Reorganization vs. liquidation

Kevin Drum and James Surowiecki both take Richard Shelby to task for advocating “closing down” banks.”I don’t want to nationalize them; I think we need to close them,” said the Alabama senator. He wants to “bury some big ones.”

For the record, I agree. I think that both Surowiecki and Drum are not being fair to the good Senator. Here’s Surowiecki:

[I]t seems clear that what he’s advocating is liquidating these troubled banks—shutting them down, paying off the depositors via the FDIC or selling them to another bank (though it’s hard to imagine any other bank coming up with the money right now), and then selling off the assets piecemeal, with the proceeds going to pay off as much of the banks’ debts as possible. In this scenario, the banks’ shareholders would obviously get wiped out, and its creditors would also be forced to take a massive haircut. In effect, he’s recommending something like a more orderly version of the Lehman Brothers bankruptcy.

I don’t think that’s clear at all. The question of whether creditors other than insured depositors are paid off by the government is entirely distinct from the question of whether a bank in receivership should be managed as a going concern or liquidated. There’s little dispute that under any nationalization scenario, some or all uninsured creditors would have their claims guaranteed by the state. Whether or not to impose haircuts on junior claimants is a tough call, trading off moral hazard and justice against systemic stability concerns. But even saber-rattling moral-hazard fetishists like me acknowledge that we can’t force all creditors of broken monsterbanks to take the losses or debt-to-equity cramdowns they deserve. Sometimes you have to swallow and pay the ransom. But you don’t have to be nice about it.

Citi, for example, is a recidivist source of systemic risk (not to mention other corrupt dealings). Three times in three decades it has been on the verge of insolvency and required forbearance. Two of those three times, rather than being chastened, it became a turnaround story someone could gloat about. That shouldn’t happen a third time. Citi should be closed and liquidated. The bank should suffer the equivalent of corporate capital punishment, pour encourager les autres. Three strikes.

That doesn’t imply that creditors necessarily takes a loss. It doesn’t imply that all of its operating assets get sold for scrap, or even that all of its employees get fired. It does imply, first and foremost, that the brand goes away, that Citi, like Continental Illinois, becomes a historical cautionary tale rather than a gigantic but still scrappy comeback kid one more time. Secondly, the pieces in which its assets are sold must be small relative to the buyers, so that successor bits are put under the control of larger firms rather than representing mergers of near equals. Corporate culture matters, and some corporate cultures don’t deserve to survive.

Surowiecki has argued on a number of occasions that moral hazard concerns are overstated, that punishing banks usually fails to punish the agents who run banks, and the costs of being punitive outweigh any possible benefit. It’s worth pointing out that there are two sorts of villains: governments and creditors who make available funds without supervision, and the bank employees who steal and squander that money. I agree, unfortunately, that we can’t be as punitive towards creditors as some of us would like to be. But we can deal more roughly with the people who run large banks aground. We have banking crises about once a decade. Each time, it is the same story: mistakes were made but lessons have been learned. Obviously, the bankers say, we would never do this again. Just as obviously they always do. They play the same basic game in subtly different ways.

In a different post, Drum points out that

The fact is that these people did what they did not because they’re stupid, but because the system practically begged them to act the way they did. That’s what’s broken.

That’s true, but it’s not exculpatory, and it isn’t anything new. Subprime loans and CDOs are just a new twist on traditional real-estate booms. European banks are reliving our Latin American debt crisis in Eastern Europe, just hypercharged. This is a nightmare that comes at us over and over and over again. Each time we’ve paid the ransom and shrugged it off.

Drum is right when he argues

[Fi]xing it depends mostly on what kind of new financial regulations we put in place going forward. I guess we’re still in firefighting mode and don’t have time to address that right at the moment, but I’d sure like to start hearing more about it sometime soon. In the long run, figuring out an effective way to regulate leverage, wherever and however it appears, is probably a lot more important than deciding which bureaucratic solution we should use to clean up the corpses currently littering the battlefield.

