This morning, we’ll get accelerated earnings announcements from Citigroup and Bank of America. They basically have to do this because the whispering and the uncertainty about both enterprises is starting to get really hard to ignore.
And BAC just became the recipient of a government-assistance deal much like what Citi got in December: $20 billion in new preferred equity, and a guarantee of $118 billion in bad assets.
This ad-hoc approach to dealing with bank near-failures has become the new normal. At some point very, very soon, regulators will have to decide how small a bank has to be before it can simply be allowed to go out of business.
You have to figure the answer is something like: “If there’s a bigger bank available that we can merge this piece of garbage into, then we’ll fail it. If there isn’t, we’ll nationalize it.
Very reminiscent of Japan in the early Nineties, what obviously isn’t being considered is to simply let banks fail altogether, under the weight of large clumps of toxic assets. But the way we’re doing this really isn’t that much different, as the equity of “rescued” or “assisted” banks goes more or less to zero.
Of course, it remains to be seen whether the ad hoc-bailout model will result in major transfers of taxpayer wealth to stakeholders of assisted banks (either the debt or the equity). One suspects the answer to this question will not be no.
Clearly, for all the hand-waving over the economic recession, we still haven’t solved the deep and worsening banking crisis that was the trigger for the recession in the first place. There is talk that we need to add more than another trillion dollars’ worth of “assistance” (in effect, new equity) to American banks.
(It just astounds me to be throwing these numbers around as it they were normal. Not too many months ago, a billion dollars was an awful lot of money. Now it’s more like a penny: something you add up a lot of, to get something more useful. The very fact that we’re talking this way has an eerie effect of making clear something that many people underappreciate: money has no reality in the first place. It’s all just computer blips. When this knowledge finally sets in among non-finance types, who knows what it will do for consumer confidence?)
All of this distress is actually the residue of the collapse of the housing bubble. The vast reduction in housing values has to go somewhere. It’s getting split between the public and the banks.
The fact that many people now own an asset that’s worth considerably less than they paid for it affects consumer behavior, and over many years it will necessarily act as a drag on consumption (and economic growth). This effect is a “hidden” one, because its impact is mostly indirect.
But the effects on the banking system are immediate. The assets resulting from writing mortgages that are now worth much less than par, impairs bank balance sheets and capital ratios now. There is a lot more banking crisis yet to come.
The talk now is that the original TARP proposal (purchasing mortgage and other asset-backed securities at an overvaluation) needs to be revisited.
And the tenuous arguments in favor of this idea are considerably stronger now than they were back in September.
Basically, have the Fed and/or the Treasury establish something that, in blog postings last September, I called the “First National Bad Bank of the United States.” This entity would establish a one-way secondary market for impaired assets that banks would like to get off their balance sheets.
There’s a huge technical problem with determining the purchase prices, and it might be interesting to create a quasi-hedge fund structure so that some smart but underemployed Wall Streeters can get rich finding the right prices. But whatever those prices turn out to be, they will have to be much higher than current market.
In this way, we’ll recapitalize the banking system with fresh public equity. How do you avoid saving the bacon of a lot of current bankers and debtholders? You don’t. You just accept that the biggest moral-hazard-creating event in world history is preferable to not having a banking system at all.
(Will there be a cost to this, in efficiency and returns to capital from private industry? Oh yeah, baby, you’d better believe that. And consequently you’d better avoid buying into the stock market for a lot of years to come.)
But let’s get down to brass tacks. Where will the equity of the First National Bad Bank come from? And what will its business model be?
Well, the last time I checked, the five-year US Treasury rate was a big, big, big 1.5 percent. Back in September when I first did this analysis, it had a 3 handle, if memory serves. The cost of funding this venture from the world’s investors has become damned attractive.
And this makes a lot of sense. Since September, a deep global recession has started that is freezing private investment and adjusting capital flows all over the world. There’s a huge amount of money out there that’s readily available for a systemic bailout of American banks.
Let’s go out there and get that money. The business model would be to charter an institution that would issue debt on a full-faith-and-credit guarantee, possibly with an agency-like imprimatur that would generate a few exra basis points of yield. It would be used to buy up maybe half a trillion dollars’ worth of asset-backed paper from banks, and simply hold to maturity. (That’s why I’m thinking of a three-to-five year term structure for the financing.)
As with a hedge fund, the point would be to capture the risk-adjusted yield from the asset portfolio and repay the investors. Risk is simply the credit risk of the portfolio, because the purchases would be non-leveraged. (The low cost of capital makes this possible.)
Downsides? Well, there’s the moral hazard of course. The banking system will never return to full-normal because everyone will know how rigged and nationalized it is. This effect will last for at least a generation. More than a generation, if the textbooks start getting rewritten to reflect a new dogma that private enterprise doesn’t really work in banking.
More practically, the downside is that the global capital that gets into this won’t be available for private investments until after the run-off period. We’re looking at tying down hundreds of billions of dollars in equity capital for a duration that will probably stretch out to three or four years.
But you’ve already been getting used to the idea of a New Great Depression to go along with Obama’s New New Deal. Haven’t you?