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More on Big Bank Endgames

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Some readers and fellow bloggers have been anticipating an over-the-weekend resolution of some sort for Citigroup and/or Bank of America, given the impressive fall (admittedly from already distressed levels) in their stock prices over the last ten days.

I could well be proven wrong, but I didn’t expect it this weekend, and I don’t see it happening…..yet. It will take another trigger, which could very well come shortly.

The reason that stock price falls in the past have provided the impetus for nailbiting and sometimes precipitous government action has been that the bank (and the same dynamic applies to the monolines) were under pressure to bolster capital levels somehow to avoid downgrades. Given that accomplishing that via retained earnings seemed unlikely to impossible, with continued writedowns likely, the only hope was new capital raising. A certain amount of that could be accomplished via the issuance of preferred stock, but the ratings agencies had limits on the ratio of common to preferred, and most affected institutions would need in pretty short order to issue stock. So a tanking share price would greatly lower the odds of shoring up capital levels (it would be massively dilutive, assuming it could even be carried off).

With the TARP, for better or worse, that pressure is in abeyance. The Treasury has given money to banks on non-market terms; there is no reason to think that won’t continue.

I see no desire of Geithner and Summers to move forward on pre-emptively-take-zomibe-banks-out front. Geithner announced his plan to have a plan; Obama is making an announcement of some sort next week (apparently an effort to soothe rattled nerves; presumably some elements of the Geithner work in progress will be released to shore up confidence).

Team Obama is still on Plan A, which is “we can patch this up with the duct tape and bailing wire we have on hand” and they really want to play that out if at all possible. I’m sure they believe that when, for instance, the trillion dollar consumer credit facility is out buying credit card, student loan, and auto receivables, that that will lead to more commercial bank lending (ie fee generation on their part) and we will see some halting progress towards normalcy.

Now what could force their hand is a run on either bank, either depositors (replay of WaMu, on a bigger scale) or counterparties refusing to extend credit or moving accounts out (the Bear scenario). The possible perps of a deposit run would be those whose balances exceed FDIC guarantees (most likely businesses, since if you have payroll of any size, it is impractical operationally to divide your payroll processing among a lot of banks, and you need to have enough cash in the till to make the payments) and foreign depositors. As Felix Salmon noted earlier, Citi has a LOT of foreign deposits. as in….over half a trillion (this relative to a balance sheet of $1,9 trillion).

I haven’t (yet) seen any indication of counterparties headed for the exits. Again, with the government apparently at ready to throw cash at institutions deemed systemically important, there is far less cause for anxiety. Everyone seems to have gotten the memo that there won’t be a second Lehman.

Now let us go to part two. Let us say the stock markets are right, and something happens to push one of these two a lot closer to the edge.

As much as the drumbeat for nationalization/receivership is increasing, I don’t see that happening either (and I would really prefer to be wrong here, see related post). First is the fact that (as I am told by those more expert than me in these matters) that neither bank could be taken out involuntarily over a weekend. Part of the reason apparently is that the FDIC is too short-staffed; it had 20,000 employees during the S&L crisis, it is now down to about 5,000, and the cuts in the staff that handle receivership were deeper. It would take more planning and lead time. Maybe the stress tests are a Trojan horse for this course of action. They seem to be far too superficial to be useful (Stiglitz among others, as reader Dwight pointed out, has made this observation), but the banks may be so deeply under water that a cursory exam will show that.

But the other issue is that these banks (Citi in particular) have operations way way outside the FDIC’s normal ken: big overseas offices, and large capital markets operations. Does the FDIC have the foggiest idea of what to do with a CDS book, CDOs, foreign currencies (some of the exotics and long dated forwards can create headaches, particularly in volatile markets like the ones we have today), proprietary trading operations, prime brokerage? And forget the SEC, they’ve never taken interest in these areas.

So we have two constraints, albeit both operational: a receivership for banks of this size would take longer to put into place than another cobbled together bailout package of some sort. And the power that be almost certainly do not have any sort of blueprint for how to put a major capital markets operation into some form of receivership, either mechanically or legally.

