RBS will come under attack next, or whether we can breathe a sigh of relief until the next round of writedowns or share price losses. We will have to wait and see.

RBS did come under the government umbrella and both RBS and HBOS have proven major sinkholes for the UK taxpayer, with more money still coming.

What Lloyds are looking to dodge is the government’s Asset Protection Scheme, which Bloomberg estimates will cost the bank 15.6 billion pounds in fees and easily raise the government’s stake to a majority at 62 percent.

Below are the defining paragraphs of the scheme:

1.1 Under the Scheme, in return for a fee, the Treasury will provide to each participating institution protection against future credit losses on one or more portfolios of defined assets to the extent that credit losses exceed a “first loss” amount to be borne by the institution.  It is intended that the Scheme will target those asset classes most affected by current economic conditions.

1.2 The Treasury protection will cover the major part but not all of the credit losses which exceed this “first loss” amount.  Each participating institution will be required to retain a further residual exposure, which is expected to be in the region of 10 per cent. of the credit losses which exceed the “first loss” amount.  This residual exposure will provide an appropriate incentive for participating institutions to endeavour to keep losses to a minimum.

1.3 The Treasury currently expects that the fee will usually be satisfied by the issue of capital instruments of the participating institution.  These instruments are not expected to include ordinary shares, but will include a range of alternative capital instruments.  The Treasury will be open to consider other forms of fee, including cash.

Nevertheless, Lloyds are being forced to flog off assets , effectively deleverage, in order to escape the APS. Insight Investment management was sold to Bank of New York Mellon for 235 million pounds on Monday. The Intelligent Finance business, Cheltenham & Gloucester accounts and mortgages, and a number of Lloyds TSB branches in England & Wales will be gone within four years. The TSB brand is also history. No mention of plans concerning the Halifax or Bank of Scotland brand has been made.

It is unclear what kind of reception such a large rights issue will receive. Lloyds is down almost 2% in heavy trading so far today.

Sources

Lloyds to Raise $34 Billion to Avoid Control by U.K. – Bloomberg

Sale announcement of Insight by Lloyds – Lloyds TSB website

Related posts:

• RBS reports a record loss of 24 billion pounds
• Lloyds gets HBOS for a song
• Nils Pratley: A tale of two banks at RBS and Lloyds
• HBOS to raise new capital
• $467 billion in writedowns and counting

In a clear break with US economic policy, the UK government have decided that too big to fail is too big to exist. As a result, three large financial institutions now owned at least in part by government are to be dismantled. Moreover, talk of Tesco’s or Virgin getting the assets is yet another momentous shift in the British banking landscape.

The BBC reports:

Chancellor Alistair Darling has confirmed that Lloyds, RBS and Northern Rock will be broken up and parts sold to new entrants to the banking sector.

He said there could be three new High Street banks in the UK over the next three to four years as a result.

But the chancellor said he would only sell parts of the banks when "the time is right", to ensure taxpayers get their money back.

There is speculation that buyers might include Tesco and Virgin.

One should not understate the importance of this decision. This is a game-changing move by the UK government. One year ago, it was the U.K.’s decision to recapitalise its banks which changed the economic policy landscape. U.S. policy makers were forced to switch TARP policy from buying up dodgy assets at inflated prices to injecting capital (see my post “Recapitalising Britain” from 7 Oct 2008).

Yet again, the British are leading the way in reform. If you recall, just two weeks ago Mervyn King, the Governor of the Bank of England, made a blistering attack on government policy and advised breaking up too big to fail banks. At the time, Prime Minister Gordon Brown publicly rejected this idea.

However, it seems Labour were not as against King’s ideas as Brown’s comments suggested. The move last week by the Dutch to break up the bankassurance giant ING may have been the impetus. The Chancellor, Alistair Darling, suggested an increase in competition on Britain’s high streets was uppermost in his mind.

Mr Darling said this was the best way to ensure "proper competition and choice". He said having just "half a dozen big providers was not acceptable".

Why Bradford & Bingley was not mentioned with the other three banks under government control is unclear. Tesco’s and Virgin have been two of the more innovative financial service providers on Britain’s high streets and we should look on their ability to compete at scale as something which will shake up financial services in Britain. Tesco’s bid to compete in the banking sector is particularly noteworthy because of its enormous presence on high streets and immense customer base.

I reckon this move will put pressure on the US where the Obama Administration has been completely unwilling to break up the large banks, which are now even more dominant than before the crisis.

Related posts:

• Nils Pratley: A tale of two banks at RBS and Lloyds
• German deposit guarantee sets up a German-British row
• Irish government unveils plan to recapitalise banks
• The EU driving changes in European banking
• Einhorn: Break up too big to fail financial institutions

And you thought the bailouts were over and market discipline might be restored.  Not a chance – the bailouts will continue, come hell or high water. The latest demonstration of this is GMAC, where the government will now be majority owner. GMAC has officially been nationalized. Now the government is running auto financing in addition to running the companies making the cars.

Below is a quote from the Financial Times. Notice the parts I have bolded.

GMAC, the car financing company, is set to receive up to $5.6bn in a new capital injection from the Treasury, filling a hole identified in the “stress tests” earlier this year and paving the way for the government to become the majority shareholder.

The company, formerly the financing arm of General Motors, was one of 19 institutions to submit to a capital adequacy programme led by the Federal Reserve and completed in May. That determined that GMAC had a shortfall, which will now be provided by the government in the form of preferred equity, according to two people familiar with the situation.

As widely expected, GMAC has been unable to raise the necessary capital in the market and the company – which will take on fresh lending responsibilities when it merges with Chrysler Financial – was seen as vital to the government-led restructuring of the US automotive industry and deserving of more funds from the $700bn troubled asset relief programme.

“When we laid out the stress tests, we expressly said that some additional Tarp capital may be needed given the severity of the downturn – this capital need is not new information,” said an administration official.

“But the transparency brought about by the stress tests allowed all other institutions to raise the capital required by the stress tests to ensure these firms could withstand a more severe economic scenario than anticipated,” the official said.

What you should be reading from this statement is the following:

• All the firms identified as lacking capital under the stress tests were given time to raise funds in the capital market to meet the shortfall.
• Some firms did meet the shortfall and they are now free to do as they please.
• Others have not and we the government are now going to take a more muscular approach in dealing with them.
• GMAC is the first public example of our flexing our muscles.
• But there surely are/will be other examples; some may already be happening in secret.

If the US government is going to throw its weight around to deal with financial firms short of capital, I would personally prefer they try a process which allows these firms to fail whereby equity and debt holders suffer consequences that are consistent with taking market risk.  Bailing out GMAC is a moral hazard plain and simple.

But, what’s done is done. The GMAC case does, however, give a lot more credence to my view that Citigroup’s actions are being dictated by government. As I indicated when the stress tests were done in April, firms were going to get some time to raise capital and if they didn’t, the government was going to move on to Plan B (debt-for-equity swaps, nationalization, and FDIC seizure). Expect to see more indications that other financial companies with capital shortfalls are falling under the government umbrella.

Related posts:

• Bank by bank breakdown of stress test results
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• GMAC: Loosening credit standards in the teeth of recession
• GMAC gets a helping hand
• GMAC chairman resigns effective immediately

Back in March when the US Government felt compelled to bail out out Citigroup, Tracy Alloway over at FT Alphaville noticed a curious thing – Citigroup had effectively been nationalized.

No, they were not seized by government, but Citi was controlled by government.  The Feds had 36% of shares outstanding, which in many cases is considered to be a controlling interest for a government (for instance, until the Open Skies Treaty pushed the level to 49%, foreign carriers could not take more than a 25% stake in any airline as this is considered a threat to national security).  That matters because of Banamex.

From Alphaville on 2 Mar:

Does the US government’s 36 per cent stake in Citi violate Mexican ownership laws? Have we got our countries confused? No.

Citi owns Banamex, a Mexican bank with circa 1,200 branches and 2.6m checking accounts. And Latin American finance blog Inca Kola sees a fight brewing over the Southern subsidiary:

The nub of the issue revolves around Mexican law, which states in crystalline manner that foreign governments cannot own more than 10% of any bank that operates inside Mexico. It’s as clear as a bell and on the statute. So as Banamex is a wholly owned subsidiary of Citigroup (C paid $12.1Bn or so back in 2001 for the bank) if the US Gov’t takes its 36% stake in Citigroup then it will be a larger-than-10% shareholder of Banamex, something against Mexican law. Won’t it?

Mexico’s National Banking and Securities Commission is therefore investigating, while Banamex is saying that the North American Free Trade Agreement will (somehow) protect it.

The next day Bloomberg reported that Mexican law makers had decided to pursue a bill to force Citi to disgorge itself of Banamex because of it was a government –controlled entity.  Then this story disappeared from the mainstream press. 

Now, as background, after the recession of 1991, Citicorp was bailed out by Prince Waleed of Saudi Arabia because it was in danger of failing. Low interest rates and the money from Prince Waleed did the trick and Citi experienced a remarkable recovery – and eventually the broader economy did as well. In fact, recovery was enough that Alan Greenspan attempted to raise rates fairly rapidly (this was before policy asymmetry at the Fed because the norm). The result was the Tequila Crisis and the near bankruptcy of Mexico (see my post “1995” for more.)

Banamex , the 2nd largest Mexican bank, was made insolvent due to the Tequila crisis. And what do you know, Citi swooped in to buy it lock, stock and barrel. Spain’s BBVA later took over the re-privatized Bancomer that had been nationalized after the Latin American Debt crisis in 1982 (also induced by rising rates in the US).

These incursions into Mexico have caused outrage. Why should foreigners own the two largest banks in the country? So, the topic of Nationalized Citibank has been percolating for a while in Mexico. And it has just resurfaced.

From Breakingview.com:

Mexico’s high court is set to decide this week whether to hear a case brought by a contingent of Mexican senators that Citi must offload Banamex because a foreign government owns more than 10 percent of its stock. They want the court to decide whether the finance ministry had the constitutional right to decree in March that the United States government’s 34 percent slice of Citi was acceptable because it was intended to be short term.

So Citi is hardly up against a wall just yet — and it reckons any decision to force a sale would breach the North American Free Trade Agreement anyway. But if push comes to shove, the bank should be prepared to put up more of a fight than it did for Phibro.

Quite frankly, America is used to treating Mexico – all of Latin America, really – like its poor cousin. This displays a lack of respect that many there find galling.  If Citi is forced to disgorge itself of Banamex, it will be interesting to see not how Citi reacts, but how the Obama Administration reacts since he wants to present a new American image on the world stage.

By the way, below is a hilarious video of ‘Nationalized Citibank’ that captured the mood in America back in March when the bailout happened.

Related posts:

• Does Obama have the legal authority to take over Citi?
• Citi: looking for as much as a 40% stake from the government
• Will Mexico suffer contagion?
• Citigroup and Redecard: shedding international assets
• Is Mexico imploding?

The title of this post is somewhat misleading – designed to be provocative to get you to read what I have to say. Indeed, I am going to defend Goldman Sach’s right to pay what it likes to its employees. But, I am also going to defend your right to be outraged and to look for redress.

Socialism?

Let’s start this off with another provocative statement which encapsulates my thinking on the issue:

The teabaggers who showed up in the summer at Town Hall meetings to shout down politicians and scream ‘socialism’ at anyone who would listen because Barack Obama was going to pull the plug on granny need to redirect their anger. By socialism I take it they mean central planning in a capitalist society. If they want to see socialism in action, look no further than banking.

Yes, that’s how I want to lead into this issue.

Let’s state the obvious: banking is a legally sanctioned cartel. In the US, the federal government by law has nominal control over the entire monetary and lending apparatus- both the printing press and interest rates – via the Treasury and the Federal Reserve respectively. The state and federal government also control who gets to be a bank by accepting and rejecting applications for bank charters and seizing banks which fail to meet their obligations as safe and sound lending institutions.

Let’s call this what it is: socialism.  One can argue whether this is the right way to run a banking system. But let’s put that (ideological) argument aside and focus on the specific issue of bonuses within that system – and whether the government’s controlling them is ‘socialism’ and whether we should accept that control.

Should the government Get to dictate who gets how much in the financial sector?

Goldman’s bonuses?

When Goldman Sachs reported record profits for the third quarter of this year, they also told us they were setting aside a record amount of money to pay bonuses.  Goldman’s record bonuses were not the only signs of champagne and caviar on Wall Street: JPMorgan Chase reported preparations for huge payouts as well. Even Citi and Bank of America are poised to pay billions. Over in the UK, the same is also true in the City of London, one reason London residential property prices are rising. Bankers are poised to make tens of billions.

Meanwhile, in the real world, the unemployment rate is still rising, we are seeing record numbers of foreclosures, and households are struggling with unprecedented levels of debt. And much of this has to do with the the inability or unwillingness to lend by those same bankers, many of whom are making millions individually. Clearly, there is something wrong with this picture.

The Obama Administration, which helped orchestrate a bailout of the banking system as the first priority when it came into office, has been asleep at the wheel quite frankly. It should have been patently obvious to them that bailing out the bankers while allowing them to pay themselves billions in the middle of a depression was going to create a backlash, ruin their credibility as agents of change and sow the seeds of a Democratic Party nightmare in 2010.

