History repeats itself, the first time as tragedy, the second time as farce. But when it’s your farce, sometimes it’s hard to appreciate the humor.
We’ve railed about the stress tests since they were announced, but the chicanery, starting with the March 10 Citi and Bank of America pronouncements that they had had a decent couple of months, have lead to a big rally in bank shares. Of course, before we get too excited, it’s important to remember that Citi is still trading at a bit over $3 and Bank of America at just over $10.
Nevertheless, the insistence of the cheerleading is looking strained, particularly when pretty much every professional investor we know is skeptical of the rally, even those who had the foresight to buy into it early. And even an equity broker (generally of the bullish persuasion) commented on earnings season: “One third had earnings that beat expectations, one third were short, and one third were delusional.”
I’ve also noticed more than a few headlines, particularly on Bloomberg, that take any snippet of the positive and play it up. For instance, one a few days ago called a morning when stocks opened down and then moved into weakly positive territory as ‘stocks gain” which was technically accurate, but when the averages again fell into losses, it was “stocks fluctuate.” Please. Similarly, tonight Bloomberg tells us, “Chrysler Bankruptcy May Not Dent Economy as Cutbacks Were Set”. The point of the story is that (assuming the bankruptcy goes according to plan, an open question) the plant cutbacks and furloughs had already been planned as part of the restructuring. But that means that much damage was inevitable, regardless. Saying “Bankruptcy May Not Dent” is not the same as “Bankruptcy May Do No Incremental Damage,” which is what the story really says. I plan to keep closer tabs on this and readers are encouraged to e-mail sightings of misleading headlines.
Back to the matter at hand. Matthew Richardson and Nouriel Roubini, in “We Can’t Subsidize the Banks Forever,” provides a welcome bit of reality to the unwarranted optimism about banks. Having companies look viable as the result of massive, and seeming open ended subsidies does not say much about how they’d be faring ex life support. And even worse are the distortions. We’ve seen that large scale banking with score based credit paradigms has fared badly. Yet these companies are being subsidized to the detriment of smaller regional and local players who are closer to their communities and can incorporate local knowledge into their credit decisions. But no, just as old style computer jockeys had trouble accepting that big iron might be inferior to PC and distributed processing, so to the powers that be seem unduly fond of very large banks when the superiority of that model is in question.
From the Wall Street Journal:
The results of the government’s stress tests on banks, to be released in a few days, will not mark the beginning of the end of the financial crisis…..the overall message is that the sector is in pretty good shape.
This would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak — $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators’ conclusions.
The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter’s unemployment rate of 8.1% is higher than the regulators’ “worst case” scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year — the stress test’s worst possible scenario for 2010.
The stress tests’ conclusions are too optimistic about the banks’ absolute health, although their relative assessment is more precise, because consistent valuation methods were used….We fear that we are back to bailout purgatory, for lack of a better term. Here are some suggestions for how to extricate ourselves.
First, while Treasury Secretary Timothy Geithner’s public-private investment program (PPIP) to purchase financial firms’ assets is not particularly popular, we hope the government doesn’t give up on it. True, the program offers cheap financing and free leverage to institutional investors, which will lead to the investors overpaying for the assets. But it does promote price discovery and remove the assets from the bank’s balance sheets — necessary conditions to move forward.
And to minimize the cost to taxpayers, banks must not be allowed to cherry-pick which legacy assets to sell. All the risky loans and securities banks were never meant to hold should be on the block. With enough investors participating in the PPIP program, the prices of the assets should be competitive, and there should be no issue of fairness raised by the banks.
Yves here. With all due respect, the program is voluntary, and the whole point is NOT price discovery but to permit banks to unload crap assets at at least the inflated carrying price on their books. It does NOT serve the intended goal, a hidden subsidy, otherwise. The banks don’t need more liquidity, they need to fill the hole that would otherwise be caused if these assets were valued fairly. These assets trades actively. The issue is not price discovery, but that the banks don’t like the prices on offer. Back to the piece:
Second, the government should stop providing capital, loan guarantees and financing with no strings attached. Banks should understand this. When providing loans to troubled companies, they place numerous restrictions, called covenants, on what these firms can do. These covenants generally restrict the use of assets, risk-taking behavior, and future indebtedness. It would be much better if the government focused on this rather than on its headline obsession with bonuses.
For example, consider the fact that the government, while providing aid to banks, did not restrict their dividend payments. A recent academic study by Viral Acharya, Irvind Gujral and Hyun Song Shin (www.voxeu.org) notes that banks only marginally reduced dividends in the first 15 months of the crisis, paying out a staggering $400 billion in 2007 and 2008. While many banks have been reducing their dividends more recently, bank bailout money had been literally going in one door and out the other.
Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn’t the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior — and it’s incredible that there are no restrictions against it.
Third, stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.
And we shouldn’t hear one more time from a government official, “if only we had the authority to act . . .”
We were sympathetic to this argument on March 16, 2008 when Bear Stearns ran aground; much less sympathetic on Sept. 15 and 16, 2008 when Lehman and A.I.G. collapsed; and now downright irritated seven months later. Is there anything more important in solving the financial crisis than creating a law (an “insolvency regime law”) that empowers the government to handle complex financial institutions in receivership? Congress should pass such legislation — as requested by the administration — on a fast-track basis.
Yves here. We have been saying that pretty much since the Bear collapse. We also called then, for the power that be to go into the firms that were most at risk (and throw in a few better ones so as not to create stigma) and go over their books with a fine toothed comb. The stress tests come nearly a year late, and are no where granular enough. Back to the article:
The mere threat of this law could be a powerful catalyst in aligning incentives. As the potential costs of receivership are quite high, it would obviously be optimal if the bank’s liabilities could be restructured outside of bankruptcy. Until recently, this would have been considered near impossible. However, in 2008 there was a surge in distressed exchanges of debt for equity or preferred equity.
Still, the recent negotiations with Chrysler’s creditors suggest large obstacles. The size and complexity of large banks’ capital structures make debt-for-equity exchanges an even taller task, particularly because creditors will want to hold out for a full bailout along the lines they have been receiving.
The government should be able to dangle an insolvency law as an incentive to cooperate. This will result in a $1 trillion game of chicken. But given the size of the stakes, and the alternative of the taxpayers continuing to foot the bill, it’s the best way forward.
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So let me see if I’ve got your gist of permitting banks to unload crap assets at at least the inflated carrying price on their books. Yesterday I treated myself to a brand new 2009 SLR Mclaren Base RWD 2-Dr Roadster V8~MSRP $495,000. This afternoon in the rain I let my testosterone get the better of me, unwisely pressing the peddle too hard but it was oh so thrilling . . . until I hit a pothole, blew a tire, skidded out, losing control on the slick road and totaled my beautiful SLR.
Are you saying that I can fully expect some entity to come along and relieve me of this heap of metal for close to what it was worth moments before departing blacktop? I was in fact showing it on my books as an asset worth that much. With all due respect, my point is we need to take a long hard look at who turned these assets into crap. We need to understand how they did it and make sure it never happens again. Some of those responsible may require prolonged stays in the big house, so be it. Paying inflated carrying price on their books just sounds like more reward for criminal behavior, as if TARP and all the other quiet funding wasn’t enough. What message would this send?
FDIC Insures $4.7 Trillion in Deposits with a $13.6 Billion Deposit Insurance Fund. This is Like Going into a Hurricane with a 99 Cent Store Umbrella.
Link:http://www.mybudget360.com/fdic-insures-47-trillion-in-deposits-with-a-136-billion-deposit-insurance-fund-this-is-like-going-into-a-hurricane-with-a-99-cent-store-umbrella/
This guy must be bluffing. Or else we shall see bank runs by now.
YS:
I read Roubini’s piece this morning. I disagree with some of it. Yes, Uncle Sam’s various MLEC incarnations were desgined to prevent price discovery. I disagree that any special rules need be created for TBTF banks. Let them file bankruptcy.
As for subsidizing banks, as long as we have a Fed which can suppress interest rates to the detriment of real lenders, bank liabilities will be devalued. On net, banks not only don’t supply capital, they destroy real capital. Kill the Fed.
Hysterical. I had the very SAME reaction to that Chrysler headline last night. Orwell would be proud. What a bizarre time period we’re living through.
The following are the context of this crisis:
1)Since we saved AIG, everybody, I mean everybody, has been hanging tough for govt money.
2)Since we let Lehman fail, everybody has been unsure of our commitment to guarantees. With China, it actually started earlier.
The stress test didn’t work because:
1) It’s being invested on as part of the investment strategy of how much govt intervention there will be.
2) The stress test was supposed to actually be a govt guarantee to make these banks solvent come what might. Unfortunately, the credibility of the US govt is not sound.
For me, we should not have let Lehman fail, but have guaranteed everything. Once we let Lehman fail, we should have guaranteed everything. Subtlety will not work well in alleviating Debt-Deflation. You can either clearly get out, or get in full force. Since only government guarantees stop Debt-Deflation, all eyes have been turned on the level of govt guarantees since Lehman. The implicit strategy has worked, but not well. No one knows if implicit means explicit or not.
We have a bill to deal with seizing large financial concerns:
“March 25, 2009
tg-70
Treasury Proposes Legislation for Resolution Authority
Treasury Secretary Timothy Geithner on Monday called for new legislation granting additional tools to address systemically significant financial institutions that fall outside of the existing resolution regime under the FDIC. A draft bill will be sent to Congress this week and several key features are highlighted below.