The latter problem is an appalling, criminal lapse. When Bear went under, it illustrated vividly how quickly securities firms go down (Drexel Burnham also went poof). Securities firms collapse into liquidation. Counterparties will not trade with a bankrupted entity. They have to extend credit in order to trade (repos and reverse repos are the lifeblood of trading), and no one is going to extend new credit to an entity in receivership.

It was also VERY well known at the time of the Bear collapse that other securities firms were at risk. Lehman was top of the list, but other names were bandied about: UBS, Morgan Stanley, Merrill. But Paulson & Co. were in kick the can down the road,. There is no evidence they made any effort to determine whether some change in procedures, regulations, or even bankruptcy law, might allow for a more orderly resolution of a failing large investment bank. But no, instead the officialdom decided to redefine the problem. Lehman was deemed to be systemically unimportant since the powers that be had never bothered to develop a Plan B, and Plan A, fobbing it off on the industry, turned out to be a non-starter.

Now it may have been there was no tidy solution, or any “tidy” solution would have required legislative changes that might have been awkward to impossible to get through. For instance, it may have been possible to segregate certain operations and put them in receivership of some sort to reduce the scale of the damage. Regardless, the failure to even consider the issue is an unforgivable failure of foresight.

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30 comments

  1. Anonymous

    Courtney Schlisserman writes on Bloomberg about revised GDP Drop:

    The U.S. economy probably contracted at a 5.4 percent annual pace in the fourth quarter, weaker than previously estimated and the worst slump in 26 years, according to the median forecast in a Bloomberg survey. Commerce is scheduled to release its first revised report on Feb. 27, after saying on Jan. 30 that the economy shrank at a 3.8 percent pace.

    Economic weakness and 13 consecutive months of job losses have hurt Americans’ outlook. Economists say the Conference Board will report on Feb. 24 that its consumer confidence index fell this month to 35, a record low. The Reuters/University of Michigan final index of consumer sentiment, scheduled to be released on Feb. 27, probably fell to 56, according to the Bloomberg survey.

    U.S. sales of cars and light trucks plunged to a 9.6 million annual rate in January, according to industry data. General Motors Corp. said Feb. 3 it will reduce North American first-quarter production 57 percent amid flagging demand.

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aEvEqkM7G.G0&refer=home

  2. Anonymous

    Yves,
    Have you considered hosting a weekly taped discussion, sort of a weekend or mid-week review, where you can hash out the week’s news proposals/ideas/events with a similarly sharp guest?

    A Charlie Rose format would be nice (stripped down, intelligent conversation.) Although I love the posts, some genuine back-and-forth would be interesting. The review element would bring some continuity, and the unrestricted format would be an antidote to the financial channel noise assaults.

    With cheap equipment and reduced rents, I bet reserved studio time can get dirt cheap.

    Someone like RealNews Network might be interested in hosting and/or supplying resources in exchange for shared broadcasting rights.

  3. mmckinl

    Well geithner and summers had better get plan B together quickly. I don’t see any announcement by geithner that will do anything but drop markets further.

  4. Anonymous

    Thanks Yves. I also think nothing will be announced this weekend and probably more money will be thrown at them. These banks are so complex (I prefer to use “toxic”) that even government cannot handle them.
    Improper unwinding of these will surely cause nuclear winter.

  5. Anonymous

    p.s. – Although there are a few online and broadcast news outlets that do host quality content, I can’t think of many that are hosted by experts and are not constrained by time. When discussion isn’t limited by those factors, it often is by journalists who are not well informed enough to really dig in, or are forced to lob simplified pitch-and-catch questions for a broad audience.

  6. Sukh Hayre

    Yves,

    My belief has been that the US government does have a plan and it really is designed to screw the bondholders, who I am guessing are foreigners for the most part (I could be wrong).

    The fact of the matter is, instead of the bondholders taking a haircut and in return getting ownership of the banks, what the US government is going to do is, take a small preferred shareholder position in these banks, and than, instead of the government preferreds getting wiped out, they are going to force a haircut (more like a crewcut) on the bondholders, but not give them the ability to take ownership in return. Only the US government could make it possible for preferred shareholders (the US government) to come out further ahead than bondholders in a bankruptcy situation.

