Buiter, in a very good and lengthy post, addresses various issues related to banking, such as the question of “too big to fail” and the future, or more accurately, the lack thereof, of cross border banking. I recommend reading it in its entirety, and wanted to focus on his most controversial argument, but one where I suspect he will be proven right.
Buiter says the Treasury does not have the bucks to implement the banking policies it has adopted, namely, refusing to have bondholders take any pain:
There is just one way to make the US government’s policy towards the banks work. That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks – $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital. The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero.
There is no real money left in the original $700 bn TARP facility – somewhere between $ 100 bn and 150 bn – to do more than stabilise a couple of pawn shops. The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of the Fed. The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars. Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars.
In addition to looking for money in off-budget and off-balance sheet places (and out of sight of Congress), the US Treasury has also tried to hide true extent of the problems of the US banks. In addition to supporting the FASB’s recent proposals for increasing managerial discretion as to the way illiquid assets are accounted for (that is, condoning the issuance of another license to lie), the Treasury appears to be using the ‘Stress Tests’ announced as part of the Financial Stability Plan, as a mechanism to play for time and gamble for resurrection.[1] I base this on what I have been picking up about the reality of these Stress Tests.
1. The actual decline of the real economy thus far is already steeper and deeper than assumed in the Stress Tests.
2. The Stress Tests focus on the 40% of the banks’ balance sheets consisting of securities, rather than on the 60% consisting of conventional loans. The securities (including the toxic waste) is where most of the old problems of the banking sector are concentrated, that is the problems incurred as a result of the pre-August 2007 speculative frenzy. The loan book contains the stuff that will go bad as a result of the steep and deep contraction in real economic activity the US has been in since Q4, but that will not show up in the banks’ reports until this summer at the earliest.
3. The bulk of the information provided to the authorities by the banks is private information to the banks that is virtually impossible to verify independently. Too many banks have lied about their exposure too many times for me to feel confident about the quality of the information the banks have been providing as part of these Stress Tests.
As a result I now expect a clean bill of health for the banks from the Stress Tests. For most banks this will turn out to be incorrect before the end of the year. At that point, the de facto insolvency of much of the US border-crossing banking system will become so self-evident, that even the joint and several obfuscation of banks and Treasury will be unable to deny the obvious. There still will be no fiscal resources available to sanitise the banks’ balance sheets by purchasing or guaranteeing the old toxic assets and new bad assets….
Yves here, It has been noted in the New York Times and elsewhere that no banks will “fail” the stress test; the double-speak is that they have to go get more capital, either from the market or the Treasury. This sounds suspiciously like the modern vogue for not giving children bad grades because it might wound their precious self-esteem. Back to the post:
At that point, only the ‘good bank solution’, which requires either a serious hair cut for unsecured creditors or a mandatory conversion of debt into equity will be viable, simply because the bad bank solution requires additional public money which isn’t there. (You creating a new good bank out of the assets of the old bank and the insured deposits and counterparty claims on the old bank, leaving the unsecured creditors of the old bank with a claim on the equity in the new good bank; a bad bank requires funds to buy the toxic and bad assets from the old bank and addition resources to capitalise the bad bank).
Yves here. The “good bank” idea is one of Buiter’s hobbyhorses; Stiglitz has similar ideas. As elegant as it is in concept, it is no where near as tidy to implement with large firms with global trading operations, which is the case for at least some of the badly impaired banks. Back to Buiter:
We will have wasted a lot of time – the good bank solution and the slaughter of the unsecured creditors should have been pursued actively as soon as it became clear that most of the US border-crossing banking system was insolvent, but for past, present and anticipated future tax payer support. If the Treasury can be pushed into a pro-active policy by declaring, just before the beginning of the weekend, that most of the banks undergoing the Stress Test have failed them and moving these wonky institutions straight into the FDIC’s special resolution regime where they can be restructured according to the good bank model, we could have well-capitalised banks capable of new lending and borrowing by the beginning of next week.