But you know what? Once the fire is out, the very powerful people who still run the show both on Wall Street and at Treasury, despite having misdirected and skimmed trillions of dollars, will resist structural change. I hope that we do the right thing, and quite sever the guaranteed deposit and payments function of banking from the business of taking investment risk that oughtn’t be guaranteed. That would eliminate the root of the problem, the incentive to take ever greater risks with funds supplied on risk-free terms. But getting rid of a huge subsidy to a well connected constituency is likely to prove difficult. If the structural changes don’t happen, I’d at least like to see a few of the architects of this mess disgraced, and the empires they built turned to dust. It won’t solve the problem, but it might buy us a decade or two. It’d be much better to create institutions whose incentives are aligned with the public interest. But if we can’t do that, we can at least counterbalance temptation with punishment. Neurotic banks are better than pathological banks. Consider it a kind of insurance.

If Drum is right that…

when it’s over, guess what? Pretty much all the same people will be in charge. A few senior executives will be out of jobs, but that’s about it. And the ones who replace them won’t be much different.

…then God help us. There is no amount of money we can throw at a banking system that can’t be “tunneled” or “looted” away. If we end up with similiar people, with a similar worldview and culture running broadly similar institutions, it won’t be long before the nightmare on Wall Street is back. No wonder Citi never sleeps.

We can pay off the creditors of these behemoths, because, by design, we really have no choice. But there’s no reason not to cut ’em up and shut ’em down after we do so. Let’s bury ’em, Senator Shelby.

How to take back the money

Justin Fox has been asking how we might make the miscreants pay (and here). I have two ideas to throw out.

My first thought is an old doctrine. If we could get the people who supposedly represent the people to formally acknowledge the insolvency of the institutions we are bailing out, there is a wide-ranging doctrine known as “fraudulent conveyance” that might help. Payments by a bankrupt firm during the period preceding the bankruptcy are subject to challenge and reversal, under the theory that preferential transfers by insolvent firms to some parties rather than others are inequitable. I don’t know, from a legal perspective, how far back and how broadly the doctrine of fraudulent transfer could be applied to insolvent financials, but it’s possible that a formal insolvency (e.g. a nationalization or receivership) could put a lot of people who got paid by banks during the boom at risk.

Yves Smith pointed this out a while back. I think it’s worth taking a moment to wonder whether and how much the political resistance to formal nationalization is due to fears on the part of well-connected executives of being clawed-back via this doctrine. (Has fraudulent conveyance been aggressively pursued with respect to the Lehman bankruptcy? If not, why not?)

I hasten to add that I know very little about the legal details of fraudulent conveyance, whether it could in fact be applied to large, insolvent financials, what if any legislative action would be required to make the doctrine bite effectively, etc. I do know that even good-faith sellers of firms into leveraged buyouts are quite terrified of fraudulent conveyance, since even healthy firms become risky after the levering up and capital extraction that often followed these deals, and the former owners of previously viable firms can be made to take a serious hit. People who might know stuff about this (Buce?) are encouraged to weigh in. If we treated nationalizations as insolvency for the purpose of fraudulent conveyance, could we do some clawing back? Or is this a ridiculous idea?

Another way we could claw back is to simply enact a special tax on all recipients of income from firms receiving public support. Again, we are partially screwed by Hank Paulson’s cynical strategy of encouraging healthy firms to camouflage the rotten ones by accepting TARP funds. But we might set a deadline for the return of public capital, to encourage the healthy trend of banks returning unneeded public support. People who received income as an employee or contractor of banks requiring continued public support during 2004-2007 could be subject to a special, retroactive tax on that income. The IRS presumably has W-2s and 1099s by which they can identify those who would be liable.

This is obviously mean and unfair to many innocent bank employees, and cuts against the America tradition of eschewing collective justice. To diminish the meanness, the special tax could be progressive in the amount of income collected, so that janitors and tellers at Citibank wouldn’t be unduly hit. It could be spread over several years, to help people finance the unexpected charge. But, however imperfect, this sort of tax would be far better targeted than future taxes that penalize Americans broadly, or even forward looking tax levies on financials that (if we get our act together) might be very different from the dinosaurs and innocent of their sins. (Should pay for the excesses of Citibank?) Administration of the tax should be straightforward and comprehensive, as even the sharkiest of sharks working for putrescent financials wouldn’t have seen this one coming a few years ago and contrived to hide the source of paychecks from Citi.

Of course, it would set a precedent going forward, so highly-paid agents of firms capable of forcing a bail-out might seek get paid via squirrelly networks of special-purpose vehicles in order to evade future clawbacks. But that is a feature, not a bug. One problem with our financial system is that it was easy for basically decent people to engineer rapacious and fraudulent practices while persuading themselves it was respectable work. Acting in a manner that yields private short-term profits in exchange for catastrophic risk to taxpayers and the economy is not respectable work. People who find they have to launder their paychecks like drug dealers are less likely to get confused about that (and less likely to be dealt with mildly if they push us to the edge again).