    This way, foreign bondholders get shafted, the government buys the banks on the cheap (at bondholder expense)and then, after they have been cleaned up, they are sold to Americans (the ultra wealthy currently sitting on the sidelines in Treasuries).

    This is a chess game and the US government seems to be Big Blue with 21st century capabilities – unbeatable).

    The sad part is, the Chinese, Russians, and the OPEC leaders know they been screwed (checkmate) but their isn’t anything they can do about it.

    This is the main reason I think globalization comes to an end, because in retaliation, what these investors are going to do is, not recognize US and European intellectual property rights. So, they will catch up with the US technologically wise.

    But I believe that the US was already pretty sure that their technology would eventually be reverse-engineered as other countries are only going to pay rent on these advancements for so long. So, as a pre-emptive strike, the US has maxed out its credit and has no intention of ever paying its creditors back. And this is all perfectly legal as the bankruptcy laws permit this, and these laws were in place, when the savers of the world trustingly handed over (lent) their savings to the Americans.

    I still believe that the world going forward will be better for the majority, as long as we can keep ourselves out of resource wars. And I think this may be possible for all resources except for oil, which is just too valuable and too consentrated for a hundred million people to protect against the 3 billion people who want to secure their energy supplies.

    PS. As a side note, the only way the US will ever be able to pay off the debts that they currently owe is to not just have higher tax rates for the rich, but they will actually have to tax wealth. That is the only way to get the economy going again. And if the economy falters, social unrest will ensue.

    PPS. I’d love to hear your thoughts. Am I just off my rocker?

    Sukh

  7. Anonymous

    Invaluable, sane commentary.

    The markets have already voted on Plan ‘A’. Gratuitous Obama-bashing isn’t going to help anything, but there really doesn’t seem to be anyone capable of grasping the nettle at the center of the decision-making process. Yves puts her finger on the core problem: a lack of personnel and expertise of the required sort. Brand USA is in deep, deep trouble.

    It’s impossible to overstate how dis-interested Japanese consumers are in American products and brands.

    After the last 8 years, America really needs to show a different face to the world: realistic, positive, and effective.

    That’s not what we’re seeing.

  8. Anonymous

    Sukh Hayre,

    You might be right, and it is what the US government should do, broadly speaking, because the US government should represent the US citizens.

    And every country’s government should support their own citizens.

    Furthermore, one can expect that investments in the US were made, expecting that if things went down the tubes like this, the US government would do as you describe. It was a market risk. Unless you’re speaking from some inside information, what you describe was knowable (conditional on current conditions occurring) in advance.

    The difference is that we expect foreign governments to act in the best interest of their own people. But some people are shocked if the US government stops being so international and does the same.

    Actually it’s not that bad. China is in a symbiotic relationship and is continuing to receive value from the US. See how Hillary Clinton is urging yet closer relations between China and Taiwan? China desires reuniting with the former Kuomintang, and it is happening.

    With the odd Russian sinking of a Chinese ship in Vladivostok harbor last week, China may want to regain that territory that it lost in the Opium War, and it could happen, again with US help. Just a random prediction.

  9. Yves Smith

    Sukh Hayre,

    I think your assumptions are not correct here.

    Pimco,the biggest bond fund in the world, holds a ton of US bank debt.

    My impression also, per Brad Setser, is that foreign buying of US private debt, which would include US bank bonds, pretty much stopped as of summer 2007. I don’t know how much foreigners might be holding from earlier, and US banks almost certainly haven’t sold much in the way of bonds since then, but I would imagine US investors hold a good deal of US bank debt, even if a lot is also held abroad.

  10. esb

    Sukh Hayre @ 4:57 AM:

    I hope you realize what you are saying here and I think you do.

    This is war without the bullets and the bombs.

    (Not the kind of war that appeals to Richard Bruce Cheney)

  11. Anonymous

    I wonder. So if the issue is a lack of personnel, would job listings by the FDIC on monster.com signal that investors should start selling “C”???

