One can disagree with the particulars of this comment by George Soros, but his main point is sound. The financier argues that the Treasury Department’s $700 billion Troubled Asset Repurchase Facility should be used to recapitalize banks. This blog and most economists have argued that restoring depleted bank equity is the top priority for shoring up the financial system, and the original TARP program was a costly and inefficient means to that end.
The provision that will likely strike some readers as odd is Soros’ call for banks to have their assets written down, then get new equity infusions to bring the ratio of equity to total assets to 8%, but then permit banks to operate at lower (unspecified) equity to total balance sheet level. The reasoning behind that is if equity is brought to a prudent level based on accurate valuations, banks will not be able to make new loans, and those balance sheet constraints would hamper growth. It is typical for bank regulators to let banks run at lower equity levels in downturns (although they usually do this in ways that are not obvious to the public at large). This is a realistic approach, but one would also hope that regulators would apply pro-cyclical capital rules in good times (ie, requiring banks to hold higher equity levels when the economy is robust. There have been proposals advanced for how that would work operationally that appear sound).
From the Financial Times:
Now that Hank Paulson has recognised that the troubled asset relief programme is best used to recapitalise the banking system, it is important to spell out exactly how it should be done. Since it was not part of the Treasury secretary’s original approach, there is a real danger that the scheme will not be properly structured and will not achieve its objective. With financial markets on the brink of meltdown it is vital to make the prospects of a successful recapitalisation clearly visible.
This is how Tarp ought to work. The Treasury secretary should begin by asking the banking supervisors to produce an estimate for each bank, how much additional capital they would need to meet the statutory requirement of 8 per cent. The supervisors are familiar with the banks and are aggressively examining and gathering information. They would be able to come up with an estimate in short order provided they are given clear instructions on what assumptions to use. The estimates would be reasonably reliable for the smaller, simpler institutions, but the likes of Citibank and Goldman Sachs would require some guesswork.
Managements of solvent banks would then have the option of raising additional capital themselves or turning to Tarp, which would state the terms on which it is willing to underwrite a new issue of convertible preferred shares. (Convertibles are better than warrants because the banks should not need additional capital infusions later.) The preferred shares would carry a low coupon, say 5 per cent, so as not to impair banks’ profitability. The new issues would dilute existing shareholders but they would be given preferential rights to subscribe on the same terms as Tarp and if they were willing and able to put up additional capital they would not be diluted. The rights would be transferable and if the terms were set right, other investors would take them up.
Using this approach, $700bn should be more than sufficient to recapitalise the entire banking system and funds would be available to buy and hold to maturity mortgage related securities. Since insolvent banks would not be eligible for recapitalisation, the Federal Deposit Insurance Corporation would certainly require topping up.
Concurrent to the recapitalisation scheme the authorities would lower minimum capital requirements so that banks would compete for new business. The Fed would also guarantee interbank borrowing by banks eligible for recapitalisation. This would reactivate the interbank market and return the spread of Libor over Fed funds to normal and reduce the abnormally high interest rates on business and mortgage loans linked to Libor.
The success of the bank recapitalisation programme could be undermined by a downward overshoot in housing prices. A separate set of measures is needed to keep foreclosures to a minimum and to fundamentally restructure the deeply flawed US system of mortgage finance. Taken together the two sets of measures would not prevent a recession – too much damage has been done to the financial system and the general public has been traumatised by the events of the past few days – but they would reduce its duration and severity. Once the economy returns to normal, the minimum capital requirements of banks would be raised again.
The international financial system also needs repairing but there are grounds for optimism. Europe has realised that it needs to complement the euro with a government safety net for interbank credit. And the International Monetary Fund is finding a new mission in protecting countries at the periphery from the storm at the centre.