Obama has wasted political capital bailing out the financial sector. This is why people were yelling socialism at town meetings when Obama wanted to pass healthcare reform – something you should see as misdirected anger which the health insurance lobby is all too willing to exploit. What’s funny is that the bailouts are not just killing Obama’s street cred; they are also poisoning the chalice on Wall Street. Big bank CEOs – to a name – spited the man by not showing up at his big financial reform speech. And bankers are not ‘happy’ with Obama for having received their bailouts as political contributions are down.

At least they are beginning to realize their mistake. They are now admitting publicly that even Goldman Sachs would not exist except for the largesse of government. Witness these comments from Larry Summers as reported by Paul Krugman on Monday.

There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.

But, what are you going to do about it?  Are you going to try to cap bonuses?  How about a windfall tax as has been proposed in Britain. This is where I say “keep your hands off Goldman’s bonuses.”

Capping pay

Is capping pay a legitimate way to run an industry?  Paul Krugman thinks so:

I was startled last week when Mr. Obama, in an interview with Bloomberg News, questioned the case for limiting financial-sector pay: “Why is it,” he asked, “that we’re going to cap executive compensation for Wall Street bankers but not Silicon Valley entrepreneurs or N.F.L. football players?”

That’s an astonishing remark — and not just because the National Football League does, in fact, have pay caps. Tech firms don’t crash the whole world’s operating system when they go bankrupt; quarterbacks who make too many risky passes don’t have to be rescued with hundred-billion-dollar bailouts. Banking is a special case — and the president is surely smart enough to know that.

All I can think is that this was another example of something we’ve seen before: Mr. Obama’s visceral reluctance to engage in anything that resembles populist rhetoric. And that’s something he needs to get over.

It’s not just that taking a populist stance on bankers’ pay is good politics — although it is: the administration has suffered more than it seems to realize from the perception that it’s giving taxpayers’ hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.

Equally important, in this case populism is good economics.

No, it’s bad economics.

Here’s an idea:

You, down the street, packing and hauling those boxes –everyone else in the city is making $27,000 for packing and hauling. You’re making $43,000. I don’t care if your company is more profitable — that’s too much. We’ll leave you a little upside but not THAT MUCH upside. Your pay is officially capped at $37,000.

Is that what you want?

You say:

Edward, it’s different with bankers. They’re just greedy. They don’t need the money for basic necessities like food, rent and utilities.

Neither do Madonna, Will Smith, or Tiger Woods. Should we cap their pay too?

You say:

Well, no. They earned the money. The bankers are greedy. Greed is not good. It is excess and it needs to be stopped. it’s just not fair.

Now, you are on to something.

The issue is the bailouts

The problem here is fairness.  What you have here is a case where bankers have received huge wads of taxpayers’ money to save them to perform their central roles in supporting economic growth as lenders and depositary institutions.

The populist take: The banks took the bailout money and, instead of lending, they went out, leveraged up, and put their casino money in proprietary trading, mergers and acquisition and broker dealer activities. Then they paid themselves record – not just large, but record – bonuses with our money.  It is theft, plain and simple.

I hope I have the sentiment about right.  I share those sentiments. 

The question again is: what should we do about it? The position that government can just arbitrarily reach into some private enterprise’s internal affairs and make individual decisions on its behalf is indefensible. That is not how capitalism should work and I am not buying into that argument.

What should have been done when Obama came to office in the first place is bankrupt organizations should have been seized and broken up, sold, recapitalized or liquidated. That is what was discussed in February as nationalization, but what I call pre-privatization. If insolvent big banks had been seized during the panic, all contractual obligations would have been rendered null and void. There would have been no $100 million payout for Andrew Hall, no billions in bonuses, nothing.  The slate would be wiped clean and the government as temporary owner (and a bankruptcy judge) could briefly decide who gets what before the assets were disposed of. And of course, all of the other problems like overcapacity, lower lending to protect weak capital bases, excessive risk taking would have disappeared as well.

But, that never happened because the Obama Administration and Congress are captured. Rahm Emanuel is famously rumored to have said ‘never waste a crisis.’ Well, guess what? Your administration just wasted a crisis. As for capture, call it kleptocracy. Call it corporate communism. Call it crony capitalism. Call it whatever you want – that ship has sailed. We never took over the banks. We never demanded a say on pay in exchange for government backstops. We gave the banks everything they wanted with no strings attached. Oh, there was the stress tests. But the stress tests were a sham right from the word go. Irrespective, the government has no legal authority to reach inside Goldman Sachs and start dictating pay any more than it has authority to do the same at your company.

What the government has the power to do is four things:

1. Break up the big banks
2. Start regulating the banking industry properly.
3. Prosecute fraud and criminality in banking.
4. Set up a proper too-big-to-fail resolution process to seize bankrupt large financial institutions.

What can you do?

1. Stay informed.
2. Speak out.
3. Show politicians you want real change.

Financial Reform Poll Memo

Related posts:

• Goldman loses $2.1 in the third quarter
• Goldman partners get margin calls
• Forget about Goldman
• Goldman and Morgan Stanley are now banks
• Obama and health care: Wasting political capital

The Irish government today announced that, if necessary, it is prepared to take majority shareholding in ailing Irish banks. However, it has ruled out full-scale nationalisation. But, what is a majority share by government except nationalisation?

This is a duplicitous parsing of words that hides a more sinister interpretation of what is happening in Ireland.

Here’s what Ireland’s Finance Minister Brian Lenihan has to say, according to the Guardian newspaper:

"Some institutions may need capital after they have transferred loans to Nama," Lenihan told a joint Irish parliamentary finance committee this afternoon. But the minister ruled out full-scale nationalisation of the country’s banks. "This will increase the state’s ownership in these banks and in some cases that may result in a majority shareholding," he said.

So, if I could paraphrase Lenihan, he is saying: we are having a temporary problem in Ireland whereby some of the weaker but systemically important institutions need more capital.  We in government are going to give them that capital to maintain the functioning of the financial system.  Technically, this makes us the majority owner, with all the rights, privileges and responsibilities ownership entails.  However, we don’t want to be bank owners and will look to reduce our stake when these firms return to a better capital position or raise more funds from private investors.

I translate this as Lenihan implying the government intends to socialize the losses of the Irish banking system despite the looming fiscal problems in the country.  In my view, this is the worst outcome of potential policy remedies and the least free-market approach.  However, there may be a silver lining in terms of a healthier banking system.

Back in March when everyone was actually talking about solutions, James Kwak categorized three dominant potential banking system solutions. I have bolded the parts I intend to stress:

I think there are three main positions in this debate:

• A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
• A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
• B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

Do you recognize these solutions? A1 is America’s dead-on-arrival PPIP program which was killed by A2, used successfully by the FDIC every Friday night, and A3, otherwise know as the bailout of too-big-to-fail institutions like Citigroup and Bank of America, neither of which has yet to return TARP money.

It sure sounds like Ireland is trying to implement solution B a.k.a. socialization of too big to fail bank losses.  The problem of course is the Iceland scenario i.e. a situation in which the government, now majority owner of several large financial institutions, cannot credibly act as guarantor for those institutions, but has implicitly or explicitly promised to do so. I don’t like the drip-drip-drip approach because it creates the zombie bank problem I just spoke of in my last post on Scandinavia.  This is the same approach taken with RBS and Lloyd’s-HBOS and in the U.S. with Citi and BofA. But, in Ireland, there is even more downside risk as there was in Iceland.

However, at a minimum, the Irish are talking about hiving off bad assets from good and trying to re-insert the cleansed financial entity into the banking system.  This is the approach Sweden took in its early 1990s bank crisis. If one is going to have government banking – and this is what is happening in Ireland no matter how you parse the words – one needs to know that the resulting private financial institutions will be healthy.  Ireland’s National Asset Management Agency gives the country a good chance of getting those healthy banks.

Related posts:

• Irish government unveils plan to recapitalise banks
• Ireland nationalizes Anglo Irish bank
• Ireland guarantees bank deposits at six banks
• Irish equities suffer largest losses in 215 years
• Is Ireland the next Iceland?

Germany never participated in the upswing of the housing bubble. This fact has led German politicians of all stripes to mistakenly believe their banking system was somehow immune to the problems infecting bubble markets like the US or Spain.  Unfortunately, it has not worked out that way because the globalization of finance has shifted risk far and wide within the global financial system. 

German banks have long had low returns on assets with bloated balance sheet and low margins in both retail and wholesale banking, particularly at the state-owned Landesbanken. This has caused the largest German financial institutions to either move into investment banking or reach for yield abroad. 

During the credit bubble years that meant loading up with higher yielding but supposedly bullet-proof AAA paper in markets like America’s residential mortgage-backed security market.  Unfortunately, many of these assets were toxic. And as these market bets have gone pear-shaped for Germany’s banks, these poorly capitalized institutions have become weak, limiting their ability to serve their traditional function domestically.

To date, there has been relatively little open debate about how sick the German banks are. Sure, HRE has been nationalized and Commerzbank has been topped up with cash.  But, the Landesbanken have become a bottomless pit, with repeated bailouts having been necessary. Government officials have threatened the Landesbanken. But little else has been done. Most German leaders – politicians, bankers and academics, have had their heads in the sand, thinking minimal recapitalization and reform efforts along with manoeuvres to fix a few bad apples would do the trick.

Have things now changed?  Read the excerpt from an FT editorial below. It was written by the president and research director of Financial Markets at DIW Berlin, the German Institute for Economic Research. I see this as a very public call for reform by high profile German finance professionals.  Let’s see what kind of response it receives.

Germany has seven independent state banks, or Landesbanken, which are jointly owned by the state governments and the savings banks. Established to provide state guarantees for regional business development, this practice was essentially outlawed by the European Commission back in 2002. Since then, Landesbanken have faced corporate governance problems. For example, the advisory boards of Landesbanken are supposed to control the top management but professional expertise plays no role in the allocation of seats. In some Landesbanken, neither the management nor the board had reliable information about their holdings of subprime mortgage products when the crisis hit.

Worse, the already doubtful sustainability of their business model – international wholesale banking – has been shattered by the financial crisis.

To compensate for their low rates of return compared to private banks of equal size, many Landesbanken before the crisis created structures to hold assets outside their balance sheets. Protected by state guarantees, they borrowed large sums of money in capital markets, which they invested in supposedly high-yielding subprime products with good credit ratings. When the products were subsequently downgraded, two state banks were forced to merge immediately. Four of the remaining seven state banks lost much of their equity and had to be bailed out by various state governments with tens of billions of euros.

This situation could get much worse: If the Landesbanken fail to clean up their balance sheets, the next decline in equity capital could prove lethal. To avert such an outcome, it is imperative to establish a “bad bank” to receive their toxic assets – and then continue the clean-up by reducing the number of Landesbanken through mergers.

The full Op-Ed is provided at the link below with recommendations and preamble lamenting a similar lack of reform-mindedness in America.

Source

No time to waste in reforming German banking – Klaus Zimmermann and Dorothea Schäfer, FT

Related posts:

• The Germans get tough with the state banks
• Are European banks sitting on 16.3 trillion in toxic assets?
• The Germans guarantee all savings deposits
• Regional banks: Zions falls
• Hypo Real Estate: 600 billion in off-balance sheet assets

This comes via the Telegraph:

UK Financial Investments (UKFI) said in its annual report that its loss on the two stakes – 70pc of RBS and 43pc of Lloyds Banking Group – had reached £10.9bn at the end of June.

The losses, which are not yet realised, have been wracked up since Gordon Brown was forced to inject billions into the troubled lenders in October.

The investment, which amounts to more than £3,000 that each UK household, will not be quickly disposed of. The recession is continuing to hit both banks hard.

“Given the size of our holdings and assuming that there might not be a strategic buyer for our stakes in these banks, we might expect to undertake several transactions in each bank’s shares, and that these will take place over a sustained period,” UKFI said.

The Treasury is hoping that the disposals of its stakes will eventually generate a profit for the taxpayer, after bailing out the banks when the system almost collapsed at the end of 2008 in the wake of the failure of Lehman Brothers.

Analysts at UBS have speculated that Lloyds could be forced to write off as much as £13bn on mortgage and commercial property lending, and lending to businesses, when it posts its results for the first half of the year on August 5.

You can forget about generating profits.  It’s not going to happen.  After all, we’re looking at another £13 billion in losses.  The UKFI should focus on mitigating losses.  That is a believable story.

Related posts:

• RBS reports a record loss of 24 billion pounds
• Lloyds gets HBOS for a song
• Lloyds has a decent first half
• British commercial property prices down 27% in 2008
• Deutsche Bank and HBOS hit by writedowns

Let’s say you’re an American named Maria living in Southern California.  The year is 2006.  You make $45,000 and your husband David makes another $40,000.  You have two children aged six and four and your two-bedroom apartment is getting too small.  So you decide to consider buying a house.  Eventually, you and your husband find a new home. Now, granted you know nothing about mortgage finance.  But, your guy at New Century Financial hooks you up and with the help of a teaser-rate adjustable rate-mortgage you are able to afford the home.  In the end, you shop around and get another bank you consider more reputable to match New Century’s terms. Sale Price $390,000.  As you have no money down and roll up some fees into the mortgage, the final mortgage price is $390,000 with a second piggy back mortgage of $10,000 for a grand total of $400,000 of debt.

