From hysterical misery to ordinary unhappiness…
March 10th, 2009By David Goldman
…is the way Siegmund Freud described the objective of psychoanalysis. Market expectations seem to have shifted in a direction indicated by this blog, as well as Bronte Capital, Tom Brown’s Bankstocks, and a handful of other venues that look at banking in a traditional way. The positive feedback loop of asset writedowns, capital reduction, equity price declines, government intervention, and the fear of nationalization brought the system to a branching point.
It seems hard to believe that Fed Chairman Bernanke’s discussion about reducing the deleterious impact of mark-to-market losses, Presidential advisor Paul Volcker’s proposals about a return to traditional banking, Treasury Secretary Geithner’s assurances that no large institutions would be allowed to fail, and Citigroup CEO Vikrim Pandit’s claim that Citi was running a profit were entirely isolated events. What sort of profit Citigroup reports this quarter is up to the regulators. If the regulators compel Citi to write a good deal of its loan book down to market, the bank could show an arbitrarily large loss. But Citi’s cash-on-cash returns in a cheap-funding, wide-spread environment probably are reasonably strong.
Meredith Whitney’s comments today seem a bit impertinent. It may be true that Citi is not making money on any of its businesses, but that presumes that portfolio income will be eliminated by mark-to-market writedowns. At the same time, the redoubtable Ms. Whitney argued that banks didn’t want to return to mark to market because that would eliminate their upside should asset prices recover. All this is beside the point.
The bank regulators have a set of problems to address.
They cannot easily nationalize the banks because
a. Nationalization immediately would collapse the value of bank asset books relative to liabilities and balloon the negative equity assigned to taxpayers
b. The value of bank hybrid and other capital securities would collapse, intensifying the misery of the institutions with the greatest exposure to bank capital securities, such as the insurers.
The simplest and least costly approach is to keep the banks alive on a respirator: provide cheap liabilities through a variety of mechanisms including FDIC-guaranteed bond issues, and allow the banks to clip coupons in a very wide spread environment. The deteriorating economic environment (and it will continue to deteriorate nastily) will pile up loan losses almost as fast as the banks can generate cash flow. Cheap federal funding may just allow the banks to stay in positive territory.
Bank stocks were artificially depressed by market fear of nationalization. I have maintained throughout that this was an irresponsible and unworkable proposal by academics (Krugman, Nourini) who did not understand or did not think clearlky about the financial system. But this is not an enthusiastic case for bank stocks. On the contrary, my view is that keeping zombie banks alive is the scenario to which regulators will iterate. What is the value of a zombie Citigroup or Bank of America? Somewhere in the low-to-mid single digits for C, and in the upper single digits for BAC. That implies a substantial percentage gain from Monday’s opening levels, but not a sustained rally.
As loan losses (prime mortgage, commercial real estate, commercial and industrial loans, and so on) continue to pile up, the zombie existence of the banks will remain tenuous at best, and it will be years before they pay anything resembling the kind of dividends they offered as recenty as a year ago.
Investors who own bank stocks should already be considering targets for profit-taking.
March 11th, 2009 at 12:43 am
Have you a view on whether money center bank bond holders should stay or bail?
Bill Gross thinks he is safe snuggled up to the government umbrella shaft. I’m not so confident that we can ignore the possibility of debt-equity swaps or at least haircuts. Especially if accounting continues to be based upon liquidation rather than going-concern valuations.
March 11th, 2009 at 6:07 am
Mr. Goldman, You have a great mind and are a fine writer. Tom Brown is a nice man and thoughtful analyst. You both know many bank executives. Please explain what you mean by traditional banking? Who might we put forward as a paradigm for such an enterprise? Now, Mr. Buffett, another thoughtful analyst, believes that WFC has $40 B in potential p/t earnings power. It seems to the uninitiated that, in these troubling times, everyone is just talking their respective book.
Good luck with the blog. Tis a valuable addition to the blogosphere.
March 11th, 2009 at 9:39 pm
I think Bill Gross is right about bank debt. The impact of partial default would be catastrophic and I don’t believe governments will impose it.