The same policy should be pursued wherever banks have failed: it never makes sense to put the interests of the unsecured creditors before those of the tax payers. It is bad economics in the short run and in the long run. And it is political poison. I fear, however, that only in those countries where there is no fiscal spare capacity (as in the US, for political reasons or in Iceland, for economic reasons), the right solution to bank restructuring will be adopted. Elsewhere the unsecured creditors will continue to feed off the carcases of the tax payers and the beneficiaries of public spending programs that will have to be sacrificed to foot the bill.
There is still some dispute as to how sick the banks really are. One comment yesterday (unfortunately also laced with ad hominem attacks) questioned the contention in the John Dizard article I featured yesterday, which said Citi’s days are numbered. The comment contended that Citi post its pending common for preferred exchange would have $150 billion in equity and $30 billion in loan loss reserves on a $1.8 trillion balance sheet (this individual managed to omit the $1 trillion in off balance sheet exposures, not a trivial matter). With that plus $35 billion in subordinated debt, things will be hunky-dory. I ran the observations by Dizard and got this reply:
Again, whatever I say about Citi’s condition, look at what others implicitly think. Several European governments have been cutting Citi off their list of approved counterparties for state companies— all this after the reported “news”. Possibly they know something. Citi has already been organizing, internally, for a forced good bank/ bad bank restructuring. Anon’s positive view is a minority one among investors in bank paper….
The numbers for Citi’s assets and liabilities are suspect, apart from the off balance sheet liabilities you mention. Why does Anon think that Citi has been disposing only of the bad paper, not the good stuff for which there has been a market? What happens to their CRE book, or their leveraged loan book, or, for that matter, their consumer loan book? Does he think he knows the marks for those assets? How do those marks compare to those of others who hold those assets? I would say they are not…more conservative. And no, Citi is not representative of the U.S. banking system as a whole. It is a fundamentally dysfunctional institution run by terrible, self-serving senior managers. Dismembering it would be a good thing for the system as a whole. If Anon thinks the reorganization is working, just wait until the fourth quarter, or even the third, and then think again.
Citigroup also has the dubious distinction of being on an FDIC list of “Failures and Assistance“.
Do read the rest of Buiter’s piece.
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First, let me again register my frustration that we’re wasting our time talking about bank recapitalization and rescue, much less imminent economic vitality. Lending is not occurring not because banks are choked with bad assets or there is a shortage of liquidity, but instead because there is a dearth of economically viable lending to be done.
This is simply extension of a twenty-five year trend in equilibrium real interest rates, and until that is changed by the forces of time or policy(somehow), we’re going nowhere fast. Cap utilization is below 70%, for goodness’ sake.
Disposition of bad assets can at best make foolish creditors whole again, and should not even be a discussion topic until we find a way to make the general risk-adjusted return on lending positive.
As Buiter notes, we’ve attempted to do so by Federally guaranteeing risk. This doesn’t mean the risk has gone away, but so long as we’re stuck in deflation, the losses can hypothetically be eaten by the government to the benefit of the system as a whole. I’m unconvinced that the dispersion of losses and lending is at all related to the areas where we need investment to occur, and hence, quite unconvinced that this is a beneficial exercise even beyond its zombie, unliving nature.
On to specific points…
There is no ‘too interconnected-to-fail’ problem separate from the ‘too-big-to-fail’ problem. I can be infinitely interconnected. If I operate on a small scale, I and my interconnections are immaterial from a systemic stability perspective.I don’t precisely follow Buiter here. It’s basically definitionally impossible to have extremely large banks because financial depth is in some sense a direct measure of their size.
But I think the logistical argument that it’s very difficult to unwind a tangled mess of a headless, mismanaged firm is legit. This can at the very least cause a liquidity crisis, as it’s unclear who owes how much, and who’s lost how much.