If we do this kind of thing, we should make it clear that its purpose is to cover actual rescue costs, not to arbitrarily discourage risk-taking. (I’d view it as similar to how people who get stuck on mountains are sometimes billed for the cost of their search-and-rescue.) Agents of firms that are clearly small enough to fail could rest assured that the taxman would have no claim against people caught in private tragedies. Fear of such a tax might discourage managers and executives from building up large or insidiously interlinked firms and then capitalizing on an implicit “too big to fail” guarantee. Firms may be too big to fail, but the people who make them that way needn’t be invulnerable.

Update: Reader Paul Morelli directs us to the excellent Adam Levitin at Credit Slips on the subject of fraudulent conveyance and bonuses. See also the comments, in which Tom Grey suggests a “windfall bonus tax”.

Update 2: Skeptical CPA has a great deal about bankruptcies and fraudulent transfers, for example here. He also points to this interesting summary of bankruptcy scams. To reiterate the connection between this stuff and current events, if the government bails out an insolvent bank by making creditors and counterparties whole, that is like a bankruptcy, except the government steps into the shoes of creditors and takes the hit they otherwise would take. Conduct that would harm private creditors in a bankruptcy harm the taxpayer in a bailout, and in theory should be litigated just as aggressively by the aggrieved party, which is all of us. However, by preventing any formal declaration of insolvency, bailouts enable scavengers to avoid the whole skein of case law surrounding bankruptcy, which tends to put people who extract benefits from a firm while it is foreseeably bust in jeopardy.

Update 3: Buce weighs in on fraudulent transfer (and distinguishes them usefully from preferential transfers) in the comments. His conclusion? “…maybe less here than meets the eye.” Thanks Buce! Not too many comments on the tax idea, which I thought the more incendiary of the two proposals…

Update History:
  • 8-Mar-2009, 4:40 a.m. EDT: Added update re creditslips post.
  • 8-Mar-2009, 12:15 p.m. EDT: Updated with stuff from Sketical CPA.
  • 8-Mar-2009, 5:15 p.m. EDT: Added update re comment from Buce.

Rethinking subsidized finance

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won’t speak for CR, but some of us would disagree with JH’s presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH’s plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers’ put option and its “vega” — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry’s quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It’s as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms’ reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we’d like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don’t think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking has ever been a successful industry for capital providers? A “healthy” banking system is arguably just a bubble, worth investing in only if you’re smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we’ve never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It’s long past time to try something else.

A hopeful way out

Call the President!

The indispensable John Jansen has hit upon a way of preventing the next teetering shoe in the financial crisis from going thunk. So far, we’ve heard surprisingly little from the long maturity financial intermediaries — insurance companies (excluding the counterfeiters at AIG FP) and pension funds. Apropos, JJJ notes

Metropolitan Life announced that in its holdings of corporate bonds they are sitting unceremoniously on $14 billion in losses. I suspect that they are now hoping that advances in medical science will render current actuarial assumptions void and vacuous and the time value of money will work in their favor.

Really, Mr. Obama, has there ever been a better time to fund a Manhattan Project to invent immortality! Kill two birds with one stone. It’s immediate stimulus, quick-start investment in a sector where the USA retains a comparative advantage, high-tech medicine. Plus it’s a nearly bottomless, um, well of employment opportunity for less skilled workers, who could comb the Lake Okeechobee environs in search of the Fountain of Youth. If successful — and of course it would be successful, this is America, can do, yes we can, shut up we can too — it would save the financial system from the slow tremors of unfunded baby boom retirements and unpayable life insurance obligations. No, Mr. Dole, building a better Viagra doesn’t cut it. However, an appeal to the patriotism of Dr. Carlisle Cullen might yield rapid progress.

Our financial system is not the same as “our” big financial institutions

I’ve just listened to NPR’s recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation.

As an aside, we’ve come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn’t that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it “more responsible” to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?

Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner’s repeated conflation of our “financial system” and our “institutions”. Mr. Geither’s unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are “strong”. But that’s not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become “too big/complex/interlinked to fail”, but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.

