If you thought the bailout of too big to fail institutions was a massive gift from taxpayers to captains of Wall Street, the news that TARP funds are being repaid should confirm your beliefs. Just today the U.S. Treasury has agreed to allow 10 financial institutions to repay TARP funds they received last October after Lehman Brothers failed. The institutions are the following:
- Passed the stress tests: JPMorgan Chase & Co., American Express Co., Goldman Sachs Group Inc., U.S. Bancorp, Capital One Financial Corp., Bank of New York Mellon Corp., State Street Corp. and BB&T Corp.
- Failed the stress tests: Morgan Stanley
- Was not subject to stress tests: Northern Trust
Here’s why this confirms your worst fears and what it means for U.S. finance going forward. The U.S. taxpayer ponied up $700 billion even while the unemployment rate has zoomed up to a 26-year high and home prices have plunged more than 30% nationwide. Going forward, things look fairly difficult for the taxpayer, but some bankers are now free to return to business as usual.
The government’s investment
According to government officials, this was an investment in the banking sector and the fact that the money is now being repaid is being touted as proof that this investment has been successful. After all, the government has received $1.8 billion in preferred dividends in the months since these monies were disbursed. But, don’t be fooled. These companies are still dependent on government largesse via debt guarantees from the FDIC and credit lines from the Fed.
Free from compensation restrictions
The general animus for repaying TARP funds is the restrictions the government is likely to impose on those companies receiving TARP funds, principal among them is the likely compensation restrictions to be announced tomorrow. Now, remember, all of these banks are still eligible for the PPIP and other government programs. Moreover, the Fed refuses to release information regarding the collateral used for the credit lines that the Fed is providing. Bloomberg News is suing under the Freedom of Information Act to find out more. So, those banks still so sickly that they cannot repay the funds will face restrictions. However, those institutions still using Federal aid in other more opaque ways will not.
What does all this mean?
For one thing, we now see who is sick and who is not. While the stress tests were a bit of a sham devised to give banks the opportunity and time to raise money privately (see my post “Channeling my Inner Larry Summers”), this repayment makes clear who really is in trouble and who is not. Do you see Citigroup’s name anywhere? How about Bank of America? Wells Fargo anyone? I anticipate every bank that is still receiving TARP funds will struggle to get off the government breast as soon as possible because we are likely to see a divergence in stock/preferred share performance between those who get off TARP and those who do not.
Here’s what I said in April about the likely outcome down the line in my post “Stress tests reveal Citi and BofA need more capital, but you knew that already." (emphasis added)
Just one look at the credit ratings and stock prices of the 19 banks and financial institutions in the stress tests will tell you which are the weak institutions. So, why the charade?
Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.
Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.
Honestly, I think Wells Fargo is going to eventually make the grade. But Citigroup probably will not. After all, Sheila Bair is already looking to take a firmer hand at the company.
Is risk-taking coming back then?
Going forward, many banks are free to operate as they did before. In fact, the recent steepening of the yield curve can be taken as a sign of renewed risk appetite. After all, not that many firms failed, so the basic over-capacity in the financial sector (and the basic systemic fragility) is still a problem that can only be solved by reaching for yield. Last month, in reviewing comments by former Merrill Chief Strategist Rich Bernstein, I said:
As to the bailouts and the government plan, Bernstein believes that the government is attempting to keep the excess capacity in the financial sector alive. His basic point is that bubbles create overcapacity (think tech stocks). This is the case in finance. The sector must shrink. In my own, there are only two ways a sector in over-capacity can perform. They can have poor earnings (Bernstein’s first point) or they can seek heavy risk taking and reach for yield. One of these two outcomes in financial services is likely unless the sector is rationalized. Hence the reason for consolidation through merger, nationalization and liquidation. Bernstein warns this looks nice in the short run but will lead to a Japanese scenario in the longer term. We are not going into free fall Bernstein says. That is a big change from the view just a few months ago. However, longer-term, the lack of consolidation in places like financial services necessarily means a Japanese outcome of lower than expected growth.
So, to me it looks a lot like we learned absolutely nothing during this crisis. Sure, Wall Street is chastened and firms will be more risk averse than they were at the height of the bubble. Nevertheless, prior experiences like the S&L crisis in the U.S. and the Lost Decade in Japan demonstrate that allowing zombie companies to remain afloat or promoting overcapacity invites market participants to swing for the fences.
As a banker in this scenario, one might think: If I hit a home run, great – I can make a wad of cash and get the firm back to health. If not, we just might fail – but nothing ventured is nothing gained. Heads I win, tails you lose.