  12. esb

    Yves Smith @ 5:33:

    I would be most interested in looking at the call log of one William Gross for Friday, 20February2008 for the hours immediately ahead of the White House statement on nationalization.

    I just cannot stop wondering if a memo “spoke with BHO” appears somewhere.

  13. Anonymous

    "Team Obama is still on Plan A…."

    Yes, there are still on Plan A but what is Plan A?

    Plan A is to ensure that the Influential and Elite suffer as little pain as possible. That means giving them the opportunity to transfer their toxic and undervalued assets into structures guaranteed by the Government and then take their cash away and start up or invest in new toxic enterprises. (Thus, no report on what and how much crap has been dumped to the taxpayer.)

    What may also be happening as the Markets crash is that more insecurities need to be dumped as values wither. And as the Game continues and the Influential and Elite can continue dumping then why not just get rid of all the crappy investments? So, Plan A will only end when the Government guarantees dry up, the Influential and Elite are sated or some other factor overrides the Game, like public outrage.

    Until then, Mr. & Mrs. Big will be cashing their crap at the friendly FED and other taxpayer guaranteed Dumps. "Nationalization" whatever that means, will consist of a compilation of how the Influential and Elite can benefit and dump and then building the "Nationalization" around that cover.

  14. ruetheday

    “But the other issue is that these banks (Citi in particular) have operations way way outside the FDIC’s normal ken”

    This pretty much nails it, and is why Glass-Steagall should NEVER have been repealed. The bank regulatory mechanisms exist primarily to protect depositors, as they should. Banks should be in the business of taking deposits and making loans, not proprietary derivatives trading, so long as their deposits are FDIC insured.

    Now might actually be a good time to cut the cord. Have the FDIC protect all deposits, step up the Fed’s activities in the money market fund and commercial paper markets as they have been to ensure this source of financing to business does not seize up, and let the rest of the banks’ obligations fall into the abyss. If this puts Goldman and MS out of business overnight, we’ll consider that a feature rather than a drawback. I don’t care if CDS traders lose everything, it’s largely irrelevant from the standpoint of the real economy. I care that depositors are protected and business can still access short term financing, even if the gov’t has to provide it.

    To paraphrase Simon Johnson on Bill Moyers, this really comes down to how great a percentage of GDP (10%, 20%, more) we’re willing to spend to make the banking elite whole again. I’m not willing to spend anymore.

  15. Anonymous

    The FDIC and the other regulatory agencies have been thinking about systemic risk and a large banks failure for years (most recently on Shelia Bair’s initiative in 2007). Yes, there are and have been people studying the best way to resolve a c or b of a failure. Resolving citi would most likely have to be a bridge bank, and the FDIC would have to hire someone to help mange the off-balance sheet mess. And keep in mind, NO ONE really has any idea what that mess is composed of. That said, the FDIC is beholden to the Fed and Treasury, the latter of which has been forcing the FDIC to implement initiatives including the TLGP (the debt guarantee was designed for the big banks, most of whom were forced to participate so as not to stigmatize citi).

    Re: the stress tests they are forward looking and designed to identify banks that may be in trouble under certain scenarios 6 months to a year from now. Those institutions would be required to take TARP money. As it stood last week, other the usual supervisory process they were not looking at identifying banks that are insolvent RIGHT NOW. And btw, the FDIC is the only agency that has a stress testing model in place and has been think about the issues for sometime.

  16. d4winds

    “Everyone seems to have gotten the memo that there won’t be a second Lehman.”

    This memeo was sent, by the way, not with the passage of TARP and the recapitalizations but with the (temporary?) “saving” of Citi by Paulson/Bernanke in Nov. and then cc’d with the “saving” of BofA.

    This week Roubini’s interpretation of Geithner’s plan soaked in: (a) no more free money–at least none that is obviously so; (b) at least a perfunctory audit independent of any “in-bed” accounting firm; and (c) private capital as well as government to be used in any purchases of toxic assets (sayeth the banker: uh-oh).