The recapitalisation scheme outlined here would suffer from none of the difficulties of reverse auctions for hard-to-price securities. It would help restart the economy and likely produce returns for taxpayers comparable to my fund’s. But time is of the essence. The authorities have lost control of the situation because they were constantly lagging behind events. By the time they acted, measures that could have stabilised markets were ineffective. Only by promptly announcing a comprehensive set of measures and executing them vigorously can the situation be brought under control.
Actions speak louder than words. Specifically, Morgan Stanley urgently needs rescue. The Treasury should offer to match Mitsubishi’s investment with preferred shares whose conversion price is higher than Mitsubishi’s purchase price. This will save the Mitsubishi deal and buy time for successfully implementing the recapitalisation and mortgage reform programmes.
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Yves,
Your coverage is absolutely heroic, especially considering the crazy weekend news cycle the world’s been on for too long now.
Thank you.
I’d say that removing mark-to-market rules would be much easier. It’s what they are doing right now in Europe.
“The success of the bank recapitalisation programme could be undermined by a downward overshoot in housing prices. A separate set of measures is needed to keep foreclosures to a minimum and to fundamentally restructure the deeply flawed US system of mortgage finance.”
Use fre/fnm as a platform for this.
FT: “This is how Tarp ought to work. The Treasury secretary should begin by asking the banking supervisors to produce an estimate for each bank, how much additional capital they would need to meet the statutory requirement of 8 per cent.”
Are you flipping kidding me??? Who is the author of that nonsense??? Thsi passes for respective journalism at FT???
Why don’t we just have Paulson ask the bums on the street corners with their tin cups how much capital they will need to meet their minimum RDA to thrive.
This is the most flipping irresponsible course of action imaginable. It’s no diff than Paulson going to Capitol Hill and saying “hey guys, I need $700 billion no questions asked, got it?”
The only prudent course of action is to send in the bank examiners to determine if the financial entity is hopeless or not. Hopeless entities must never be recapped at taxpayer expense.
Socialist/ Liberal Economic journalism such as this is worse than offensive to one’s sensibilities precisely because these opinions are being espoused from the esteemed FT. Many opinions on FT are simply accepted and go unexamined by their many readers.
Insofar as these errant opinions sway or otherwise influence consensus, this is journalism at its foulest and most dangerous
“…insolvent banks would not be eligible for recapitalisation…”
If you marked all assets on bank balance sheets realistically, what big banks would still be solvent, especially with the inevitable continued decline in prices of all forms of collateral? I’m skeptical that even the “good” banks (JPM, BAC, etc.) would meet any reasonable definition of solvency.
Oh, that was only George Soros I was attacking! Why, Hello George…
john bougearel,
With all due respect, it is clear you are a latecomer to the discussion of the financial crisis and what to do about it.
Far and away the best remedy was the approach used by Sweden, and Soros is advocating a variant. In the early 1990s banking crisis in Sweden, the government determined how deeply under water the banks were, nationalized them, decided which ones could be salvaged, consolidated the others into the winners, and spun the dud assets into a liquidation vehicle (this is grossly oversimplified but captures most of the elements). They also threw out incumbent management.
The cleaned up banks were later brought public when the economy was back on its feet, and the government showed a profit from this exercise.
Other large scale studies of banking crises have found Sweden and Sweden-like approaches to be the most successful.
Swift action is also important. Propping up assets or dud banks, and recapitalizing them later, does NOT work well. Japan, which had its crisis in the early 1990s and did not recapitalize its banks until 1999, is still in a deflationary trap.
There are no good options here, only horrible and less bad. The Swedish option is far and away the least bad. For you to reject it so vehemently merely proves your lack of familiarity with banking crises.
bougearel, the supervisors are employees of the FDIC, not the banks, and are reasonably informed and unbiased judges of capital requirements.
See also Soros: The game is out.
WASHINGTON, Oct 12 (Reuters) – Billionaire investor George Soros predicted on Sunday that the financial crisis would mean the end of a U.S.-led market system that has dominated the global economy with debt and deregulation since the 1980s…..