We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of “Mussolini-style Corporatism“. Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it’s pretty clear that quite a few familiar financials have failed the market test. What’s good for Citibank is not what’s good for America.

Did you catch this bit from Warren Buffett’s letter?

Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

“Lemon socialism” has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don’t see how preventing healthy good banks from harvesting the organs of our megabanks “strengthens our financial system”.

I think it’s time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn’t mean that we would shutter all of Citi’s branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling’s #2) while the government backstops some obligations and seeks buyers for the bank’s assets, operating as well as financial. In other words, it’s time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that’s more likely in a world where Citi’s logo goes all retro chic like Pan Am. Frankly, I think that’s all the (non-negative) “franchise value” that’s left in Citi, and several of its peers.

How to fund financial system stablization

Word on the street today is that the Obama administration’s proposed budget includes a $250 “placeholder” for support of the financial system. (ht Economics of Contempt, Calculated Risk) President Obama made an admirable commitment “to restoring a sense of honesty and accountability to our budget”. However, his administration has failed to live up to that commitment with respect to financial system support. Unusually for government expenditures, the budgeted $250 billion dollars represents an estimated “net cost”. It presumes recovery of a substantial fraction of funds “invested” and actually enables cash payments that might amount to $750B. (See EoC, Marc Ambinder.). In plain English, buried in a $3.55 trillion dollar budget as a $250 billion dollar placeholder is a plan to more than double the controversial and unpopular TARP program, whose original enactment nearly tore the political system apart.

We do have a bit more transparency this time about how the “Capital Assistance Program” will be managed. Taxpayers will purchase securities at prices which, as Michael Shedlock points out, appear to have been back-dated in order to give taxpayers a raw deal. In an astonishing abuse of the customary language of finance, the “convertible preferred” shares the government intends to purchase, in addition to mandatory conversion after seven years, are convertible to common stock at the option of the the banks, rather than at the option of the taxpayers holding the securities. James Kwak unearthed this bit of chicanery in the must read piece of the day. In addition, existing bank shareholders would be protected upon any conversion by “customary anti-dilution adjustments”. God forbid that shareholders in bankrupt institutions who would otherwise be wiped out entirely get diluted. The poor dears. (To be fair, it is inaccurate to characterize all institutions that will receive “capital assistance” as bankrupt. The new Treasury Secretary will almost certainly continue the old Treasury Secretary’s strategy of “encouraging” healthy institutions to take government money, so that angry taxpayers cannot use acceptance of funds as evidence that a bank is in trouble. Under the new program, any publicly listed US bank can apply for a capital infusion of up to 2% of risk-weighted assets as a matter of course.)

President Obama’s obvious intellect, idealism, and diplomacy are a breath of fresh air for a nation whose economic and political institutions have suffered a near catastrophic collapse. But the President cannot put his imprimatur on continued financial obscurantism and expect to retain a reputation for honesty and transparent government. It is wonderful that the President intends to come clean and account for the wars in Iraq and Afghanistan on-budget. But Mr. President, past and proposed expenditures to support the financial system dwarf the total financial costs of both those wars combined. This is not a small thing. You can’t hide the terms of these transfers in fine-print befitting a credit-card agreement and expect to retain your reputation with the American people for forthrightness.

Here is my advice to the U.S. Congress: Put $750B in the budget, right up front, for financial system stabilization. But don’t contribute another dime to Secretary Geithner and Neal Kashkari‘s little slush fund. Allocate funds to the sole use of the FDIC, for resolution of troubled banks as foreseen by Congress under the FDICIA (text). See this excellent piece by former bank regulator William Black. The government has been flouting the terms of a binding legal regime designed precisely to resolve insolvent and near insolvent banks transparently, at least cost to the taxpayer, in a manner that minimizes both moral hazard and systemic risk. Former Secretary Paulson’s ad hoc let’s-pretend approach has been tried, and has failed. Why not try following our own laws?

We have a new administration in Washington that claims to be committed to the rule of law and good governance. Congress should help the President achieve these goals by funding an accountable FDIC rather than by putting more discretionary funds into the hands of a compromised Treasury secretary.

Update: The always excellent Nemo also noticed the odd reverse-optionality of CAP “convertible preferreds”. He finds the coincidence of widely publicized insider purchases during CAP’s price-determining 20-day window to be intriguing as well. Purchasing shares with the intention of increasing their effective price to taxpayers under a foreseen government relief program would certainly constitute a crime. What did Ken Lewis know, and when did he know it?