Fast forward to 2009. The economy is in tatters but you and your husband have your jobs. You’re doing alright. And, as it turns out, you have picked wisely by buying the smallest house on the block in a really up-and-coming neighborhood.  The only problem is that house prices in your metro area are down 40%.  Your house, while down less, is still down 20% and is only worth $320,000. This is a big worry because your mortgage was a 3-year ARM and the rate is about to go way up.

Enter the federal government’s “Making Home Affordable” plan.  Just the other day HUD Secretary Shaun Donovan announced that mortgages owned or guaranteed by Freddie Mac and Fannie Mae can be refinanced up to – get this – 125% loan-to-value.  That means, you can take out a refinance loan on your house now valued at $320,000 for up to $400,000. Bingo!  That’s exactly what you need to keep your house.  Do you do it?

Debtor’s Prison

If you do go ahead, we might as well stick you in the King’s Bench because you are about to find yourself in debtor’s prison.  The Blog Seattle Bubble has this nailed (with some nifty charts to boot):

Let’s take a look at some hypothetical home borrowers who currently owe $400,000 in various mortgages with difficult terms or high rates, and whose home is presently worth $320,000. They jump on the new FHFA Home Affordable Refinance Program and refinance into a single 30-year fixed-rate loan at a 5.75% interest rate with a 125% loan-to-value ratio…

With the home value appreciation tweaked to a slightly less rosy scenario, it takes 17 years before our couple can break even selling their house.

Nice, huh?  Their comment on this is dead on:

If the goal of this new 125% loan-to-value program is to financially imprison people in their current homes for a decade or more, then it looks like it could be a rousing success. However, I’m not sure how many currently struggling home borrowers would really consider that to be much of a “help.”

I have a post from last year describing circumstances in Japan that are eerily similar. Take a look.  It’s called “A cautionary tale: story from 1994 Japan.”

Predatory Lending?

I have another angle too.  You’ll notice I mentioned Maria is no financial wizard.  She probably does not appreciate the intricacies of mortgage finance.  Here are two points to consider.

1. In the state of California, you can just walk away because first mortgages on primary residences are non-recourse.  That means that the mortgage is only secured against the house you have bought.
2. However, in the state of California, refinance mortgages are recourse loans.  What does that mean?  It means you are on the hook for that loan.  You cannot just walk away.  The bank can come after you and take your car and the stocks in your E-Trade account. They can garnish your wages. They can even take your clothes and the shirt off your back, literally.  The only thing they can’t touch is your 401-K.  But it’s down 40% anyway.

Why would you trade a non-recourse loan from which you can walk away for a recourse loan that guarantees you’ll end up as bad as some poor slob at Tappahannock?  It doesn’t seem like an incredibly appealing choice, does it?

But, of course, this is a classic case of asymmetric information because you don’t know that you are getting a poor trade, but your bank and the government do.  In fact, the bank makes more money this way because of incentives it receives for refinancing these loans – incentives, I  might add that come straight from the taxpayer to the bank via the Federal Government (see my post “How refinancing helps the likes of Bank of America and Wells Fargo”).

So, to recap, you get shackled to a house with a recourse loan because you don’t know what the bank and government do.  Meanwhile, your bank gets to forgo a writedown (remember, your loan was for the same amount as before).  And the bank gets a refinance fee which is goosed by government incentives.

Is this predatory lending? Sure sounds like it to me.

Related posts:

• Can I borrow the full amount and an extra 25% too?
• Nationwide brings back 125% LTV mortgages
• The fixed rate mortgage is king again
• Home Equity Lines Pulled
• UK mortgage crunch

Apparently the answer to this question is yes.  CNBC is reporting that home ‘owners’ who refinance their mortgages through loans backed by Fannie and Freddie will be able to borrow up to 125% of their homes’ value (hat tip Marshall Auerback).  That’s not a typo: we’re talking no-money down and 25% cash back.  Sign me up.

Homeowners refinancing their mortgages through loans backed by government agencies will be able to borrow up to 125 percent of their homes’ value under new regulations enacted Wednesday.

The rule changes, part of the government’s attempts to restore housing affordability and stem the foreclosure crisis, apply to loans backed up by Fannie Mae and Freddie Mac.

Previously, homeowners could borrow up to 105 percent of their home’s value. The new loan-to-value ratio is set up at 125 percent in a further effort to address those mortgage holders who owe more than their homes are worth.

"By expanding refinance eligibility, we can bring relief to more struggling homeowners more quickly,” Treasury Secretary Timothy Geithner said in a statement.

Is this sitting well with you?  Doesn’t this seem like the reckless lending which got Fannie and Freddie nationalized? Well, if you were wondering whether Obama, Geithner and Summers were trying to reflate the economy by bringing back the bubble, I don’t imagine you will find better proof.

Apropos borrowing 125%, you will recall that over a year ago I was wondering why U.K. mega-lender HBOS wasn’t writing down more assets because they were a recklessly lending – you guessed it – 125% loan-to-value.

Looking through old e-mails, I read an article from the FT in 2006 that surfaced claiming that HBOS (Halifax Bank of Scotland)were poised and ready to go offer loans for 125% of value. That’s right, HBOS thought it a good idea to cover 95% of the house price and loan another 30% over appraised value unsecured as a personal loan.

Now that the UK has joined the housing bust, one must ask where are the massive writedowns that have to be sitting on HBOS’ books? Why aren’t they looking to do another rights issue like RBS? I fully expect some pretty horrific things coming from HBOS as the housing crisis heats up in Britain.

We know what happened there: HBOS would have gone bust after Lehman had Gordon Brown not foisted it upon Lloyds. And Lloyds was a bank that subsequently was almost fully nationalized despite having a relatively clean balance sheet – all because of its merger with HBOS and HBOS’ reckless lending.

Now that the U.S. government is underwriting similar policies on this side of the pond, shouldn’t we expect things to go seriously pear-shaped here too?

Addendum: just in case it isn’t clear, this measure is intended to keep banks from taking writedowns.  A homeowner now 20% underwater can borrow the full amount of the original loan even though the house is worth 20% less than that amount.  The home ‘owner’ stays in the house.  The bank gets its regular payments (and a nice re-financing fee to goose earnings in Q3).  And no one defaults. It’s all good, right?

Second addendum: Yves Smith, who also got the same e-mail, notes “in most states, a purchase money mortgage is non-recourse, but a refi is. So some borrowers will put themselves in worse shape it they take up this offer.”  Check out her post here.

Related posts:

• HBOS versus Freddie and Fannie
• Treasury Considers Plan to Halt Home Price Slide
• Where’s HBOS?
• Consumer loan delinquencies paint bleak picture
• Is the new affordable FHFA loan program predatory lending?

Kyle, a long-time reader, recently asked why I think mark-to-market accounting actually matters.  After alI, savvy investors know that accounting does not necessarily change cash flows.  I think his question has a lot to do with not just accounting, but also with the stress tests.

Kyle writes:

My point is that it has really NOT changed, and people are trying to make it seem like it did. To be honest, I’m glad most people do feel that way, because it means those idiots in Congress will hopefully leave well alone. The capital raising that just occurred due to stress test mumbo jumbo has no connection to FSP 157-4. It is a requirement of GAAP to disclose when an accounting change has affected reporting, in order to explain the change. Out of the probably fifty different financial institution 10-Q’s that I’ve looked at, only one, Wells Fargo, indicated that 157-4 had a material impact on their reporting, which it did to the tune of 4B. The other 49 explicitly state, “157-4 had no material impact on our reporting, and we do not expect it to in the future.” It’s in the notes for anyone to read. I just do not understand how an accounting change which explicitly has had no impact on reporting (this is the ultimate point I am trying to make, the rule change was and has been almost completely meaningless), could lead to changes in whether or not a bank is undercapitalized.

Here is my thinking on that issue. I understand what Kyle is saying: FAS 157 guidelines will have no impact on reported earnings. I think it will and that this will alter behaviour. Wells and the Home Loan banks are just two early uses of the 157-4 alterations. Others may follow.

But more important is the affect on future writedowns.  A bank only has to attribute its actions to 157-4 if it is amending prior accounting to reflect a change in asset designation to ‘holding to maturity.’ However, if it marks assets today as ‘holding to maturity’ and then is later forced to write down those assets, these writedowns will not be attributed to changes in the FAS 157 guidelines. So, anticipated future writedowns that would have gone through the income statement from marking to market will now be accounted for as held to maturity. This means the guidelines are affecting accounting and causing the company to report differently. In short: future writedowns for 2009 will be less because of FAS 157.

In my view, it is future credit card, jumbo loan and CRE exposure which will be most affected by this. These are areas where you should expect heavy pressure from securitized assets on bank balance sheets due to deterioration in income from credit card receivables,prime mortgage loans, and commercial real estate loans. What mark-to-market guidelines effectively mean is that banks will not have to reduce capital by nearly as much as had they not marked these assets as hold to maturity.

That is where the stress tests come into play. The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to be in regards to nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution.  Notice that bondholders did not lose any money here.

So, the stress tests and the capital raising exercise have revealed that no one is going to be nationalized unless they can’t come up with the capital.  But since even Citi and Bank of America have been raising capital, few big banks are going to be seized.  You probably saw Huntington (HBAN) and Fifth Third (FITB) coming to market and their shares coming under pressure as a result. But, HBAN said it was going to repurchase $470 million in preferreds immediately after it raised the common equity capital.  Why?  Tangible Common Equity.  This is the measure by which the stress tests are being conducted.  Preferred shares don’t count, so why not issue common and retire preferreds in order to boost your TCE? Remember, pass the stress test and you’re good to go.  Fail and Sheila Bair plays the Grim Reaper on you, your management team, and your shareholders.

My conclusion from all of this building from March on was that bank shares would pop and I said so in April.  Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital.  However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again.  Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention.  This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• At least six banks need more capital under stress tests
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Black: Stress tests and the Big Lie

Bloomberg has the goods on Fannie and they’re not good. Fannie’s regulator wants $19 billion from the U.S. government because the firm has negative capital. Fannie Mae had $23.2 billion in losses last quarter alone. And it says losses in 2009 will be worse than 2008.  Nice.

Here’s the money quote: “Fannie says it does not see itself operating profitably for the foreseeable future.”

Video below.

Related article

Fannie Mae to Tap $19 Billion in Treasury Capital – Bloomberg

Related posts:

• Fannie and Freddie need $75 billion
• CDS Market: Did Fannie and Freddie Default?
• Everyone’s talking about Fannie and Freddie
• Fannie reports $171 billion in non-performing loans
• Gateway Financial and Midwest Banc have one-third of capital in Fannie and Freddie Preferreds

The first bank nationalization in German history is about to take place. At issue is Hypo Real Estate (HRE), a troubled Munich-based company that lends to commercial property developers and to build offices, hotels, roads, airports, you name it.

This issue has been building for nearly 7 months. Back in late September, just after Lehman went under, the Germany government was forced to bail HRE out as it ran into funding problems at its Irish subsidiary, Depfa. Since then, the situation at HRE has gotten considerably worse. Cognizant that it had a Lehman situation on its hands, the German government went so far as to change the laws to allow it to nationalize HRE. This is about to happen.

The Financial Times writes:

The government has given HRE shareholders until May 4 to accept the offer. As of Thursday more than 7.5 per cent of HRE shares had been tendered, giving the government control of 16.2 per cent of the company. It already held a stake of more than 8.6 per cent after a small capital increase last month.

At the end of the offer period the government hopes it will control enough HRE votes to force through a much larger capital increase at a shareholder meeting. It could eventually use “squeeze-out” rules to force out JC Flowers and other remaining minority shareholders.

If this does not work – as it may not, if enough shareholders reject the tender offer – a recently passed law will allow expropriation of HRE shares. It would be the first nationalisation of a German bank since the 1930s.

Expropriation would be compensated but the government has warned this is likely to be at a lower price than that proposed in the tender offer.

The US firm hinted at a legal challenge to try to stave off expropriation, pointing to expert opinions that “indicated considerable reservations” about the expropriation law and another piece of legislation approved last month. “JC Flowers is reviewing, in the interest of its investors, all options,” the firm said.

Some JC Flowers investors, holding less than 1 per cent of HRE shares, will accept the government’s offer.

I have written a number of posts about the situation at HRE:

• European banking collapse including nationalisation of three banks – 29 Sep 2008
• Germany: banking system collapse possible due to Hypo Real Estate – 4 Oct 2008
• The Germans guarantee all savings deposits – 5 Oct 2008
• The German $400 billion toxic asset time bomb – 17 Jan 2009
• Hypo Real Estate: 600 billion in off-balance sheet assets – 20 Feb 2009
• More problems at three European financial institutions – 29 Mar 2009
• German banks loaded with 816 billion in toxic paper – 26 Apr 2009

I have been following this story closely because I used to work for the predecessor bank of HRE. In the mid-1990s, I worked at a consulting company in Munich under the now head of HVB Group in a project to re-engineer HRE predecessor Bayerische Vereinsbank’s credit processes. My boss, an extremely decent man, later moved on to Goldman Sachs and then over to HVB as their CEO.