Even if we agree that a particular bank or other financial institution is too large to fail, as soon as there are multiple fiscal authorities and border-crossing banks, there remains the unanswered question as to who should bail it out.This is a profoundly important issue that is not at all limited to banks. Bank failures are spectacular, but many other markets can fail, resulting in natural international monopolies. Look at Google, Facebook(soon) or Microsoft: these are virtually invincible corporations occupying natural monopoly space, with no governance mechanism capable of creating a market place or effectively challenging the multinationals.
We are going to need to solve this problem generally, not just for banks. As many of these globe-spanning institutions are American in origin and nexus, it is not in the U.S. interest to lead such an effort, which the rest of the world probably already noticed.
I’m largely in agreement with all of Buiter’s points. He neatly skewers the (what’s a good word) inanity of the ‘stress tests’ as performed, since they didn’t even look at half book of any zombie financial and took the measure of the morticians of the latter for what they did peruse. I’m in agreement with Buiter on another general surmise also, that the regulatory charade being performed presently cannot last the year out. While I’m personally incensed at the policy and executive failure of the US government on dealing with zombie financials, the game has a ‘drop dead date’ to it. The public can expect to have had $1T of their tax obligations lost by then, there’s the rub.
I recall advocating largely for an end to behemoth banks in discussing issues of systemicity near on a year since. Buiter rakes up an interesting twist on this via another commentator (Baker?) to the effect that above a certain size reserve requirements for regulated banks could be set so as to rapidly scale up to levels which would make the erection of colossoi uneconomical. Buiter also mentions briefly what is a very important point from the perspective of effective regulation and the public good, that the _monopoly power_ of a few large institutions is inimical to both market stability and good governance. This is an issue we should, and I expect will, hear far more about once the crisis plateaus and we get into re-build mode. Titans of wealth create monopolies or at least oligopolies from which they force the financial system into their optimum potentials rather than _its_ optimum potentials; that’s a Bad Thing, by the way.
So ndk, I take exception to your first contention, that there are _no_ ‘economically viable’ opportunities to lend. Cap u is 70% odd, not zero. But the broader point is that the real economy needs effective credit intermediation for _normal operations_, something quite separate from high-margin speculative investment. I know that you understand this, but you’re glossing over it in pursuit of the valid point that high-margin lending is dead for the immediate future. If those retail stores are going to put clothes on the rack in the Fall, they need working credit at a reasonable price. Yes, we all have too many clothes; we will need some, however, so they must have costable and payable sums to work with to get that product through the channel. But right now, the Big Boys of finance are buying up each others rotting ASBs with money borrowed from the government so that they can sell those rotters back to the government for profit. That’s dysfunctional use of resources, and worse sucks the credit oxygen out of funding the working capital of the real economy at a reasonable rate rather than an exorbitant rate.
But that brings us back to Buiter’s point, that attempting to sustain/revive credit intermediation to the real economy via suppurating behemoths is both unworkable and undesirable. —But his underlying point is that functional choices on this issue—cutting the behemoths down to size—need to be made IMMEDIATELY. We have demand collapse putting deflationary pressure on the real economy (even while bubbled asset prices are not ‘deflating’ because they are still above long-term trend stability levels). So again, to address how to provide basic credit intermediation one needs to decide, now, today, before next Monday as he illustrates, that the Wide Boys can and must go down. The business of more than one of the Small Sound Bank(s) would be to make normal capital loans to put those clothes on the rack, and etc., and etc. Yes, yes, we need a broad economic redesign; it would be nice to have a chance to implement it in something other than depression-level conditions.
Its the economy or the giant rotting banks, one or the other; the government doesn’t have the dough to save both. Right now, Barack Obama and Co. have chosen to save the zombie banks rather than the national economy. Well, we can’t fire him for close on four years, so let’s hope we can change his mind.
