Roger Ehrenberg And Readers Steve, BondInvestor, on Banking Industry Woes

Tonight brings some useful commentary on the prospects and possible remedies for the banking industry. Roger Ehrenberg offers a good overview, highlighting an area that hasn’t gotten the attention it deserves, namely, proposals to change the Bank Holding Company Act to attract more investors.

Reader Steve sent an e-mail that relates to some of the issues that Ehrenberg discusses, which I’ve included below, along with an excerpt from a comment by reader bondinvestor.

First from Ehrenberg:

We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed….

The plight of equity-holders should be ignored;
Long-standing rules governing bank ownership shouldn’t be compromised in a panic; and
Bank balance sheets won’t heal unless deep pain is felt, and preferably as quickly as possible.

Bank Equity Holders: Out of Luck

Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario….

Don’t Play Games With the BHCA

2. The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me…These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?…

Good Bank/Bad Bank as a Way to Move Forward

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it’s potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a “Citi Bad Bank”) or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital. This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity – now – in order to lay a strong foundation for future growth.

Note to Bank Managements: Take the Medicine – Now

3. Bank management’s steps towards fixing their balance sheets has been a slow, painful process…This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books…Mr. Paulson should devote more calories to this issue and less to bailing out the GSE’s and protecting their common stockholders….

Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool’s game. Get to it.

While in theory Ehrenberg’s observations are correct, differences in degree can constitute differences in kind. Bridgewater Associates estimates in a recent report that marked to market, US banking industry losses would constitute over $560 billion versus the $116 billion they have raised today. I guarantee that if banks were to mark their books in accordance with the levels indicated by Bridgewater, investors would collectively have a heart attack, liquidity would evaporate, credit spreads of all kinds would widen massively and the stock market would head south, pronto.

While a “good bank/bad bank” structure may be part of the eventual resolution of this mess, pray tell how does a non-failed bank go about creating this sort of vehicle? A restructuring of this sort would presumably require shareholder approval, and an admission that a bank was in bad enough share to go this route would not merely tank the stock price, but almost certainly make any kind of debt funding, including routine money market operations, difficult to impossible. An effort to implement this sort of program would likely lead to a bank failure (if I were a depositor in excess of FDIC limits, I’d head for the hills). Thus in the absence of a Federal program, I am at a loss to see how this could work (even if the bank had a “pre-pack” negotiated with private equity investors, you’d still need shareholder approval, and you’d be subject to adverse reactions from funding sources).

Reader Steve e-mailed some observations about recent FDIC actions that bear on this discussion. One of his lines of thought is how analogies to the S&L crisis (which was considerably smaller than our current mess) can be misleading. I’ve highlighted some key points:

Simple comparisons–the number of bank failures, or the total assets of failed institutions–can be misleading. A more important measure is the percentage of assets that remain under FDIC control vs. the percentage sold either at the time of failure or immediately after. For example, in the FNB/Nevada and First Heritage transactions, FDIC is keeping 94% of the assets. FDIC has so far been unable to sell Indymac’s servicing arm, and hasn’t announced any portfolio sales. FDIC holds 100% of the assets of the second largest bank failure in US history. Fewer banks are failing (so far), but the number of healthy institutions able to absorb their performing assets has shrunk as well.

There is also a significant difference in type of troubled assets between the 80’s and today. Construction and development financing caused the majority of failures twenty years ago. Losses on household mortgages were not a big factor, because underwriting standards were higher. Today the problem assets are C&D, CRE and huge numbers of first and second home mortgages.

The law governing FDIC has changed since the last crisis. The FDICIA of 1991 makes it impossible for FDIC to create bridge banks at will. Twenty years ago, Indymac would have been bridged, meaning that uninsured deposits would have been covered. Today, the `too big to fail’ test for creating a bridge bank is codified, and very few institutions qualify.