I mention this because I see HRE’s problems as linked to its predecessor organizations and the culture of risk that developed after the Berlin Wall fell. Obviously, this is just my view given that I in no way have worked for HRE.

Here’s my understanding of the matter. Bayerische Vereinsbank and Bayerische Hypothekenbank both ran into trouble due to ‘Verspekulierungen (bad speculation)’ in the period immediately after German re-unification. Vereinsbank and Hypobank were front and center in the speculative property bubble that developed in the former East Germany after the Wall fell. This was one reason my consulting firm was working at Vereinsbank.

In 1996, Hypobank revealed huge losses in eastern Germany even though the Board of Directors had been aware of the problem since early 1994 (does this sound familiar).  In fact, fraud was a factor at Hypobank.

Vereinsbank had their own problems.  So, subsequently, in 1998, those two organizations came together as Hypo Vereinsbank (later HVB Group) in a merger of necessity despite being bitter crosstown rivals. They are the largest banks in Bavaria with a long crosstown rivalry and history dating back to 1780 at Hypobank and 1869 at Vereinsbank.  The deal was touted as a Munich counterweight to the big three German banks Deutsche Bank, Dresdner Bank and Commerzbank, all based in Frankfurt.

Unfortunately, they were forced to write off 3.5 billion that same year because of Hypo’s eastern German speculation. (Later in 2005, 7 years later, bad bets on the Vereinsbank side were uncovered as well costing the bank 2.5 billion).

Fast forward to 2003 and HVB spins off HRE before HVB itself gets taken over by Unicredito two years later. Now, I haven’t been integrally involved with HVB or HRE since, but again the history of risk taking is there.  And I should mention that HVB and Unicredito are problem children with huge exposure to Eastern Europe.

By 2007, HRE was a force to be reckoned with and they looked to increase in size. They bought Depfa at the top of the market in a deal not unlike the Golden West Financial deal that Wachovia did in 2006.

Now Depfa, which caused HRE’s near collapse in October, is not an Irish company at all. It is in Ireland merely as a tax dodge (another example of how the Irish are massively and unwisely leveraged to the financial services industry). In reality, Depfa is a German institution, the Deutsche Pfandbrief  Bank. (As an aside, back in 2008, Hank Paulson talked a lot about Pfandbriefs as a panacea for the U.S. mortgage market.  I have two posts on that from last summer here and here).

So Depfa was lending long and borrowing short. When Lehman collapsed it ran into liquidity problems, so a consortium of German bank creditors struck a deal to bail out HRE and its subsidiary.  But, this deal collapsed and the German government was forced to step in.

In reality, HRE was a ticking time bomb and this is the reason it had run into liquidity problems (By the way, this is much the way I see Northern Rock – which was also nationalized by the UK government).  The company has massive commercial property (CRE) exposure and the CRE market is imploding in financial centers like Frankfurt, London and Dublin and elsewhere.   HRE is highly leveraged to these places.

HRE is also systemically important because it has a huge loan book in commercial property in Germany, Ireland and in Europe more generally. It also has a lot of off-balance sheet exposure a la Citigroup. Its failure would cause great distress to the market it operates in.

Moreover, it has counterparties and lenders. So, its demise would adversely impact those institutions. I don’t have a list of those lenders in front of me but the consortium banks which failed to bail it out in October are the biggest ones. I’m sure it’s a list of who’s who in German finance.

What has the press left out in all of this? Dunno. I would say the bailout is similar to what we are seeing with systemically important institutions in every single Western country (Fortis in the Benelux, RBS in the UK, Citigroup in the US).  In short, a property bubble and massive bust has meant that the most imprudent lenders now face ruin. Unfortunately, the web of actors in our financial system is so intricate and the imprudent lenders so large that governments are loathe to allow them to simply collapse. The demise of Lehman Brothers has sent a signal that this raises a very real spectre of Financial Armageddon.

Come May 5th, a large part of this problem will be solved for the Germans.  The only German non-state bank left with massive exposure is Commerzbank, and its day is coming too.

Sources
JC Flowers rejects Berlin’s offer for HRE – FT.com
HRE: Die erste Enteignung in Deutschland – Handelsblatt
HypoVereinsbank – Wikipedia (German)
HypoVereinsbank – Gourt (German)
Depfa Bank – Wikipedia (German)

Related posts:

• The German $400 billion toxic asset time bomb
• Commerzbank gobbles up Dresdner
• Germany: banking system collapse possible due to Hypo Real Estate
• German banks loaded with 816 billion in toxic paper
• Hypo Real Estate need for 10 billion also reveals huge problems in Spain

This weekend has seen two major European financial institutions forced into the hands of government and a third on the verge of major new asset writedowns and job cuts. The events highlight the fragility of European banking and the need for concrete solutions at the upcoming G-20 summit in London.

First, in the UK, you may have seen a link in our news feed yesterday to reports of the demise of Dunfermline Building Society in Prime Minister Gordon Brown’s constituency.

Savers in the Dunfermline Building Society, Scotland’s largest customer-owned mortgage lender, will have their deposits protected by the U.K. government as it seeks to broker a sale of the company in the coming days, Prime Minister Gordon Brown said.

“Savers will be protected,” Brown said today at a press conference in Vina del Mar, Chile, where he was on an official visit. “It is important to recognize that throughout this whole crisis anyone who has saved has been protected. Our determination has been to ensure people’s savings are even safe in years to come.”

The government is seeking to arrange a merger or takeover of Dunfermline, a U.K. Treasury official said today. Authorities are looking for a “long-term solution,” said the official, who can’t be identified in line with departmental policy.

The government’s rescue of Bradford & Bingley Plc, an English mortgage lender, may be an example for Dunfermline, Scottish Secretary Jim Murphy told British Broadcasting Corp. radio today. Bradford & Bingley was nationalized in September as the global financial crisis worsened. The bank’s branches and deposits were purchased by Banco Santander SA, and the U.K. Treasury took over 41 billion pounds of mortgage loans.

The U.K. government has looked at “every possible option”, but “no other option was possible,” Murphy said of Dunfermline.

In the current financial crisis, the British government already has bailed out Royal Bank of Scotland Group Plc and Lloyds Banking Group and nationalized mortgage lender Northern Rock.

Scotland’s First Minister Alex Salmond said in a statement he was “deeply disappointed that the Treasury now believe it isn’t possible to sustain the society as an independent institution.”

Dunfermline employs almost 500 people, half at its headquarters in Fife and half in its network of 34 branches, the BBC said.

The company, which is based next to Prime Minister Brown’s parliamentary district, has been hit by losses on commercial real-estate loans.

This past December, I indicated that the U.K. and Ireland would see major domestic residential mortgage-related downturns and this looks to be occurring.

Meanwhile, in Germany, Hypo Real Estate (HRE), the mortgage lender which threatened to take down the entire German banking system last year, is in the news again. The company is haemorrhaging losses, having reported another 5.5 billion euro loss. Recently, the Germans changed their nationalization laws with the express purpose of taking over HRE. This now seems imminent.

Hypo Real Estate Holding AG, the bailed out German commercial real-estate lender, said it posted a wider-than-expected loss of 5.46 billion euros ($7.3 billion) last year and that the government will take an 8.7 percent stake as a first step toward nationalization.

Hypo Real Estate had a pretax loss of 5.38 billion euros compared with a pretax profit of 862 million euros in 2007, it said in a statement today. Four analysts in a Bloomberg survey had expected a net loss of 4.5 billion euros.

Germany’s bank rescue fund, Soffin, will acquire 20 million shares valued at 60 million euros, the company said in a separate statement. The new stock must be issued at a “minimum prescribed” price of 3 euros a share.

Hypo Real Estate, which lost 93 percent of its market value over the last 12 months, has already been bailed out by the government and financial institutions with credit lines and debt guarantees totalling 102 billion euros. The lender, which almost went bankrupt after its Dublin-based Depfa Bank Plc unit failed to get short-term funding in September, said today it expects to remain in a “loss situation” for at least two years.

“It is a prerequisite for the intended recapitalization of Hypo Real Estate Group by Soffin that either Soffin or the German government gain full control over Hypo Real Estate Holding,” the Hypo Real statement said. “To this end, it is intended to make use of the options that will be provided by the German Financial Markets Stabilization Amendment Act, which is currently being discussed in the legislative process.”

Nationalization Law

Hypo Real fell 1.7 percent to 1.14 euros a share yesterday in German trading, valuing the company at 240.6 million euros.

J. Christopher Flowers and Richard S. Mully, who lead a group of investors that together owns 23.7 percent in Hypo Real Estate, said on yesterday they were leaving the lender’s supervisory board because of “possible measures to be taken by the German government against Hypo Real Estate shareholders.”

Germany’s upper house, the Bundesrat, will be asked to approve the Hypo Real Estate seizure legislation when it comes before them on April 3, following its passage by the lower house on March 20. The law also imposes a time limit, stipulating that any seizure has to be initiated by the end of June.

The lender’s nationalization would be the first of a German bank since the 1930s.

The third European institution in trouble is a familiar one, UBS, the Swiss giant. Reports are emerging that they are poised to take writedowns, this time on their CLO (Credit Linked Obligations) portfolio. The Swiss are in a bit of a pickle because UBS is too big to bail, but remains systemically weak.

Switzerland’s UBS is expected to announce more writedowns and job cuts in the coming days, Swiss newspaper Sonntag reported on Sunday.

Shares in UBS, the world’s largest wealth manager in terms of assets, fell 7 percent on Friday as rumors swirled of a profit warning and more writedowns in the first quarter. The bank, one of Europe’s hardest-hit in the crisis, has already written down more than $49 billion since mid-2007.

Sonntag said UBS would write down at least another $2 billion on illiquid assets, including asset categories so far not much in the spotlight such as Credit Linked Obligations (CLOs), the paper said citing people familiar with the matter.

The Swiss bank giant would also slash another 8,000 jobs, the newspaper said, including some private banking staff.

You should note that NONE of these troubles have much to do with Eastern Europe, revealing that Western European banking has problems all of its own. With the G-20 in London coming up, these revelations make it that much more imperative that the Europeans step up and help deliver a multilateral solution to this mess.

Billionaire investor Gorge Soros has said the G20 summit will be a “make or break” event for the world’s economy.

In a BBC interview, Mr Soros said the international financial system had collapsed because it was flawed and it had to be restructured.

Mr Soros say it may be the last chance to prevent a full-scale depression.
He said the G20 meeting had to come up with concrete solutions to help the developing world in particular, which had been been worst hit.

‘Depression’

Mr Soros warned that any attempt to pull economies out of recession had to be done co-operatively.

He said: “The G20 meeting is make or break because unless they do something for developing world there will be serious collapse in that part of the world.

Don’t hold your breath.

Sources
U.K. Government to Protect Dunfermline Customers – Bloomberg.com
Hypo Has EU5.46 Billion Loss; Germany Buys Stake – Bloomberg.com
Fresh writedowns, more job cuts seen at UBS: report – Reuters
G20 ‘make or break’, Soros says – BBC News

Related posts:

• Hypo Real Estate need for 10 billion also reveals huge problems in Spain
• The German $400 billion toxic asset time bomb
• Hypo Real Estate: 600 billion in off-balance sheet assets
• Germany: banking system collapse possible due to Hypo Real Estate
• Is this Austrian real estate company a canary in the coalmine?

This video from yesterday’s Council on Foreign Relations symposium gives Treasury Seretary Tim Geithner a chance to explain why he has constructed his bailout plan in the way he has. Rather than editorialize the video, I will provide it without comment.  I do suggest you watch it if you want to develop a well-informed view on his bailout package.

Just after the 23 minute mark, they open it up to questions, the first one being how Geithner sees the liquidity versus solvency issue. The second questions is equally interesting: are we socializing risk and privatizing profit here?

Related posts:

• Tim Geithner defends bailout plan on “Meet the Press”
• Video: Geithner calls for single agency to oversee systemic risks
• Geithner testifies before Congress on financial reform
• Statements on Capitol Hill by Geithner and Warren
• World Economic Forum: Experts voice their views on the economy

Here we are just days out from the announcement by Treasury Secretary Tim Geithner that the Obama Administration will be buying up so-called toxic assets as originally planned by Henry Paulson during the Bush Administration.  The initial reaction has been one of euphoria as most asset markets responded positively to the news.

Now that the dust has settled somewhat, another reaction is taking place behind the scenes and it looks an awful lot like banks — specifically Citigroup and Bank of America — are gaming the system (hat tip Yves, Tom and Barry).  Note my highlighting:

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation’s largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post.

Both Citi and BofA each have received $45 billion in federal rescue cash meant to help prop up the economy and jumpstart the housing market.

But the banks’ purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

One Wall Street trader told The Post that what’s been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds.

Yields on such securities can be as high as 22 percent, one trader noted.

BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market.

“Our purchases in [mortgage-backed securities] increase liquidity in the mortgage market allowing people to buy a home,” said BofA spokesman Scott Silvestri.

A Citi spokesman declined to comment, though people familiar with the bank say it argues the same point.

You can read the rest of the Post article to see the full details. Of course, I am sceptical here. But, for the sake of argument, let’s assume Citi and BofA are telling us the truth as to their true motivations.