March 11th, 2009 at 10:05 pm
I also think you are right. However, the government could guarantee all liabilities of the banks that they put into receivership. as Krugman suggests I think the problem with that is the potential true defaults later on could lead to a situation where the government has to assume too much debt ie balooning state liabilities. Moreover that type of guarantee would set up equivalent moral hazard for bondholders as is present for equity holders. Another problem realistically not mentioned is the US government doesn’t have the capacity to Nationalize entities as large as CitiBank and Bank of America. It literally would have to draft bank examiners and perhaps kidnap them from elsewhere. A more reasoned proposal would be to split the large banks after the crisis stabilizes. Note that doesn’t really fix the problem which is significantly in the shadow banking system and in systemic failure. The proper solution is a rational regulatory structure and a hugh stimulus.
March 12th, 2009 at 6:36 am
Karlmarx,
Thanks for your thoughts.
A number of people including “Curious Capitalist” at Time have made a similar argument: the bank liabilities might swamp government finances. As Jamie Dimon told Bear Stearns a year ago, there’s a difference between buying a house and buying a house on fire. A seized bank is a house on fire and its asset book value collapses. That would leave the taxpayers on the hook for very large sums. In effect the government has guaranteed bank liabilities (no problem of deposit runs or funding) already. Breaking up banks is already happening with government prompting, and if Paul Volcker is right, it will become the norm.
March 12th, 2009 at 10:01 am
I’d like your thoughts on this solution to a run on a bank/s. Given the international nature of the problem it seems unfair to ask any one nation to bankroll depositors completely (ie Iceland?) although clearly no single depositor(or bondholder)should take the total fall for past sins. However they should wear some pain for some insurance gain perhaps, bearing in mind they choose to get some return from a particular choice of bank. Now it might be presumed that any one institution could be vulnerable to say 40% of toxic assets at present, albeit that may be much ameliorated over time. Therefore the particular jurisdictional Govt gurantees only 60% of deposits/bondholdings in the event of a run. Should the run occur the bank is immediately closed, the shareholder equity wiped out, every depositor/bondholder’s account reduced by 40% and new shares issued to each depositor/bondholder based on their pro rata share of the total 40% accounting loss. The bank reopens with a Govt guarantee for the remaining 60% (ie the central bank lends any working funds required up to that amount at its normal rate) and the new depositor sahreholders are free to hold their shares or trade them at any time on the sharemarket for whatever they can get. Essentially any new shareholder could hold and earn dividends as bank profitability returns and asset prices improve, or cut and run immediately. Basically it becomes a cooperatively owned bank or ‘their bank’ with that guarantee on their other 60% of funds. Clearly they have a vested interest in staying with the bank and seeing it all through, with the benefit that remote taxpayers don’t have to engage in TARp bailouts with all the non’market valuation problems. Naturally the percentgaes could be tuned here for particular circumstances eg 50/50, but a 40% ‘virtual’ haircut sounds about right.
March 27th, 2009 at 6:33 am
[...] Inner Workings » Blog Archive » From hysterical misery to ordinary … [...]
April 24th, 2009 at 11:29 am
[...] 2. Seizure and writedowns might have been the proper course of action last year, but now that Treasury and the Federal Reserve have already put up trillions of dollars, backed by the very loans and securities that would have to be written down, it would be spectacularly costly to the government. It also might wipe out large swaths of the insurance industry, because insurers own lots of bank preferred shares and debt. So letting the banks slowly and fitfully earn their way out trouble is really the only alternative at this point. So sayeth David Goldman. [...]
April 24th, 2009 at 2:29 pm
[...] 2. Seizure and writedowns might have been the proper course of action last year, but now that Treasury and the Federal Reserve have already put up trillions of dollars, backed by the very loans and securities that would have to be written down, it would be spectacularly costly to the government. It also might wipe out large swaths of the insurance industry, because insurers own lots of bank preferred shares and debt. So letting the banks slowly and fitfully earn their way out trouble is really the only alternative at this point. So sayeth David Goldman. [...]
April 24th, 2009 at 3:05 pm
[...] 2. Seizure and writedowns might have been the proper course of action last year, but now that Treasury and the Federal Reserve have already put up trillions of dollars, backed by the very loans and securities that would have to be written down, it would be spectacularly costly to the government. It also might wipe out large swaths of the insurance industry, because insurers own lots of bank preferred shares and debt. So letting the banks slowly and fitfully earn their way out trouble is really the only alternative at this point. So sayeth David Goldman. [...]