(It’s worth mentioning that the allegation of backdating and that of insider price manipulation are mutually inconsistent — if insiders knew that the window would be 20 days preceding Feb 9 in late January, that implies the price-determining date was appropriately set in the future. You can either suggest that the date was chosen retrospectively, or that it was chosen in advance and shares were bought and talked up, but you’ve got to pick one conspiracy and stick with it. I guess if you’re really cynical, you might suggest that Feb 9 was tentatively chosen in advance, but only finalized when it was clear in retrospect that prices were advantageous, relatively speaking…)

Update History:
  • 26-Feb-2009, 5:15 p.m. EST: Added update re Nemo’s posts.
  • 26-Feb-2009, 5:25 p.m. EST: Added bit about inconsistency between back-dating and price-manipulation stories, and hedged the main text a bit, saying that the window appears to have been backdated rather than stating that as though it were fact.
  • 26-Feb-2009, 6:05 p.m. EST: Removed an “as the” to split an overlong compound sentence about Geithner countinuing to encourage healthy institutions to accept money so the zombies blend in.

There’s no reason for non-recourse

We don’t know exactly what Timothy Geithner has in mind for the “Public-Private Investment Fund”. But we do have a few hints. First, we know that among its purposes is that it

allows private sector buyers to determine the price for current troubled and previously illiquid assets.

And we also know, that on the very day Mr. Geithner offered his outline of a financial stability plan, the Federal Reserve announced its intention to expand its Term Asset-Backed Securities Lending Facility, or “TALF” to up to a trillion dollars, coincidentally the round number that Geithner suggested the “PPIF” might expand to. Hmmm. What is the TALF again?

Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral… As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets… The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

Does your head spin, acronym upon acronym, non-recourse, warranties, and covenants? Well, unspin it. The New York Fed is telling us, in plain and simple legalese, that it is planning to make a very generous gift to investors that participate in this program (and indirectly to the banks that sell assets to them). A non-recourse loan bundles an ordinary loan with an option to “put” the collateral back to the lender instead of paying off the loan. Sometimes this is not much of a gift: When a pawnbroker lends you half of what your Fender Stratocaster is worth, and the fact that you can surrender the guitar rather than pay off the loan is cold comfort. But if someone fronts you substantially all of what an asset is worth, and the value of that asset is uncertain and volatile, then the put option bundled into the “loan” becomes extraordinarily valuable. If the asset appreciates, you take the profits and “ka-ching!”. If the asset falls in value, the lender takes the trash and eats the loss.

A near-the-money option is itself a valuable asset. Offering non-recourse loans to participants in the PPIF would directly contradict the program’s goal of “allow[ing] private sector buyers to determine the price for… troubled… assets.” Private sector buyers would not be pricing the assets themselves: they would be pricing a portfolio containing a troubled asset and a free, three-year put option, courtesy of the Fed. Depending on how much of the transaction the government is willing to finance, the value of the put option could represent a substantial fraction of the value of the asset being priced. This is a subsidy, that would be incorporated in the sales price of the asset and split by banks and private investors. It amounts to the government bribing investors to certify banks as more solvent than they are, by overvaluing bank assets in subsidized purchases.

John Hempton wrote a very brilliant essay on what it means for a bank to be solvent. If you haven’t read it, go do. Hempton’s definitions 2 and 3 of bank solvency — current accounting value (which implies mark-to-market valuation for many assets) and economic value as an ongoing enterprise — diverge because the cost of funding for investors in risky bank assets is unusually high. Under these condition, Hempton reasonably suggests, private fund managers will be unable bid assets up to their best estimates of “hold-to-maturity value”, less a “normal” risk premium, because investors are desperately unwilling to hold anything other than government guaranteed securities. Definition 3 is a very generous view of what it means for a bank to be solvent, because it implies that the actual market risk premium is wrong, that an estimate of hold-to-maturity asset values by a reasonable analyst, even accounting for risk, would put those values above current market bids. But in evaluating bank solvency we should be generous: Since an insolvent bank must be nationalized (reorganized, received, conserved, preprivatized, whatever), we should try to avoid declaring as insolvent banks that do have positive economic value, since that would amount to a capricious expropriation of private property.