One must still ask the question: why are BofA and Citi, two of the weaker large banks in the U.S., aggressively buying up the same toxic assets which have already caused them huge writedowns? Here’s another one for you: if Citi and BofA are so bullish on these Mortgage-backed securities, why weren’t they buying them aggressively two weeks ago or last month? What’s changed between then and now?

I’ll tell you what has changed: the Geithner Plan. See, the U.S. government has pledged to purchase these toxic assets from banks like Bank of America and Citigroup. That means Citi and BofA know full well that they aren’t going to be holding these assets for long. So why are they buying? A couple of reasons:

1. The Geithner Plan effectively pledges to insure the purchases of these assets against downside risk.  This implicit put option means the sale price will be higher than a free-market transaction.  In essence, this is a transfer of money from taxpayers to both the selling and investing organizations.  Therefore, it behooves sellers to sell more assets.
2. The auction process is non-binding meaning the selling organizations do not have to sell if they don’t like the price offered.  In effect, this means the sellers have yet another option: the right but not the obligation to sell at a specific price.  This is the definition of a put option.  That means sellers are going to transact only if the sale does not force them to writedown the assets too much. Of course, they have received this option free of charge.  

Now, if you were Citi or BofA, wouldn’t you be looking to get the most out of this process as well? Their actions are wholly predictable. Nevertheless, their actions demonstrate the problems with this plan i.e. that we are about to see a massive transfer of money from taxpayers to banks. The interesting thing about all of this is that most Americans won’t necessarily know that these implicit options are embedded in the transaction structure unless they are familiar with derivatives.

My take on this is similar to Barry’s: Citi and BofA’s actions demonstrate yet again why the government must take control of the organization and get rid of existing management. Neither the Bush Administration nor the Obama Administration has been willing to do so.

For more on embedded options in the Geithner plan see Steve Waldman’s piece, Degrees of recourse.

UPDATE 1150AM ET: The Economist has this to say:

These assets can’t be comparable to ones for which the Geithner plan is designed, because that plan is designed for assets for which no secondary market exists. If a secondary market does exist, then presumably there’s no need to discover prices—we can just look at them—and there’s no question about which banks are solvent. I don’t see how Bank of America can go out and by a bunch of MBS on the market, then turn around and auction them based on the idea that they don’t know what they’re worth.

Right? What am I missing?

Source
Citi, BofA buying back laundered loans at lower rates – NY Post

Related posts:

• Roubini: Nationalization “fully on the table” in Geithner’s Plan
• Is Citi being forced to downsize by Obama?
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• S&P downgrades BofA
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

This is yet another semi-positive post about the Geithner plan. To reiterate, I think the plan is inadequate because it assumes illiquidity instead of insolvency and is a huge gift to the financial sector. But, that does not mean it will definitely not work in conjunction with other moves by Obama.

In fact, to the degree the Obama Administration has Plan B up its sleeve, bankruptcy/pre-privatization is still an option here (Remember, they did speak to the Swedes recently about their 1990s resolution).

Nouriel Roubini agrees with this assessment as quoted by the New York Times.

Mr. Roubini believes that the Treasury’s plan does not preclude nationalization at all. Rather, he said, it will help to clear the way to full government takeover of some troubled institutions.

“I see the option of nationalization” and the one presented by the Obama administration “as being complementary,” Mr. Roubini said. He believes that the stress tests the government plans on conducting on the banks will reveal which are solvent and which are insolvent.

In his view, those banks that are deemed insolvent will not participate in the toxic-asset plan and will be taken over by the government. Banks deemed solvent will be the ones that get to participate.

Nationalization “is fully on the table for banks that are insolvent,” Mr. Roubini said.

Do I like the plan? No. I don’t even like the way the stress tests will be conducted. Is the plan fair to ordinary Americans? No.

Will it work? I have my doubts, but it could do. But, then again, there is always Plan B later.

Source
Dr. Doom Finds Promise in Obama’s Toxic-Asset Plan – NY Times

Related posts:

• America needs a pre-privatization plan
• Are Citi and BofA gaming the Geithner Plan already?
• The Obama-Geithner Plan will fail
• Nouriel Roubini: Bloomberg Interview on Banking Crisis Plan
• GMAC has been nationalized

You may have seen Ed’s post “Gillian Tett: Washington is talking to Swedes about banking crisis solutions” a week back about how the U.S. government was getting ready to talk to Swedish officials regarding the banking crisis. This is a very important development and I have a lot more to provide below on the issue as it pertains to today’s events and Japan’s crisis early this decade.

Bo Lundgren, one of the original architects of Sweden’s successful banking bailout program, went to Tokyo in 2001 (I wrote about it in “Prudent Bear”) and a lot of his ideas were subsequently adopted by Heizo Takenaka, Japan’s Economics Minister in Prime Minister Junichiro Koizumi’s administration.

It is also worth noting that Sweden only nationalised two banks, so the key challenge is minimising the contagion effect (i.e. if you take over Citi and BofA, how can you spare JP Morgan or Wells Fargo?).

But one of the key aspects of the Swedish plan which helped it gain widespread public acceptance was the notion of SHARED SACRIFICE. This gave the nationalisation tremendous public legitimacy. Geithner’s plan looks like it is being directed by Wall Street and in TALF you give them a huge political weapon — i.e., we don’t partner with you if you continue to adopt measures we don’t like.

US calls on Sweden’s “Mr Fix It” Bo Lundgren

The Swedish financial chief known as “Mr Fix It” has been summoned to Washington to advise on how Sweden’s model might avert a global banking meltdown.

Bo Lundgren, the steely-eyed head of Sweden’s National Debt office, played a leading role in averting the collapse of the Swedish banking sector when a property bubble burst in the early 1990s.

Sitting in his office in downtown Stockholm before his trip to Washington, Mr Lundgren chuckled at the Wall Street joke that “Swedish models used to only attract attention if they were blonde and leggy”.

Now, US President Barack Obama cites Sweden as a possible model of how best to tackle failing banks. Mr Lundgren, who was fiscal and financial affairs minister at the time of the last crisis, yesterday outlined the Swedish solution to the Congressional Oversight Panel, which supervises the US administration’s troubled asset relief programme.

“I am a market liberal. I was even called the nearest Sweden had every come to having a party one could call libertarian,” said Mr Lundgren, the former head of the Moderate Party with links to the Conservatives.

This did not stop him nationalising two failing major banks in 1992: the already majority state-owned Nordbanken, and the privately owned Gota bank.

“In the case of a crisis, the state needs to be strong,” he said. “If it decides to act, it should become an owner.”

After initial hesitation, when the Swedes chose to act they soon reached a broad political consensus.

The first, and in his eyes crucial step Mr Lundgren took was to restore liquidity by issuing a so-called “blanket guarantee” for all non-equity claims on Swedish banks.

This was vital to restore confidence, he said, and is something that has not been done in the US and UK.

It was also crucial not to put a figure on the guarantee, according to Stefan Ingves, the governor of the Riksbank, Sweden’s central bank. Mr Ingves was a finance ministry official in the early 1990s and led the Bank Support Authority, created to resolve the crisis.

“If you pick a very low figure, people will say: ‘That’s not credible, we think the problem’s bigger than that.’ If you pick a very high figure, then people say: ‘Oh gosh, is it that big a problem?’,” he said.

The government did not extend its credit guarantee to shareholders of the nationalised banks, who were wiped out.

In the UK, the Royal Bank of Scotland has refused to go this far, but the Swedes insist this acts as a wake-up call to shareholders of troubled but still solvent banks to shape up or ship out. This decision spurred two private banks to raise private capital.

A “stress test” was worked out to determine how bad the problems were in each bank for the coming three years.

Banks were then ranked as healthy or as candidates for nationalisation, and those in between were told to clean up their act or face being taken over by the state.

Next, the toxic assets of the nationalised banks were ring-fenced into two separate bad banks and run by independent asset-management companies. The good assets were placed in a single, merged bank.

As central banks and supervisors “don’t do corporate restructuring”, the Swedish authorities decided to bring in investment bankers from the private sector to run the corporate finance side of the bad banks’ assets. “Huge numbers” of bankers and auditors were flown in from London to do the “daily running of these businesses,” said Mr Ingves.

Private banks were also urged to place their non-performing loans in separate bad banks. However, unlike what has been mooted in the US, there was never any question of the authorities buying bad assets from banks that remained in any way privatised. “We refused to do that because we could never agree on the price. If you pay too much it’s a giveaway to the shareholders. If you pay very little then the transaction simply won’t happen,” said Mr Ingves.

Despite calling it a “political value judgment”, it is clear he disapproves of countries such as Britain and the US who have committed huge sums to insure bad assets of private or part-private banks.

Once split, the two Swedish bad banks managed to liquidate their assets by 1997 and the state recouped at least half the funds it had made available.

While the process worked back then, the two Swedes recognised that the 1990s crisis, essentially home-grown and involving half a dozen national banks, was very different from the current global meltdown, involving far more banks and complex “packaged and repackaged” assets. Still, the solution remains the same, said Mr Ingves, even if far more co-ordination is today required.

“Clearly, one of the lessons that comes out of all this is that in Europe, the financial integration between countries ran way ahead of the EU’s willingness to have a regulatory framework following at the same pace,” said Mr Ingves.

The Swedes also expressed concern that other countries’ handling of this crisis was still too piecemeal.

“In the US, certainly early on, there was no consistent policy over capital injection and bad assets. Now it’s better but there are still too many loose ends,” he said.

“To restore confidence you have to show exactly how big the problems are and how you are going to take care of that.”

Here’s what I had to say on this very topic in 2002 in Prudent Bear as it relates to Japan’s own struggles:

Two Visitors to Tokyo
03/26/02

“Government intervention is unavoidable if non-performing loans and bank loans are mounting in an economy…In order to limit moral hazard problems and to secure public support…it is important to enforce the principle that losses are to be covered in the first place with the capital provided by the shareholders. If that means the banks must be nationalized, so be it.” – Bo Lundgren, former Swedish Minister for Fiscal and Financial Affairs

In addition to President Bush, there have been two other important foreign visitors to Japan in the past month: the leader of Sweden’s parliamentary opposition, Bo Lundgren, and chairman of the executive committee of Citigroup, Robert Rubin. During their time in Tokyo, both men commented on the state of the country’s financial crisis, the gravity of which is being debated yet again in light of the recent strong rise in the Japanese stock market. Needless to say, the visit of the former US Treasury Secretary occasioned much more coverage and corresponding press commentary, but it was Mr. Lundgren, in his discussions of Sweden’s own banking crisis and its unstated implications for Japan, who ultimately imparted far greater wisdom to his hosts.

Reading Mr. Lundgren’s recent speech on the so-called Swedish Solution (delivered at Tokyo’s Swedish Embassy), one is struck by the government’s sheer decisiveness to overcome its problems that struck in the early 1990s. The Swedish financial crisis was entirely resolved within 6 years at minimal cost to the taxpayer, at which point the Japanese authorities were still debating the question as to whether public money was actually required for their ailing banks. In the words of HSBC Securities banking analyst Brian Waterhouse, “The Swedes have finished the ‘race’ and have dealt with their banking crisis; the Japanese are still stuck in the starting gate”. The huge costs of Tokyo’s inactivity are increasingly apparent to many outside observers. The inevitable policy response, which is coming closer in time as crisis conditions intensify, will likely be widespread bank nationalization, a collapse in the value of the yen, and the onset of a rapid rise in inflation.

This might seem an unduly alarmist viewpoint now that Tokyo’s bureaucrats have successfully engineered another year-end ramp of the Japanese stock market over the past month and familiar talk of recovery is in the air. But as appears to be always the case in Japan, the country’s politicians and bureaucrats have yet again wasted valuable time and resources on eradicating the symptoms, rather than the underlying disease of deflation, of which the inexorable rise of non-performing loans in the commercial banking system is the most visible manifestation. The rally in Japanese bank shares has merely deferred the day of reckoning as well as engendering complacency yet again amongst the country’s policy makers. Hence, the respective insights of Messrs. Rubin and Lundgren take on added significance.

First Mr. Rubin. He told Japanese Prime Minster Junichiro Koizumi that the central bank should set an inflation target as a means of alleviating the deflationary pressures current afflicting the banks real estate portfolios and, indeed, the economy as a whole. The case for inflation targeting is certainly not new. Paul Krugman urged this course of action in 1998 when he proposed that the Bank of Japan opt for a policy of controlled inflation. Krugman’s argument for a controlled inflation for Japan arises out of his application of a model that does not incorporate private debts and debt related behavior. To our mind, this would seem to miss the basic issue that most realize is paramount in the current Japanese crisis. Nonetheless, Krugman’s argument has merit and his policy prescription has since been echoed by other commentators.

Economist Andrew Smithers has argued for an eventual inflation in Japan for, in our opinion, the right reasons: namely, that the change from price deflation to price inflation would lead to a consequent reduction in private indebtedness in real terms that would allow for a recovery of domestic demand, the weakness of which is the root cause of Japan’s current economic woes. Whether one accepts the Smithers or Krugman framework, Rubin’s reiteration of this advice is a most surprising departure for a figure who prominently advocated Western style restructuring as the optimal means of turning around the moribund Japanese economy during his time as US Treasury Secretary. Indeed as Treasury Secretary, Rubin publicly warned Japan against pursuing a devaluation policy in the pursuit of economic recovery.