The legislative proposal would fill a significant void in the current financial services regulatory structure and is one piece of a comprehensive regulatory reform strategy that will mitigate systemic risk, enhance consumer and investor protection, while eliminating gaps in the regulatory structure. “
http://www.treas.gov/press/releases/tg70.htm
I’m assuming that they’re talking about this.
“Yves here. We have been saying that pretty much since the Bear collapse.”
Nothing against you, but I’m wondering what people are actually calling for now, and why Bear was seen as a turning point. If it was Debt-Deflation, what would you have done? Without backing assets, showing that the problem was imminent was a terrible risk. That’s what I heard Dizard saying. The governments would need to pretty much bankroll the unwinding.
If you can’t convince people of that now, how would you have convinced them of that then?
Don the libertarian Democrat
Let me please add this:
To the extent that Bear worked, it was because it showed that the govt would back the unwinding, if it came to that. At whatever point either:
1) The unwinding began to get out of control.
2) The govt’s commitment to backstopping the unwinding was not total.
You were going to begin the crisis. To risk 1, by making clear the depth of the problem, without doing 2, would have put us right where we are now or worse, no matter when it began.
Don the libertarian Democrat
Matthew Richardson and Nouriel Roubini, in “We Can’t Subsidize the Banks Forever,” provides a welcome bit of reality to the unwarranted optimism about banks.Well, not really. Roubini and Richardson essentially have the same position as Geithner, Bernanke, and the rest of the banking/political elites: that the (major) banks should be able to get out of their liabilities and continue as ongoing concerns.
True, Roubini and Richardson disagree vehemently about how to do this — Roubini and Richardson want to limit the impact on taxpayers wheras Geithner and Bernanke could less about the taxpayer.
But the following claim by Roubini and Richardson is revealing: it would obviously be optimal if the bank’s liabilities could be restructured outside of bankruptcy.Oh? “Optimal” for whom? Shareholders? The government? the “people?”
Certainly not for the holders of bank debt, i.e. bondholders and other creditors such as pension funds.
Look, the major banks have no future, unless one begins to speak of screwing over someone, whether that be the taxpayer or the bank creditors.
Roubini and Richardson simply disagree with Geithner and Bernanke about whom to screw over.
I agree with Yves that stress tests are bogus. I agree too that the PPIP has nothing to do with price discovery and everything to do with unloading crap assets at inflated prices.
I disagree with Roubini that losses are likely to be in the $3.6 trillion area. The American home mortgage market was around $12 trillion when the bubble burst. If prices decline on average by about 40% to get them back to pre-bubble levels. That’s $4.8 trillion right there. Now of course, homeowners will have to eat some of these losses. But wild ass guess I’m thinking banks will still be responsible for 3/4 of them. That’s Roubini’s $3.6 trillion right there. Add in another trillion for commercial real estate and another for credit cards, student loans, and other debt and we are in the neighborhood of $5.5 trillion. Debt deflation and depression could exacerbate these numbers.
I am someone who believes in clarity of language. Covenants and receivership seem to me just to be code for nationalization. I have no problem with this word. If this is what we need to do, we should be doing it. Getting caught up in the semantics is just a form of enabling denial.
Along these lines too, I would note a certain slopiness when we discuss “banks”. It is a shorthand but sometimes it obscures. Goldman and Morgan Stanley aren’t banks in any real sense of the term. Most of the big banks (like Citi, JPM, and BoA)that actually are banks are only incidentally so. And most of their problems and exposure come from their non-banking activities. But more than this the banks are not real entities. They are collections of individuals. They are cultures. So when we or Roubini say that banks must change, we are really saying these individuals must change. Now most of them (at least those with power) have made their careers and fortunes out of gaming the system in which they work. It is really all they know. So when we, the government, or Roubini say that banks must behave differently, it is to laugh. The banks, i.e. the people who run can’t act differently. They wouldn’t know how to even if they wanted to. Their first and only response to any government program or initiative is: “How can we game this thing.” Similarly, the government isn’t the government. It is the Fed and Treasury, and more specifically the people who work there, whose allegiance is to the gamers and finance as a game. It is Congress and the White House whose members have been bought and paid for by the gamers of Wall Street. Our problem as that collection of individuals that make up this country is that these other groups, Wall Street, the Treasury, the Fed, Congress, and the White House owe their allegiance not to us but to the game that is and remains the world’s financial markets. Policy will have little effect until the players are changed or until we demand or economic reality forces that change.