Yves,
Thank you for the quick and dirty on the Sweden solution whose govt nationalized the banks then determined which ones could be salvaged, consolidated the rest, and then liquidated the toxic assets while throwing out egregious mismanagement. I had not had time to get acquainted with that crisis and how it was handled yet.
The Swedish model you outline and the unavoidable nationalization I agree is the least horrible option(accept for the company, their creditors and shareholders perhaps).
My concern and what I am weighing in on is that in none of the proposals thus far from the Treasury have I seen any mention of determining which firms can be salvaged and which can’t be.
From what little I have studied of the resolution to the banking holiday of 1933, the RFC model bears a great resemblance to the Swedish solution. I am going to nose around my book on the RFC and check on those similarities
Faireconomist, that is a good heads up, thank you. I did not know the supervisors were from the independent FDIC agency. That is good news indeed too.
Re: balance sheet constraints would hamper growth.
The current growing uncertainties as to what value is, and how to measure it and balance it, will be a great challenge to capitlaism. IMHO, the solution is to not re-engineer a new subprime loan crisis — or to fuel a new Dotcom Bubble or reinvent The South Sea Bubble with a new patchwork quilt package of synthetic capital injections for the casinos that ran outta dough.
This is now a time to preach the gospel of restructuring, i.e, structure that bridges truth and integrity to a new foundation of confidence. Soros is part of the old system that relies on dogma that is disconnected from this new era we are rapidly entering — where new economic voices need to be heard.
IMHO, the current failure of Capitalism is an opportunity to burn down the faulty structures and begin re-building something better for a new generation of people that want changes now.
This is an era not unlike 1905, when Einstein had strange new ideas that were radical departures from the familiar theories held by many of that days finest physicists — who dismissed his originality as being irrelevant. The upper echelon of the science world refused to be challenged by notions that Newton might be wrong and that someone outside their circle might be right.
Hence, here we go again, with dogma from Soros, Bernanke, Paulson and all the old financial guard that put forth old established ideas on how to save the reputation of their Newtonian brethren. These well connected, well heeled elitists offer solutions to bail out their good old friends that belong to their country clubs, who wish to bailout their sons and daughters, who intermingle in a wonderful world of socialized nepotism, looping around in full circle dances, digging deeper holes for the rest of us — who just want something better than the same ol shit!
In being critical, I should probably provide a solution and all I can offer is the suggestion that structured synthetic derivatives should be taken out of this financial cathedral and all the crooks that have played games and bloated themselves on greed should be disgorged of their ill-gotten treasures and then many of them should simply go to prison.
These new plans don’t need to be complex and filled with supercomputer incomprehensibilities — quite the opposite is true, in this situation, i.e, a return to simplicity, as in It’s A Wonderful Life, where local accountability at your bank is something you don’t have to worry about, because they gain your trust by being honest — not some other madness where a string of swindlers rip apart your mortgage into slices, which get chopped into fractional pools that get laundered like drugs in Bermuda, which are then used to supercharge clouds of chaos that we are currently spinning in and smoking like … aaaahhck, how many sermons is this gonna take here??
See: On 7 November 1919, leading British newspaper The Times printed a banner headline that read: “Revolution in Science – New Theory of the Universe – Newtonian Ideas Overthrown”
Just for fun, see: In January 2003 Trichet was put on trial with 8 others charged with irregularities at Credit Lyonnais, one of France’s biggest banks. Trichet was in charge of the French treasury at that time. He was cleared in June 2003 which left the way clear for him to move to the ECB…
Under the original RFC Act signed into law in January 1931 by President Hoover, their "original repair work had been limited to making loans [that were] fully and adequately secured.
"Each day," relates Jesse H. Jones chairman of the RFC,"it had become increasingly clear that the banks needed investment capital [and not loans] which we had no authority to provide. Despite the restraint enforced by law, during the first seven months, [they] pumped loans into almost one out of every four banks in the country…Despite all these efforts, as fast as one situation was improved, several others got worse. Loans were not an adequate medicine to fight the epidemic. What the ailing banks required was a stronger capital structure.