Yet as Japan’s deflationary pressures have intensified, even Mr. Rubin appears to have undergone a Damascene type of conversion on this issue. But the fact remains that an inevitable consequence of establishing a positive inflation target as Rubin now advocates means substantially higher rates of monetary growth and a correspondingly weaker yen. Whether he realises it or not, the former Treasury Secretary’s advice invariably leads back to the export led growth strategy for Japan that he once repudiated.

It is also difficult to speak any longer of a policy of “controlled inflation” that would lead to a gradual decline in the value of the yen. When Krugman and Smithers first began urging this course of action on Japan’s monetary authorities years ago, the deflationary pressures were not quite as severe and the non-performing loans in the banking system had not exploded to the degree they have more recently. Such has been the cost of inactivity amongst Tokyo’s policymakers, however, that far more aggressive and unorthodox measures are needed today than would have been the case some 5-6 years ago when the calls for an explicit inflation target were first publicly made.

What are the consequences of Japan’s wasted decade? If private sector (as opposed to government) estimates of the extent of the bad debt problem in the banking system are correct (anywhere from 25-70 per cent of GDP), then the scale of money now required to nationalize the banks will almost certainly entail huge additional monetary stimulus. The likely aftermath therefore will not be a yen/dollar rate of 135-140, but something closer to 200 yen to the dollar, or possibly higher. Such has been the consequences of a decade of inactivity in Japan that (in the words of AIG economist Bernard Connolly): “– there is no happy medium in Japan, we fear, between deflation and very rapid inflation, and that in turn, we think, means that a yen collapse and very rapid inflation are all but inevitable and are coming much closer in time.”

In light of Japan’s abysmal record on economic policy making over the last decade, it seems ludicrous to analyse the potential consequences of a “successful” inflation targeting strategy. But were the Japanese monetary authorities able to weaken the yen and enable inflation to develop, it would almost certainly be accompanied by a sharp fall in JGBs.

This creates two interrelated problems: The Japanese banking system, which by virtue of its high proportion of non-performing loans, is unable or unwilling to act as a financial intermediary borrowing short from the central bank and lending to Japan’s private sector. Instead, Japan’s banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up a small additional 15 or 20 basis points of yield on those government notes. This is virtually their only source of profitability right now.

In this process, Japan’s banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks. As the banks are already heavily exposed to a weak bond market, a weak yen will consequently add to their disinclination to buy more, thereby complicating the BOJ’s efforts to reflate, since bond buying on the part of the banks is essential to keep the money supply from contracting. In the absence of huge increased purchases by the Japanese central bank, the resultant losses stemming from a rout in the bond market will also put the commercial banking system one step closer to insolvency. Hence, we come back to the question of bank nationalization, since a crash in the market value of the banks’ JGB portfolio would in effect merely represent an immaterial accounting transfer within the government were the banks nationalized, rather than another huge private sector loss that would intensify existing deflationary pressures in the absence of public ownership.

The recent visit to Tokyo of Bo Lundgren, currently Sweden’s parliamentary opposition and a former minister for fiscal and financial affairs is highly significant in this regard. Lundgren was a central figure in helping to resolve successfully Sweden’s own banking crisis in the early 1990s. Unfortunately, for the Japanese, while the Swedish solution does provide a blueprint, Lundgren’s analysis also serves to highlight Tokyo’s own remarkable delinquency and the reasons why resolution of the Japanese banking crisis is likely to be more problematic and costly.

To be sure, Sweden’s crisis was not nearly as big as Japan’s, but they might have become as large had the Swedish authorities dithered to the extent that their Japanese counterparts have done throughout the past 12 years. In Sweden, troubled loans were 20 percent of outstanding credit, 12 percent of gross domestic product, compared with (by estimates other than those officially advanced in Tokyo) 20 to 25 per cent of credit outstanding and anywhere from 40 to 70 per cent of GDP in Japan. And Lundgren himself made no explicit comparison between Sweden’s banking crisis and that of Japan. His was a low-key speech made in the Swedish Embassy, in itself quite a contrast from the hectoring “gaiatsu” that one normally associates with “helpful” advice from the West. So conditioned are the Japanese to high volume public lectures, that this might explain the comparative lack of publicity.

If the scale of the problems were not strictly comparable, there are still many similarities between the two crises. Hence, there are lessons for the Japanese to draw from the Swedish experience. In each case, there was a rapid expansion in the real economy generated by an explosion of credit interacting, on the way up, with an explosion in asset prices of one kind or another. Swedish banks got into trouble when the resultant speculative bubble that inflated during the second half of the 1980s lost its air in the early 1990s. Then property prices collapsed. The markets crashed, overexposed banks headed toward the wall, and the economy was imperiled.

But the Swedes dealt with the resultant banking crisis quickly and with total transparency. There was little attempt to mask the size of the bad debts and an entity was quickly set up, the Bank Support Authority, whose political independence enabled the government to avoid any conflict of interest and thereby secure greater public acceptance for the use of public money. The Authority was quickly able to get to the root of the problem. It divided banks into three categories: long- term profitable with short-term problems; long-term profitable with uncertain capital-adequacy ratios and medium-term problems; basket cases likely to be beyond reconstruction.

These classifications allowed the BSA to decide quite easily how to handle each bank: Some required no more than increased capital contributions from shareholders, some were to be nationalized, and some were to be closed altogether. Troubled loans were transferred to a separate company. In all, the government’s intervention was devised on a commercial basis to minimize the cost to the taxpayer. But taxpayers’ money was required, as a large chunk of the banking system was de facto nationalized, given the government’s unconditional guarantees to bank creditors (which lasted for almost 6 years).

While the global recovery undoubtedly helped to mitigate the extent of the problem loans faced by the Swedish monetary authorities, it is undeniably the case that their prompt, aggressive actions prevented a bad crisis from turning into a total disaster. According to Lundgren, within 6 years the BSA was wound up, nationalized banks were sold back to the private sector, and the total cost of the bailout ended up being around the equivalent of 6 per cent of GDP, half the number originally feared by the Swedish authorities.

Needless to say, the scale of the problem is considerably higher in Japan. But the fact of the matter is with the economy in depression, Japan’s monetary and financial authorities have virtually no good options left, as Bernard Connolly clearly recognizes. In the end, even Mr. Koizumi’s determination to stick to his policy of holding new bond issues to 30 trillion yen annually will likely prove untenable, Mr. Rubin’s reported support for this fiscal restraint notwithstanding. (In fact, it is somewhat inconsistent for Rubin to laud Mr. Koizumi’s self-imposed limit on bond issuance on the one hand in order to prevent interest rates from rising excessively if the target is dropped, yet on the other hand, to propose a policy of inflation targeting, the ultimate consequence of which would almost surely be the same as renewed fiscal profligacy – namely, sharply rising bond yields.) The government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be even greater.

Commenting on the “Swedish solution”, Brian Waterhouse identified eight keystones which ensured its success: 1. Early recognition of a crisis. 2. Acknowledgment that action is pressing. 3. Unconditional official support for the banking system. 4. Political leadership and unified public opinion. 5. Intervening legislation. 6. Independent supervision of the reconstruction process. 7. Nationalization if necessary. 8. Determination to denationalize as soon as possible.

There is an additional factor unmentioned by Waterhouse. Sweden had proper functioning, politically legitimate institutions, thereby enabling the government to mobilize public opinion and deal with the problem from a position of responsible and accountable public leadership. Mr. Lundgren himself noted that the job was basically achieved with a core committee of just three Cabinet ministers, a total of six senior government officials regularly involved, and the use of two independent consulting firms, rather than the usual morass of backroom committees and bureaucrats, which constitute the essence of the Japanese polity. In other words, Sweden had something approaching true democracy. We have often made the point that politically responsive institutions are totally lacking in Japan, and that the resultant policy paralysis brought about by 50 years of corrupt LDP leadership (and Washington’s continued patronage) has exerted a huge economic and social cost. The messy resolution of the country’s long-standing financial crisis, when it comes, will probably constitute the most vivid illustration of this point.

Source
US calls on Sweden’s “Mr Fix It” Bo Lundgren – Telegraph

Related posts:

• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• The Swedish roots of the UK bailout plan
• Lessons from Swedish bank resolution policy
• Lessons from Japan’s Bank Crisis
• Bernstein: America is turning Japanese

This is a post I wrote yesterday at naked capitalism.

Today, I want to make the case for seeing writedowns as central to this global downturn. To do so, we need to rewind and compare what is going on today with what we have experienced in the past. Drawing on this comparison, I can demonstrate that traditional policy tools are likely to be ineffective today. Moreover, the present course of action will also prove inadequate. Other more aggressive means must be applied in order to ensure a more stable banking system and a path to recovery. Likely remedies will include a reorganization of large swathes of the U.S. banking system.

Now, looking back, if one hearkens back to 1992 and the election that took Bill Clinton to the White House, ‘it’s the Economy, stupid’ was the phrase that symbolized Clinton’s victory and George H. W. Bush’s defeat. Today, as we are mired in a deep economic downturn, we should be tempted to bring back that phrase.

But, 2009 is not 1992. This is no garden variety downturn. It is something altogether different. We are not witness to a case of over-production and overheating as is usually the case. It is a case of over-leverage and over-indebtedness. As a result, the key to the outlook for the American economy is fairly simple and it hinges on a single word: credit.

My view of credit
The way I see it, our economic system is not built on work today for money today to consume today. Rather, we work in order to consume today and into the future. The mechanism through which we make this inter-temporal transfer is credit.

Think about any particular year in which you have worked. Certainly, you bought goods and services to consume straight away. But you also purchased homes, cars, television sets, shoes, washer/dryers, and tennis rackets, all to be ‘consumed’ today and into the future. In effect, you were using money in the present in order to consume later.

Now, here’s the thing. Irrespective of whether you saved money from past earnings to buy those goods and services or bought those goods on credit, it was credit that was always behind the transaction. Had you saved, ninety-percent of your savings was loaned out as credit by your bank as soon as you deposited the funds. And if you bought on credit, you were the recipient of a credit loan yourself. No inter-temporal transactions could ever occur without credit. So, in a very real sense, credit is at the core of our system (a longer explanation is here).

Garden-variety recession
In a normal recession, credit becomes tight, but it is not central to the downturn. In fact, 80% of the decline in GDP is due to a de-stocking of inventory. Basically, businesses get ahead of themselves and forecast future demand that turns out not to exist. They are forced to ratchet back production and sell off inventories. In this case, policy makers can step in with fiscal and monetary stimulus and re-kindle domestic demand with a bit of a lag. Bing, presto, we are off to the races again. That’s why recessions are over in 12-18 months tops.

Depression
That’s not what happens in a depression – and this is a depression. In a depression, what happens is macro disequilibria build up so much and become so unsustainable that when the break in demand happens, there is no bing, presto from traditional policy responses. The leverage and debt in the system is just too large. The debt cannot be worked off without de-leveraging (See my post “De-leveraging“).

Ray Dalio of Bridgewater Associates did a fantastic job of explaining this process in a Barron’s interview last month.

Barron’s: I can’t think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let’s call it a “D-process,” which is different than a recession, and the only reason that people really don’t understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn’t live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process…

Barron’s: You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what’s essential to combat deflation and a depression?

Dalio: The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

For more on this, see my post “A conversation with Bridgewater Associates’ Ray Dalio“

Increasing credit
This is what is happening now. The problem is that while all this is ongoing, the institutions that issue credit, financial institutions, are hemorrhaging losses. After all, de-leveraging means institutions are selling out of necessity, not out of opportunity. And when everyone’s a seller and few are buyers, asset prices fall and massive losses are the order of the day. When banks lose money, they have less capital and when their capital gets low enough they can’t lend. Less lending = less credit = less growth. So, if we want to get the economy back on its feet, we need to increase lending.

And that is certainly what the alphabet soup of government programs are about: the TALF, the TARP and the TLGP. That’s what the bailouts have been about too. All of this has been done in an effort to recapitalize our banks so that they can start lending again.

It’s the writedowns, stupid
The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

1. Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
2. Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.
3. Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.
4. Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

Sure, there is always quantitative easing a.k.a. printing money. But, this is inflation pure and simple. It is the effective equivalent of a partial default on payments in that the value of money erodes the real burden of debt. This is also known as beggar-thy-neighbour and leads to nasty protectionist retaliation or competitive currency devaluations — not a very good backup plan.

Better is an increase in real incomes for ordinary Americans, something Summers does discuss in his speech from a few days ago when he discussed President Obama’s stimulus package.

These plans are not going to work
As aggressive as this campaign by the U.S. government is, it will have limited effectiveness because the extent of the writedowns of assets already on the books is going to be too massive.In fact, there are four asset classes where we should expect significant further deterioration in quality (see my post “Top ten predictions for the 2009 global economy” for a longer version of this section):

1. Residential Property. There is significant evidence that residential property distress has moved well into the Alt-A and Prime classes of borrowers.
2. Commercial Property. There is equally ample evidence that the commercial real estate market is imploding (see posts here and here). There will be huge writedowns in this asset class in 2009.
3. Leveraged Loans and High Yield. In February downgrades were outpacing upgrades 49 to 6. Heavy losses are likely to occur due to defaults. (see the FT analysis here).
4. Credit Cards, Auto Loans, and Student Loans. Credit card default rates were at the highest in 20 years in February. Meredith Whitney has been beating the drum about this. She sees credit cards losses taking on tsunami proportions.