EXCELLENT POST HUGH, couldn’t agree with you more. We need to make the banking industry a public utility, everyone has access, at the same price. That way there is no “gaming” of the system availible..well, not as severe at least
Mutant Capitalism said:
Nice metaphor. But I wonder if the wealth that was “destroyed” ever really existed in the first place?
What if Goldman Sachs bought a new 2009 Ford Taurus with a MSRP of $26,000 and then, due to a Detroit Metal Bubble, inflated the value of it on its books to $495,000? Then proceeded to make loans of up to $5 million on that collateral, and then gave itself a huge bonus for being such a shrewd investor?
Even if Goldman never drove the Taurus and it was in Brand New condition it would still be a Taurus, not a brand new 2009 SLR Mclaren Base RWD 2-Dr Roadster V8.
From Goldman’s POV, they’re taking a loss of $469,000 on that asset with even worse implications for that $5,000,000 loan. So they say “our wealth has been destroyed!”
But from my POV a Taurus is a Taurus is a Taurus. A great car. But not worth more than 5.5% of Goldman’s carrying price.
In other words, the wealth wasn’t destroyed because it never really existed in the first place.
Someone please correct the errors of my thinking if I’m wrong.
Tim
First, thanks to you all, especially Yves. Your comments write a new book on the financialization of the American economy.
It has been clearly said here that the bulk of the legacy assets created by the financial service industrials were not really created by the ‘banks’ at all.
They are the private, self-regulated non-banks.
And they create the non-money thingies sometimes called innovative financial exotica.
All of it payable in $USD.
Even if they were not self-regulated, they could still do so. The Fed was totally supportive of these actions.
The practice of the creation of $USD-denominated, non-money thingies by the unregulated, private non-bank entities has destroyed the economy of the USA.
On behalf of the working people who have lost their jobs, their homes, their medical benefits, their retirement money and, for many, their dignity, I want to declare it time to change the system. It’s OUR money.
From Roubini to Paulson, it is all the same to me. They all want to preserve the debt-money system of the private bankers of the Federal Reserve, and their upstairs cousins at the investment banking penthouses.
The monetary system of these sovereign United States has been abused by the debt-money ponzi scheme of the private bankers.
Glass-Steagall doesn’t do it, in my book.
Remove the money-creation power from the private bankers, and restore it to the people who have suffered at the largesse of these non-bankers-created, non-money things.
See Milton Friedman’s Framework for Economic Stability.
See the Chicago Plan for Monetary Reform.
Ever since the first Revolution, one thing has been true – it OUR money.
Harlem Dad . . .
Your POV is not only bang on but far more to the point than my lame analogy. I just wish federal investigators would get on it and drop their F-Bombs on those deserving. Fraud is Fraud.
Also to the point, nice Seeking Alpha quote today: “Financial companies have used their agents, U.S. lawmakers, to pressure the FASB to relax fair-value accounting rules. The result has been the official endorsement of fair-value lying. . .Treasury Secretary Timothy Geithner has constructed a framework whereby politically privileged banks with worse than worthless toxic assets sell them for cash at an inflated fair value lying price to a self-funded Special Investment Vehicle (SIV), a similar entity as Enron used, that receives a non-collateralized loan from their government puppets.” http://seekingalpha.com:80/article/135283-credit-default-swaps-financial-weapons-of-mass-destruction
so, we beat this horse…is it dead yet. stress test is a sham, a PR scheme…the roll out is part of the scheme…to bore us and confuse us (as Yves pointed out seems weeks ago now).
so, let’s get down to it…taking bets here…will the market go up or down ‘after the stress tests’ are released? will the PPT let it correct normally as it should after a 9 week run? obviously they continue to inflate until some time after the stress test is ‘sort of’ over. so, maybe monday or tuesday…on some day with no ‘new’ stress test news..the markets will corrrect, say 10-12 % from this run up…then rise again on the contined PR campaign of the banks, gov’t and complicite MSM…then, in the autumn the reality shoes will drop.
surely we all see the same thing…yet beat the dead horse.
just fun i guess. Michael
Marsha:
” let’s get down to it…taking bets here…will the market go up or down ‘after the stress tests’ are released? “
Any sort of finality has to be bullish.
Maybe it’s already baked in per Monday’s rally.
Hugh:
“I disagree with Roubini that losses are likely to be in the $3.6 trillion area. The American home mortgage market was around $12 trillion when the bubble burst. If prices decline on average by about 40% to get them back to pre-bubble levels. That’s $4.8 trillion right there. Now of course, homeowners will have to eat some of these losses. But wild ass guess I’m thinking banks will still be responsible for 3/4 of them. “
Most home mortgages either ended up with the GSE’s or in some sort of structured credit — not as loans on the bank balance sheets. The banks tended to keep the better stuff and passed the trash. Therefore the 3/4 figure is way off.
Don:
I agree.