The huge losses embedded in household mortgage portfolios make the current banking crisis different, and the regulatory response is different as well. The reason for the concern over foreclosures has more to do with bank accounting than with bleeding heart concerns for mortgagors. When a property is foreclosed, a bank must write off the difference between the loan balance and the appraised value of the property (with a further downward adjustment for disposition costs). A write-off is a reduction in capital, so the bank’s capital primary capital ratio is affected. Banks are prohibited from writing owned real estate back up. On the other hand, if the bank only recognizes an impairment on the loan, there is a reserve against capital but no write-off. So the loss can be strung out over time, and regulators can allow banks a fair amount of leeway in forming `opinions’ about loss severities. In other words, an insolvent bank can appear to be adequately or even well capitalized. I believe an argument could be made that many institutions would be stone insolvent if foreclosures and write-offs were being done in accordance with traditional banking and regulatory practices. In particular, I suspect that the vast majority of foreclosed mortgages are investor owned rather than bank owned, and that regulators have adopted `go-slow’ oversight in anticipation of legislative action on foreclosures.

I agree 100% with Steve’s assessment. A lot of banks are no doubt insolvent now. Critics can argue that Bridgewater’s mark-to-market calculation doesn’t necessarily reflect true economics, since some markets are arguably short of buyers, and hence the low prices reflect illiquidity as well as impairment of the assets. But the flip side is that we are at best only halfway through the housing price decline. Case Shiller has the housing market currently at a 19% decline from peak. A number of metrics (mean reversion, traditional relationship of housing prices to income and rentals, plus the likelihood of overshoot on the downside) suggest the bottom will be at least 35% below peak, and 40% or even lower is not out of the question. Bridgewater’s $560ish billion measure against roughly $1.3 trillion in banking system equity (if memory serves me right) and the $116 billion in new equity raised so far. Even if you use the current Bridgewater figures as a proxy for ultimate losses (and that is likely to be light), there is a very big hole in the balance sheet of the banking system. And the reason for trying to fudge things is to prevent panic.

Purists also choose to forget that in the 1990-1991 banking crisis, there was a good deal of so-called regulatory forbearance, which means regulators allowed various finesses for less-than-well-capitalized banks to soldier on.

The flip side is that Swedish and Finnish banks were in similarly bad shape in 1990-1991 in an even worse housing contraction than the US, which rates among the “Big Five” post war financial crises according to Carnen Reinhart and Kenneth Rogoff. Both countries experienced housing market price declines of over 25%. They took the tough medicine route. As Bernard Connolly of Banque AIG described in a March research note, the costs proved to be high:

The Nordic economic and banking crises of the early 1980s produced output losses bigger than at any time since the Great Depression, even though the resolution of the crises is generally regarded as outstandingly successful. If the US did no worse than the lower end of the estimated range of output losses for the least-affected Nordic country, unemployment would rise to 10%

Do you think there is a snowball’s chance in hell that any politician or regulator would choose a course of action where the best possible outcome is unemployment at 10%?

Connolly notes a bit later:

The Swedish route involved aggressive writedowns and recapitalization (partly by the taxpayer); valuations turned out to be realistic, but only because an enforced change in the monetary/exchange rate regime ended the crisis and ushered in economic recovery; there is no such “magic bullet” available now for the US.

Translation: they could afford to reflate and debase the currency. We can’t.

A nice forecast of the next phase of this drama comes from reader bondinvestor, who does not like capital letters:

the fed & tsy tried to convince the equity market to bear the brunt of the costs of the credit crunch via large equity issuances. their benign rhetoric and easy monetary policy were designed to get the animal spirits of equity investors aroused so that they would solve the financial system’s problems. the market got wise to that gambit in june, and drove equity prices down to a level at which no financial company will issue equity. they will all de-lever instead.

the equity market is in effect telling the regulators & politicians that it’s time for other parts of the economic system to begin bearing some of the pain of the credit crunch. equity holders have given enough. it’s time for borrowers to do their part.

the next phase of the crisis is the forbearance phase. regulators will begin looking the other way on things like capital ratios, etc, in an attempt to give the banks an incentive to lend.

in the meantime, we haven’t even begun to see the real impact of the crunch on the economy (outside of housing) yet. we’re in the bottom of the 1st inning of that game.