The U.S. banking system is effectively insolvent
So, it should be pretty clear that we have some serious losses still left to work through in the financial sector. I reckon the U.S. banking system is effectively insolvent. This is what Nouriel Roubini means when he says there will be $3.6 trillion in writedowns before this is all over. This means that banks do not have adequate capital to absorb the likely losses facing them later this year.

To date we have addressed this problem by throwing more money at it — bailing out the banks and attempting to prevent asset prices from falling. I predict this solution will lead to another panic if continued indefinitely. (Remember, between now and the summer or fall, the unemployment rate could reach 9-10%, while home prices would still be falling and default rates rising.) American citizens would realize the system is insolvent and would cease to trust that a reasonable solution was in the offing.

Confidence in America’s banking system is already lacking, especially in the large banks and large regional banks. This confidence can only be restored if banks are adequately capitalized now and in the future. Were we to suffer another round of major writedowns and capital injections into major institutions, I expect all confidence would be lost and bank runs would begin in earnest. This must be avoided at all costs.

Given the lack of capital the banking system now has and the likely level of writedowns, many institutions are fundamentally insolvent. They must, therefore, be liquidated or nationalized BEFORE confidence in the system is lost and bank runs occur.

Buying up assets at inflated prices, halting mark-to-market, and reducing interest rates to zero will not reduce the problem assets on bank balance sheets enough to avoid further massive writedowns.

Conclusion
In sum, most available evidence suggests bank writedowns will be massive — perhaps larger than the present capital base of the U.S. banking system. While, present measures of recapitalizing and bailing out faltering institutions and buying up toxic assets may prove adequate to prevent further writedowns and capital erosion, I would rather err on the side of caution.

Caution dictates an aggressive response — one which should include nationalization or liquidation of a significant number of banking institutions. Anything less is wishful thinking, the consequences of which could be very dire indeed.

Related posts:

• Doubling down at AIG
• Mike Mayo: writedowns worse than the Great Depression
• Are European banks sitting on 16.3 trillion in toxic assets?
• 16 Jun 2008: Latest Writedowns News
• Level Three Assets: banks are hiding the ball on credit writedowns

This is a post I wrote last week on naked capitalism.

In any banking crisis, the central question always is: which financial institutions now operating are insolvent, how can we identify them and remove them from the system, and how can we recapitalize the remaining institutions in a way that restores confidence to the system generally? Therefore, any response by policy makers must address three separate issues:

1. Confidence in the system. This is the first question to be addressed because no fractional reserve banking system can function without confidence in its integrity. Is Citigroup going to be nationalized? Are the regionals sitting on massive commercial real estate time bombs? Does Wells Fargo have a fatally large exposure to California-based HELOCs? If BofA goes bust will I get my money back at the ATM? No one knows the answer to these questions definitively. As a result, each and every institution in America is subject to suspicion about its solvency by depositors, debt holders, commercial paper investors, and transaction counterparties. The whole system comes under a cloud. In short, doubt breeds fear and fear creates systemic risk.
2. Identification of insolvent institutions. This is the tricky bit for a number of reasons. First, I should note that Warren Buffett has said Wells Fargo has a pre-tax earnings power of $40 billion. That is enormous. While one should be suspicious whether Buffett is talking his own book, it points out the fact that any bank can ‘earn its way out of insolvency’ if given enough time. Nationalization is but one option. (John Hempton has noted that the Japanese banks actually did not have the benefit of time as their spread margin was so small due to the infamous zero-interest rate policy – you need a steep yield curve). But, ultimately, it is liquidity that is at issue for many bankrupt financial institutions – a loss of depositor or creditor faith. Their credit lines are pulled (Bear Stearns) or bank customers flee (Northern Rock). So, when we ask whether an institution is insolvent or bankrupt, it is a trick question because many failed financial institutions suffer a lack of liquidity — a circumstance which presages insolvency (see my take on this issue here). Identifying whether an institution is fundamentally insolvent depends crucially on the true value of its asset base as well as future loan losses and credit writedowns.
3. Recapitalization of solvent companies. Once one determines whether a financial institution is insolvent, the remaining solvent institutions might still be so fragile as to succumb to liquidity pressures. They must be adequately recapitalized in order to preserve confidence in the system as a whole. How one goes about doing so is less important than doing so. Moreover, it is crucial that government not recapitalize insolvent institutions lest they be confused with solvent entities, re-creating the loss of confidence which created the panic and crisis to begin with.

Set against these criteria, the response to date by U.S. regulators and government officials is thoroughly lacking. Let’s look a little more in depth at each step in the process to see why.

Confidence
I see confidence as the key to the entire problem. Think about it this way: one day you were walking around under the assumption that you could get money from the ATM, invest in your IRA, move money from account to account, and take out a mortgage pretty much at will. Then you woke up to news that your friend’s bank was bust and lines were forming. Then you hear that your friend can’t get his money back because he had ‘unsecured deposits.’ Suddenly, you think, “wait a minute, maybe my money is not so safe after all. How do I know that my bank isn’t next?”

The fact is you don’t know. And normally this does not matter because the integrity of the banking system is not in doubt. However, when a credit crisis emerges, psychology changes drastically and everyone — and every bank — comes under suspicion. People start yanking their money. Since banks borrow short and lend long, they don’t have all the deposits to hand. Any institution would be illiquid and forced into insolvency if enough creditors and depositors withdrew their support. This is why confidence must be restored at all costs. The question is: how do you do that?

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Bankrupt institutions
You shut down bankrupt institutions. If financial institution creditors and counterparties are reasonably sure that any institution which is potentially insolvent will be immediately shut down and liquidated, merged, sold, or nationalized by regulators and that they will be made whole, instantly confidence would be restored in the banking system as a whole. Yes, I am suggesting that senior debtholders receive substantially all funds in a re-organization

Now, the banking system is a cartel. That means the banking authority — state or national – excludes those it deems lacking in capital and credibility from sullying the system. As a result, banks operate in an environment of limited competition, garnering them larger profits. In return, they promise to uphold the rules set out by the regulator, the penalty being asset seizure and closure by the FDIC. This system operates because we all assume it has inherent integrity.

By the way, I would argue that a large part of why this system broke down has to do with de-regulation and its introduction of competition from unregulated sources, which pressured banks into seeking more risk in order to earn a decent return, fatally undermining the system’s integrity (but that is a topic for a different post).

The problem in the United States today is that it is unclear that all insolvent institutions are, in fact being shut down in a timely fashion. Is Citi insolvent? Is BofA bankrupt? How about Fifth Third or Zions? Moreover, as a creditor, you have no idea whether you are going to get paid in full. Remember what happened to the holders of preferred at Fannie and Freddie? Why would you lend to any financial institution if you are not sure that you are going to get your money back? The same is true for depositors, which is why WaMu was seized by the FDIC in my opinion — there was a run on deposits at the bank. Equity holders are a different situation as they should bear all the risk.

This is disastrous for the economy because banks must then deleverage and cut credit as their funding sources disappear, further weakening the economy and banking system until somebody fails and then we have another panic. We have had six months since the last panic began. One would think the Obama Administration might have a solution in hand.

The vague and delayed plan presented by Tim Geithner is not going to get it done. It has been widely panned and has not instilled confidence in the system. Moreover, as originally proposed it allowed the banks themselves to value their assets in order to meet the tangible common equity stress test criteria. This is self regulation in the extreme. And as Willem Buiter has said, “Self-regulation is to regulation as self-importance is to importance.”

I have come up with a number of proposals in the last few months, as have any number of pundits from Willem Buiter to Nouriel Roubini. In fact, I pointed out the Swedish model as a potential framework for the U.S. as far back as August – 7 months ago (and this has been dismissed out of hand by the Obama Administration for, what I believe, are ideological — and not substantive — reasons). Yet, the Obama Administration continues to dither. Certainly, the mechanics (FDIC seizure, merger, break up and sale, pre-privatization) are daunting given the size and scope of America’s larger institutions. And we have some frightening examples in government ownership (AIG and Fannie and Freddie), in bankruptcy (Lehman Brothers), and in merger (Bear Stearns, Merrill Lynch). However, putting off the problem is not an effective solution, as doubt grows in such an environment and this increases the need for both deleveraging and restricting credit.

Recapitalization
And that brings us to the last of the three pillars here – recapitalization. If and when Geithner and Summers decide who is insolvent and how to deal with them, they will need to present a model for recapitalizing the remaining solvent institutions. Now, for a moment, let’s assume Citigroup is in fact solvent, and that this is why it is being propped up. Even in such a circumstance, it is not a very good model for further recapitalization. The Citigroup solution has been — in a word – ad-hoc. And ad-hoc is poison because it creates doubt about how the same solution will be re-applied for other institutions. And when creditors and borrowers doubt that they will be paid in full, they do not lend or deposit their funds.

And I should point out is far from clear that Citigroup is in fact solvent at all. The propping up of potentially insolvent institutions that may eventually be seized undermines confidence in the entire system.

Now, my own site is called “Credit Writedowns” in large part because I see writedowns as the key to finance and this banking crisis. Basically, any solution for recapitalization must address future writedowns and loan losses of assets already on the books if it is to be successful. One reason that this crisis has been so protracted is because there has been a painful drip, drip of writedowns after each and every capital injection into America’s financial institutions. Clearly, investors and policy makers alike have seriously underestimated the scale of writedowns. So, Job 1 is to get a grip on the future losses, write those assets down and recapitalize institutions accordingly. Getting this done quickly is important. The mechanics, while tricky, are less important.

In my view, much of this seems axiomatic. For months, various credible economists have offered this advice and I have been puzzled as to why Paulson, Bernanke and now Geithner and Summers have not moved in this direction. I can only assume it is because they still believe the U.S. banking system can be salvaged with a minimum of invasive surgery. However, a prudent approach, a cautious approach, would recognize the need for swifter and bolder action lest the patient die on the operating table.

My advice is to pick a credible comprehensive solution quickly (there are many). Garner legislative approval and set up a bi-partisan, non-politicized process. And then stick to your game plan in each and every case – regardless of size or influence of the institution.

Related posts:

• The Swedish banking crisis response – a model for the future?
• Stephen Roach and Jim Grant: Video of credit crisis thoughts
• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• The problem with comprehensive banking crisis solutions
• The Dummy’s Guide to the US Banking Crisis

The large bonuses at AIG have sparked yet another wave of revulsion amongst American taxpeayers.  And rightfully so.  This company has cost taxpayers $170 billion and counting and yet the bonuses of the same individuals complicit in the losses is still to be paid due to contractual obligation.  While Ben Bernanke, Larry Summers and others have expressed their contempt for this state of affairs, I suspect there will be consequences down the line.

Below is the crux of the problem as detailed in the New York Times:

The American International Group, which has received more than $170 billion in taxpayer bailout money from the Treasury and Federal Reserve, plans to pay about $165 million in bonuses by Sunday to executives in the same business unit that brought the company to the brink of collapse last year.

Word of the bonuses last week stirred such deep consternation inside the Obama administration that Treasury Secretary Timothy F. Geithner told the firm they were unacceptable and demanded they be renegotiated, a senior administration official said. But the bonuses will go forward because lawyers said the firm was contractually obligated to pay them.

Austan Goolsbee, staff director of the president’s Economic Recovery Advisory Board, on Sunday detailed Mr. Geithner’s reaction.

“He stepped in and berated them, got them to reduce the bonuses following every legal means he has to do this,” Mr. Goolsbee said on “Fox News Sunday.” “I don’t know why they would follow a policy that’s really not sensible, is obviously going to ignite the ire of millions of people, and we’ve done exactly what we can do to prevent this kind of thing from happening again.

The payments to A.I.G.’s financial products unit are in addition to $121 million in previously scheduled bonuses for the company’s senior executives and 6,400 employees across the sprawling corporation. Mr. Geithner last week pressured A.I.G. to cut the $9.6 million going to the top 50 executives in half and tie the rest to performance.

The payment of so much money at a company at the heart of the financial collapse that sent the broader economy into a tailspin almost certainly will fuel a popular backlash against the government’s efforts to prop up Wall Street. “There are a lot of terrible things that have happened in the last 18 months, but what’s happened at A.I.G. is the most outrageous,” said Lawrence H. Summers, President Obama’s chief economic adviser, during an appearance Sunday on ABC’s “This Week With George Stephanopoulos.” “What that company did, the way it was not regulated, the way no one was watching, what’s proved necessary — is outrageous.”

Yesterday, I had an e-mail exchange with a number of financial and economics professionals in which we discussed the AIG bailout and the specific issue of these large bonuses. One comment which I found particularly noteworthy came from Bill Black, a well-known economist from the University of Missouri-Kansas City. Bill is well versed in both the legal and financial sides of these affairs. Below is a short bio:

Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.

He was also litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and General Counsel of the Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.