Obviously a distressed country could not support an unsound banking system, but a sound banking system could support a distressed country. It was not however until the nation-wide collapse of 1933 that Congress became convinced that a new sound foundation should be put under America's credit structure. Five days after Roosevelt's inauguration, [and 4 days into the banking moratorium] a bill authorizing the RFC to invest into the preferred stock of commercial banks was rushed through the special session of Congress which had assembled only that morning.
The Act was promptly signed by [FDR]. He then told the people in a memorable broadcast that only sound banks would be permitted to reopen. In one stroke Congress had turned the tide toward recovery.
What constituted sufficient soundness to permit a bank to open was not left to the determination of the men who managed it. The decisions were made by the Comptrollers office, the Treasury, and the RFC. Our work week became one of seven days and seven nights. In literally thousands of cases, in those feverish days and nights, it was difficult to decide whether a band was truly sound. The plunge in market values made one man's guess as good or bad as another's in assessing the probably worth of many a bank's portfolio. Mistakes were inevitably [and] a great many banks were allowed to resume business. [Many firms were only allowed to] resume operations on a limited basis. It was up to the RFC to make them sound with additional capital.
Hundreds of banks wee placed in the hands of conservators.
To take care of bank closings which were beginning to occur in woeful wholesale lots, I realized as did various others that some drastic new legislation would be necessary.
[Walter Wyatt, from the Federal Reserve and his staff began working on the Bank Conservation Act and the preferred stock amendment. Both the Bank conservation Act and the preferred stock amendment went before Congress for a vote at 11.15 pm on March 8 1933. The bull passed ]"unanimously after 35 minutes discussion. With cries of 'Vote, vote' the chamber howled down the efforts of sevearl speakers to be heard, and the measure was approved by acclamation. It was an unprecedented expression of confidence in the new admin to go forward with the program of revival.
During th arduous days and nights of the bank holiday, all national banks were classified into three categories A B and C. A banks were those whose capital was sound. B banks were those whose capital had largely disappeared, but which had assets considered sufficient to pay the depositors in full. C banks were those in which the capital was completely gone and there was an indication of loss to depositors.
A banks reopened immediately. B banks were opened as quickly as they could be got into shape. C banks were placed in the hands of conservators for reorganization and ultimate liquidation."
Yves, what a wonderful forum you have here at NC.
This morsel was excerpted from Jesse H Jones 1951 book entitled "Fifty Billion Dollars" in his own words speaking to us about how the banking crisis of 1933 was finally resolved.
I think it especially noteworthy that it was not until the nationwide collapse that Congress legislated drastic measures to restore soundness and safety to our banking system in 1933. In this regard, things are entirely the same today as only after the chain reaction or domino effect that shuttered our entire credit system did our legislators and regulators take drastic and unpleasant measures proposed by P&B to shore up the financial system.
Without the entire freezing of our banking system, legislation of this nature would never have been politically feasible in the first place.
congressinal action No, the RFC did not nationalize the banks as Sweden did.
john bougearel
That is an interesting excerpt. It describes a solvency/liquidity confusion and some duff policy that didn’t fix the problem. Sounds familiar.
I wonder if Jesse Jones’s account of the crisis is anything like Bernanke’s. That would be sad. Bernanke’s historical perspective was supposed to help avoid the policy mistakes of the 30s. That excerpt makes the last year look more like a rerun.
Richard
Of course, in 1932-1933, the entire economy had been shuttered, from business to agriculture, to real estate and banks. That is not so today. Congress in 2008 have at least begun to respond at a time prior to the collapse of the rest of the economy.
The most striking parallel between the two crises however, is the delayed response by the government to get involved when they are the only one left to do any spending after the consumer and business investment are no longer able to do the heavy lifting.