On Buiter’s point regarding ‘nothing not too large too fail is too interconnected to fail,’ just think it through: he is exactly right. If the heart of the national financial system is five-eight giant institutions which deal in everything, onshore and off, they may be too big to fail since they would shatter the capital markets if any one goes, or very nearly. If the heart of the financial system is fifty major banks, no node can have such dominance, so even a total failure of one sees most of their business redistributed to other nodes, and few counterparties so exposed to them on the basis of their size that the loss cascades. The point is to keep any node from becoming so large it’s failure blocks redistribution to the rest of the system. Flows may change rapidly even so, and that can be disruptive. If regulators have done their work, there would be no cascade of failures. A few behemoths hold the world hostage to their gluttony and whim, though. The best way to get away from that is not to save them and then try to take them apart, but to seize them, and knack them straight off. Sez I.
I am the originator of the “good bank” proposal and I cannot really see why it is no where near as tidy to implement with large firms with global trading operations.
I contend that there are banks too big to fail, too big to be bailed out but also too big to be good banks. In fact they should be broken up and risky global operations wound down identifying counterparts and operations which causes systemic risks. That’s should also be the purpose of the stress test…
Yves,
Is there any reason why a good bank solution couldn’t be done on the sly, without a nationalization step? I’m thinking that if Congress re-implements Glass-Steagal and maybe also some “breakup the too big to fail banks act of 2009,” the process of breaking up the banks could be done so that all the crap goes to one post-breakup bank that then dies instantly. It would be as American as breaking up standard oil, just with some sleight of hand to get the result we want. And it doesn’t look like nationalization to most of the public, so the administration doesn’t have to worry about the “socialism” smear.
Would this work?
I agree with most of what Buiter says. I know this blog (and a few others) have been promoting nationalization of these zombie banks. I understand the reasons behind this but question that seems to be unanswered (at least as far as I am concerned) is:
Do you really think the understaffed FDIC would be able to pull and IndyMac-style receivership of a global systemically important financial institution such as CITI or BOA? I know if they did nationalize these banks, it would not be possible over the period of a weekend (NakedCapitalism has mentioned this). I have doubts if it is even possible at all. I have no faith in anyone in the governments ability to nationalize these banks. To my knowledge the FDIC has experience nationalizing thrifts and other small banks. CITI and BOA have fixed-income desks, commodity desks, etc. I have not seen any material discussing the repercussions of these various markets if one or both of these zombies were to be nationalized.
As for the banks not lending. With there balance sheets impaired, and the economic numbers in the US getting progressively worse, who (besides B. Frank) would blame them.
I’d like to propose a slight change in terminology. Let us drop “Good Bank, Bad Bank” in favor of “Bad Bank, Evil Bank”. This new label is a much more accurate representation of the business model of most financial institutions, with Citi in particular.
Vinny
can some explain how banks can be solid, solvent, etc and still there is a need for 1-2 trillion in gov’t aid of some sort?
how the assets that are now, according to better accounting, going to be held to maturity will need the PPIP?
how can both be true and not be obvious fraud
M.G.
With all due respect, have you ever worked in financial services?
Most of these large banks have very large capital markets operations. You cannot simply strip assets out without having the attendant infrastructure: systems to book and manage positions (which means data feeds, risk management tools), a Treasury function to manage the liability side, people to keep hedges going. You can’t simply create two banks (or one bank and an half another) over a weekend with institutions of this scale. It is operationally not possible.
Yves:
To answer your question: yes, I worked before in financial services. Although I believe ideas should stand on their own merit, rather than on their author’s credentials, I have never proposed to create “good banks” over the week-end. In fact my original proposal dated back October 2008, thus I think there was plenty of time to set up the parallel good banks system. If you never start to discuss it seriously, let alone implement it, because one say you cannot do it over the week-end, you simply do not acknowledge the merit of the proposal and prefer possibly to do something else. Which it is actually the case in US and in Europe. Yet I do remember your full support for the “good banks” proposal showing nice slides in an interview. What is your position now in this respect, once you give it six months before it becomes undeniable that the current system is hopelessly broken?.