And this is what Bill had to say about the AIG situation (I have bolded the bits I find most significant):

This is the consequence of six things on the Treasury end of things:

• (1) the failure to use Chapter 11 bankruptcy/pass-through receivership to deal with deeply insolvent financial institutions,
• (2) the failure to expose, and to the extent possible, remedy through restatements the massive accounting fraud that AIG was/is engaged in that triggers the bonuses,
• (3) the failure to bring criminal charges against the control frauds,
• (4) the failure of Treasury as negotiators — they had all the leverage when they bailed out AIG and could have conditioned the aid on at least the VP tier and above giving up their bonuses,
• (5) the weakness of Treasury’s current lawyers who, if press reports are accurate, couldn’t think of any way for the U.S. government to take effective action against what it reportedly views as a scandal, and
• (6) (and I haven’t seen this discussed) why was Treasury blind-sided by this? It confirms that they did not conduct even the most obvious due diligence on AIG’s assets and contingent liabilities. Given what we know about the lack of due diligence by AIG on underlying assets, particularly nonprime paper, this confirms exactly how dangerous Treasury is to the the nation. It is also consistent with the concern that it faces such a critical staff shortage, particulary in the relevant skills (which the folks it hires from Wall Street lack). I doubt that they have five senior officials that have ever reviewed loan files for a living or conducted meaningful due diligence (which requires cracking the loan files).

On the AIG end we see the perverse incentives of keeping the senior level folks on that caused the crisis. They have every incentive not to be honest about the true extent of the losses. They know the place is dead (hopelessly insolvent) and have strong incentives to loot the corpse, e.g., through bonuses. They do not alert Treasury sufficiently in advance even to bonuses that they should know will be perceived as scandalous (though another problem with keeping these failed elites in power is that they are clueless about the reaction of normal people). They do not work to limit bonuses, e.g., by being honest about past accounting fraud. I believe when the facts come out that we will find that they did not make criminal referrals on the prior senior officials that led AIG’s accounting fraud (which would have given AIG and the Treasury a far stronger legal basis for refusing to pay bonuses that were “earned” via accounting control fraud.

I don’t oppose bonuses that are actually earned through long term performance. That is not the case with the AIG bonuses. We can offer well designed performance pay if we use bankruptcy or receiverships.

Bill’s argument is testament to the problems associated with nationalization as practised in the U.S. during this credit crisis. In effect, we are seeing private gain and socialized loss-writ large. To the degree that Citigroup or Bank of America or any other large institution is being nationalized, should we expect any different at those institutions?

I have been in favour of pre-privatization as a policy remedy in this crisis.  At a minimum, this episode should make clear that a pre-packaged or managed bankruptcy administered by the government would be superior to this ill-considered and attempted arms-length transaction at AIG.  My short-hand for this divide is “bankruptcy/pre-privatization vs. propping up zombie banks.” Propping up zombie banks while refusing to prosecute any illegal activities is likely to invite a negative populist response as I indicated in my recent post “Where are the perp walks?” In my view, the Obama Administration may well come to be viewed as an enabler of these events unless it can demonstrate a credible willingness to prosecute financial service criminal activity and end the ability of incumbent management to control likely insolvent institutions.

I will finish off my commentary with a snippet from a post by James Kwak on the Baseline Scenario, which gets right to the heart of this divide in policy options.

I think there are three main positions in this debate:

• A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
• A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
• B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

The big divide is not between A1 (Rajan) and A2 (Simon and me). In both cases, you end up with a healthy banking system, at significant taxpayer expense. (A2 should be somewhat cheaper because it wipes out the shareholders, but I agree with Rajan that it is dramatically cheaper only  if the government is willing to restructure some of the liabilities.)

The big divide is between both of these and B, the position of the Bush and Obama administrations – both of which rejected aggressive measures in favor of just-in-time, just-big-enough bailouts. Now the government is conducting stress tests on an industry it has already said is adequately capitalized, and will follow that with a public-private asset-buying program that tries to split the difference between paying real market value and paying enough to keep the banks happy. I’ve quoted these exact words before, but here’s Krugman again: “The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up.”

Now, let’s say you agree that something more needs to be done. Then you have to choose between A1 and A2. A2 is the one people typically call “nationalization.” But which is more consistent with a capitalist system: protecting the creditors who lent money to a failed bank, the shareholders who invested in a failed bank, and the managers who failed . . . or firing the managers, wiping out the shareholders, and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses? Which one better approximates the incentives you want in a free market?

UPDATE: 637PM EDT – Bill Black has a post up on Huffington Post along with Tom Ferguson, Rob Johnson and Walker Todd that is a must-read about this issue. How to Stop AIG’s Bonuses. And Yves Smith also chronicled the email exchange with Bill Black and has her own take, “Wiliam Black Savages Treasury’s Conduct on AIG”

Sources
A.I.G. Paying $165 Million in Bonuses After Federal Bailout – NY Times
Nationalization and Capitalism – James Kwak

Related posts:

• Bankruptcy expert says ‘not at all’ possible for quick Chrysler bankruptcy
• Did JP Morgan cause Lehman’s bankruptcy?
• FAS 157 and the significance of distress versus bankruptcy
• Last bankruptcy tonight: America West Bank
• Citigroup talks with US Government as bankruptcy looms

Gillian Tett has written in the Financial Times that the Obama Administration is no talking to the Swedes directly about their solution to the credit crisis, suggesting a openness to potential banking crisis solutions. Next week, Bo Lundgren, now head of the Swedish debt office, but formerly a Deputy Finance Minister under Carl Bildt, is scheduled to meet with American officials in Washington. For those of us who see positives in the Swedish crisis solution, this is positive news.

Washington’s Congressional Oversight Panel has summoned Mr Lundgren and others to explain how they fixed Sweden’s banks – presumably to glean tips on what Washington should do next.

The Nordic gods might well chuckle at this twist in the global financial saga. As recently as last autumn, the phrase turning “Swedish” was tantamount to an insult among most American politicians (and on Wall Street, the joke currently goes, Swedish models used to only attract attention when they were blonde and leggy). But these days, as the economist Nouriel Roubini recently observed, “we are all Swedes now” – at least in the sense of using state funds to fix the banking mess.

Hence Washington’s sudden invitation to Mr Lundgren and his colleagues. Whether the Americans will actually like the message that Mr Lundgren and others wish to impart, though, remains to be seen. For many Scandinavian observers are distinctly critical about what the US is currently doing with its banks. In Washington, politicians are wrapping themselves in knots about words such as “bail-out”. But to the Swedes that misses the point: the really important issue is not whether state money is used, but how it is dispersed. After all, as Mr Lundgren notes, “the word nationalisation can have many meanings” – and not all are very effective.

Sweden’s own crisis bears this out. When its banking woes first erupted, Stockholm (like the US) initially responded with procrastination and denial. Eventually, however, it nationalised two banks, wiping out the shareholders, and placed toxic assets into a special “bad bank”. That cost the government about SKr60bn-Skr70bn (although much of that sum was later recouped through asset disposals). To some extent, many western governments are copying elements of this approach. The UK and US, for example, have partly nationalised banks such as Citi and Royal Bank of Scotland. But, thus far, the UK and US have not ringfenced bad assets, preferring to urge the banks to deal with them while still on their books (supported with complex guarantee and financing schemes.) Anglo-Saxon governments have also refused to wipe out shareholders in banks such as Citi and RBS, for fear of looking too “socialist”.

Much has been made of the Swedish banking crisis solution because it involved pre-privatization of two banks and this strikes many Americans as distinctly ’socialist,’ a term reviled in U.S. political parlance. The Obama administration has repeatedly rejected the suggestion that it would nationalize any of the large American banks. Yet doubt still lingers.

I have suggested that pre-privatization should be a leading option to consider by the Obama Administration in a number of posts:

• America needs a pre-privatization plan (Feb 2008)
• Lessons from Swedish bank resolution policy (Mar 2009)
• The global economy has crashed: we need a comprehensive credit crisis plan (Sep 2008)
• The Swedish banking crisis response – a model for the future? (Aug 2008)

However, I do recognize the need to look at other solutions. Nationalization is but one option.  The key is to restore confidence in the system and this may involve guarantees for bondholders which many find unpalatable.  

But the more serious criticism lies with what is not being done. While Stockholm was nationalising two banks in the early 1990s, it also offered a blanket guarantee to any investor holding any Swedish bank liabilities (except for shares or subordinated debt). These days, that measure is not well known outside Sweden. But many Swedish officials and bankers consider that guarantee to have been the most crucial decision of all.

Moreover, it remains to be seen how applicable the Swedish crisis solution is to the United States.  Two Swedes high in the political ranks during the banking crisis there in the early 1990s have offered very different views on this subject on the site Euro Intelligence, the second highlighted here due to my preference for its analysis:

• Sweden may not be a model – Euro Intelligence
• Lessons from Swedish Bank Resolution Policy – Euro Intelligence

And, indeed there are some very negative consequences to models like the one adopted in Sweden as I argued in November in my post, “The problem with comprehensive banking crisis solutions.” Ultimately, I am heartened by the fact that the Obama administration and the Congress are looking into all available antecedents of the present crisis for potential frameworks.  This should give one a renewed sense of faith in the wisdom in Washington.

Sources
Insight: US is ready for Swedish lesson on banks – Gillian Tett, FT.com

Related posts:

• Did Sweden really nationalize its banks?
• The problem with comprehensive banking crisis solutions
• Lessons from Swedish bank resolution policy
• Roubini: Nationalization “fully on the table” in Geithner’s Plan
• Ireland guarantees bank deposits at six banks

From Justin Fox of Time Magazine:

FDIC chairman Sheila Bair doesn’t think a full government takeover of Citigroup and other multinational financial institutions is practical or even possible. Here are her reasons, as summarized by Pete Davis:

1. The legal authority to take over large banks does not currently extend to multinational financial conglomerates;
2. The FDIC lacks the funding to conduct such a massive bailout;
3. Other countries have regulatory oversight of these financial conglomerates too, and they may object to a U.S. takeover.

Perhaps we are getting the reason Geithner and company are reluctant to take on Citi: they have no deposit base for the feds to step in on relative to their asset base.  Remember, Citi wanted to buy Wachovia for more deposits. The domestic bank Citibank simply does not have that many deposits. The nearest Citi branch — which I use — is actually only 6 blocks from my house. But, it operates largely in the Tri-State area of New York, New Jersey and Pennsylvania and has little presence outside.  Justin Fox puts it well:

To repeat: Citigroup has liabilities of $1.797 trillion. The deposits that the FDIC has some responsibility for (up to $250,000 per depositor) add up to $241 billion. So we have this reasonably sensible system for winding down troubled banks, but when it comes to the most troubled big banking company in the country, said system only covers a fraction of the overall operation. Which leads to a couple of conclusions:

1. I get why the administration is so reluctant to take over Citi completely.

2. I don’t get why we all (I’m including myself in this) thought it was okay to allow the creation and growth of gigantic financial companies for which we had absolutely no plan for winding down in case of trouble.

And remember the problem with Banamex, which Citi owns.  The Mexicans could see Citi as state-owned.  After all, the TALF considers 25% the state-owned threshold.

This banking crisis gets more interesting by the day.

Sources
How much of Citigroup could the FDIC actually take over? – Time
Bana-vexed – FT Alphaville

Related posts:

• Chart of the Day: Citigroup
• Seven more bank failures brings total to 64
• Is Citi being forced to downsize by Obama?
• FDIC shuts down Haven Trust and Sanderson State
• Two more FDIC Friday Night Specials brings total to 55 failed banks

This is the name of a speech made by Kansas City Fed CEO Thomas Hoenig which is creating quite a stir. He makes the following points in his speech:

Turning to the current crisis, there are several lessons we can draw from these past experiences.

• First, the losses in the financial system won’t go away – they will only fester and increase while impeding our chances for a recovery.
• Second, we must take a consistent, timely, and specific approach to major institutions and their problems if we are to reduce market uncertainty and bring in private investors and market funding.
• Third, if institutions — no matter what their size — have lost market confidence and can’t survive on their own, we must be willing to write down their losses, bring in capable management, sell off and reorganize misaligned activities and businesses, and begin the process of restoring them to private ownership.

There are varying explanations as to why the Obama Administration has not gone this route. I believe it is because of cognitive regulatory capture. Read another viewpoint here:

Do Americans Want to Nationalize the Banks? – Five Thirty Eight

Read the full text of Hoenig’s speech in pdf form below. One thing you will note in his speech is a reference to

“The Treasury Department, the Federal Reserve and other regulators have also arranged bailouts and mergers for large struggling or insolvent institutions, including Fannie Mae and Freddie Mac, Bear Stearns, WaMu, Wachovia, AIG, Countrywide, and Merrill Lynch. But other firms, such as Lehman Brothers, have been allowed to fail.”

This is the first time I have heard a Fed official confirm that the Countrywide and Merrill deals were both facilitated by government.

Source
Too Big Has Failed – Thomas Hoenig, Kansas City Fed

Related posts:

• Where are the perp walks?
• Two largest wholesale credit unions seized
• Mark to market is beside the point
• FDIC Friday Night Special: First National Bank of Anthony
• More reason BofA is crazy to take on Countrywide