But generosity in evaluation is distinct from a generous cash gifts from taxpayers to banks and investment funds. What is required to get a generous but still accurate evaluation of bank solvency is inexpensive funding, so that analysts willing to bet on what a “toxic asset” is worth can borrow the funds they need to back their spreadsheets with shekels without giving away all the upside to nervous lenders. What is not needed, what is in fact positively counterproductive, is to give investors a special bonus in the form of a free option if they buy the asset. This guarantees that assets will not be accurately priced (they will be overpriced), and reduces analyst incentives to value assets carefully and generate reliable market prices.

I actually think having the government offer cheap, full-recourse loans on a maturity-matched basis to investors willing to bear the risk of holding currently disfavored assets is a clever idea. (“Maturity-matched” means investors don’t have to worry about margin calls: as long as they get the long-term values right, they can ride out any tempests in mark-to-maket prices.) We do need a market in these assets, and if it is true that funds availability for people willing and able to bear the risk of ownership is preventing such a market from arising, then by all means, that’s a “market failure” the government can correct. But the key point is that a market price is the price at which private parties are willing to bear that risk. If funds are provided non-recourse, much or all of the risk of ownership is absorbed by the lender. Any prices that result from “private” purchases by investors funded at high-leverage on a non-recourse basis are not market prices at all. Such prices would be sham prices, smoke-and-mirror prices, sneaky off-balance sheet public subsidy prices.

We are all tired of the lies, Mr. Geithner. By all means, let nationalization be a last resort, and do all you can to offer liquidity to private parties willing to take both the upside and downside of speculating in questionable paper. But if you keep nationalizing the downside and privatizing the upside, it will not be very long at all before the public concludes that stress tests and market prices are just a sleight-of-hand for Davos man while he picks our pockets, again. Act fairly, and you may end up nationalizing the worst few of the larger banks. Keep up the games, and we will insist that you nationalize them all. It is getting hard to believe that there is a banker in the land who has not already robbed us. Eventually we will tire of drawing fine distinctions.

Afterthought: There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ’em a ticker symbol, and put ’em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

Thank goodness…

…for Yves Smith.

If you aren’t shrill, you aren’t paying attention. Weren’t we supposed to be done with shrill now?

Bank insolvency: tips & tricks

So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that’s a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.

  1. Never, ever feed the zombies!

    Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at “hold to maturity” values. Just say no! A healthy financial system cannot be run by zombies. “Rescuing” insolvent banks makes about as much sense as tying string to the arms of a loved one’s corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it’s sure to smell really bad, and it’s gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.

  2. Help private individuals save good banks.

    A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:

    The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed… to produce fair accounts for Gotham. Ten weeks should do it… The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank’s viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can’t or won’t fund the bank in full knowledge of its position then it is nationalised.

    The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank’s shares until the loan was fully paid.

    In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks’ viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is “illiquid but not insolvent”, since the government has offered liquidity on generous terms to help get the deal done.

    (For the record, I view this procedure as too generous. As far as I’m concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people’s heebeegeebies about the government owning what it pays for, I’d put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)

  3. Nationalize, reorganize, privatize spin-off to taxpayers.

    Insolvent banks become wards of the state. They are nationalized. The “N-word”, as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn’t change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about “nationalizing”, say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.

    Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too “systemically important” to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.

    Henry Blodget suggests we

    refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn’t appropriate for people to get paid.

    But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO “pop” goes to flippers, not to the firm or its original shareholders. There’s a deep literature on the phenomenon of “IPO underpricing”.)

    Here’s an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they’d quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value “toxic” assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.

    This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild “stimulus” — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it’s far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.

Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. “Compare and contrast” is a fruitful exercise. The spin-off idea owes something to this perspective.

London calling

So, I like to go on about how we don’t have a financial system, how the system we have is inadequate and structurally broken, how we need to invent new institutions. I think we need to experiment, in a startup-y, techy kind of way, with more flexible, fine-grained, and transparent exchanges that could augment and perhaps replace traditional capital markets. Really, that’s what I want to do someday.

Unfortunately, I’m slow and lazy. But occasional commenter Thomas Barker is not. He writes to say he’s helping to organize an informal meeting in London of people interested in pursuing just these kinds of projects. I desperately want to go, though I’m afraid the odds are slim. The event will take place on February 14th. (Yes, how romantic.) For more information, try here.