In this 2008 instance, it should be noted that the bulk of this crisis climaxed in September after Lehman was allowed to fail. The market response to that failure and its contagious effects was swift, decisive and devastating.
Flipping back to the creation of the RFC, Jesse Jones noted in his memoirs that President Hoover’s response was a year too late. The RFC, which eventually whipped the devastating forces of the Great Depression “that wrenched the well-being of almost every inhabitant of the earth,…was a year too late.”
Had a few billion dollars been “boldly but judiciously lent” by an agency such as the RFC in 1931-1932, Jones believed the entire breakdown of business, agriculture and industry could have been avoided and “saved the fortunes [and] morale and self respect of thousands of Americans who had never before bowed their heads in adversity.”
In the struggle against the depression, the Corporation used $10.5 billion dollars, but eventually without a loss to the taxpayers said Mr. Jones. To the contrary, that money was all returned to the Treasury with approximately $500 million [in net profits after operating expenses]… Looking back, I don’t see how we accomplished all the myriad things we did,” said Jones.
Unfortunately, agencies like the RFC tend to never get created in the first place unless precipitated by a crisis spiraling out of control. Never-before-thought-of homeland security measures were implemented only after 9/11. When Hurricane Katrina hit four years later our government response proved wholly inadequate. Plans and provisions to evacuate residents of the city of New Orleans were be both delayed and insufficient. As a result, many residents suffered a fate much worse than was necessary as a result.
And why? The simple answer is that governments can not pre-plan for every unforeseen disaster or for the magnitude of their potential devastation. Time and again, by the time our government safety nets are eventually cast and drawn around a disaster, the collateral damage has already proven to be quite extensive.
“The RFC began lending money to troubled banks in February 1932. As the banking crisis grew, so did the powers and size of the RFC.
After Roosevelt became President, the RFC was permitted to invest its funds directly in commercial banks.
Between 1933 and 1935, the RFC purchased more than $1.7 billion in preferred stock in individual banks.
To gauge the significant size of this agency’s activity, in 1935 the total book value of equity capital (including the RFC investment) for all commercial banks was $3.6 billion.
New RFC bank investment effectively ended by late 1935, and banks gradually repurchased the government’s stock out of their earnings when the banks subsequently returned to profitability.”
FINANCIAL SERVICES REGULATORY RELIEF ACT OF 2006
‘‘SEC. 5143. REDUCTION OF CAPITAL.
‘‘(a) IN GENERAL.—Subject to the approval of the Comptroller
of the Currency, a national banking association may, by a vote
of shareholders owning, in the aggregate, two-thirds of its capital stock, REDUCE IT’S CAPITAL.
Obviously the credit worthiness of the borrower is more important.
If I held this mortgage paper, I would sort the customer database by zip code and add up the loan amounts.
Gauging the value of the loans would be relatively easy as the segregated (by geographical region), measurement of the local market declines, are fairly accurate. I.e., zip codes in California & Florida would be marked down more than Kansas, etc.
This, of course, doesn't measure the credit worthiness of the borrower, rather the value of the debt instrument (house).
Presumably, the type of loan made by the lender, or their payment history, could be used to stratify anticipated mortgage payment returns.
I just can't believe that defaults, credit ratings, etc. can't be quantified.
There are PhD’s in Credit Management. They can identify the variables or add elements to the record to establish a credit scoring system. There have been lots of companies with sick accounts receivable portfolios, and Credit Managers always find answers which allow them to measure their assets performance.
Probably it’s not that these investments can’t be valued, it’s that someone might lose their job, or the institution might have to mark what’s in the portfolio to market.
Interesting. Who offers a Ph.D. in Credit Management.
National Association of Credit Managers might have the answer.
I attended a class taught by a Ph.D. in Credit Management from I think, a college in Chicago.
The point is that you can do anything with data. And you can append any number of fields that are required, via data entry, or program. Anyone ever merge systems?