    (d)The potentially missing ingredients from the Geithner plan were (i)the extent to which–if any– the purchases of (c) might carry explicit “insurance”-like guarantees to sweeten things for both the banks and the private capital partners; (ii)the extent to which the private partners could access loans at low Treasury rates.

    What truly spooked the markets was the idea that there would be no or few guarantees as in (d), thereby repealing the Nov. memo. The administration then had to calm the markets down. But all it really committed to was a private banking system, not necessarily the one owned and operated as now. The tininess of this committment has not fully sunk in just yet.

    You’ll notice that Ken Lewis got the Roubini-Geithner memo to quit begging. He has started boasting about BofA solvency again. The JPM CEO got the new memo also and shot back with–in paraphrase–”mortgagors should quit begging too” (he forgot to mention that his own out-stretched cup runneth over.)

    Citi has been justifiably quiet, hoping that Roubini-Geithner is not what it seems: let Citi and similoar basket cases (Fifth
    Third, e.g.) twist in the winds and be slowly taken down by the market in the next 3-6 months(as counterparties back out, hedge funds establish new broker-dealer relationships, large depositors leave, more potentially profitable operations like Smith-Barney are sold off, and debt falls in value toward/to expected recovery levels) to the point of being a pure branch banking ghost for FDIC receivership. This scenario of a market-wind-down for Citi is ideal for the administration since it means no expenditure of political capital on a lost and very unpopular cause.

    Geithner may effectively disavow the Roubini interpretation this week but instead he will probably announce guarantees of (d) (that will raise a populist storm) that are both vague enough to keep the Citi market wind-down in play and also possibly enticing enough to private capital so that other bankers can believe that the Nov. memo remains in force for non-basket cases.

    For BofA the administration has its fingers crossed, apparently hoping for a clear commercial bank/investment bank legal separation so that the former may survive while the latter meets a Citi fate.

  17. albrt

    I am still wondering why the federal government cannot draft the leadership of these banks and appoint them as receivers. Additional examiners could be appointed as needed going forward.

    When I say “draft” I mean press into government service like we have done to so many teenagers over the years.

    This sounds simplistic, but I don’t see why it wouldn’t work. These folks claim their knowledge and skills are indispensable, so I say take them at their word and just give them a new set of incentives: If they desert or fail in their duties, they get shot or sent to Ft. Leavenworth.

  18. Anonymous

    I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I’m involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn’t securitize or otherwise sell participations in the loan). Even now, we expect the hotel needs at least another $100 million to finish construction and open (we are no longer under any delusions that more than a handful of buyers will close on the condo portion of the condo-hotel). So, in other words, Citi is $275M into this project, and it’s not certain that the completed hotel will even be worth the extra $100M required to complete and open. Hence, one might plausibly value this $275M loan at zero (i.e., a complete write off). I cannot imagine any stress test would uncover what a huge loss is on the way in the next 12 months. In fact, this loan has not even been pawned off to the nonperforming/distressed debt/workout section of Citi because the interest reserves make it “seem” like the loan is still performing, not to mention that completely out of date pro formas make it “seem” like (i) equity will come in to finish the project and (ii) condo sales will pay down a huge part of the principal once construction is complete. This scenario must be present in a large number of Citi loans, especially in their somewhat active foreign development divisions. Citi must be so far from solvent that it’s not even funny. Only hyperinflation in the dollar could ever make it possible for the borrowers to pay back some of these loans. I’d bet that the sooner we face reality on some of these loans and just halt future fundings, the less money the taxpayers are going to lose. As it is, it’s almost too late. Too bad for the US taxpayer.

  19. Robertm73

    I gave you one reason that a bank run might happen. Prince Alawd (SP) from Saudia Arbia, he owns 5% of Citi and most of his accounts are in the bank. No one in there right mind is going to leave all there eggs in one basket. If he pulls out the whole house cards crashes. Or he waits for the house of cards to crash. Hmm….In the end I think Tim ‘turbotax’ and Ben ‘the printer’ are desperatly doing something in the back ground to fix this. Or is they arent we are all done.

  20. Anonymous

    If I had the money, I’d buy enough debt in the big 6 banks to file an involuntary bankruptcy petition against them. Their own financials look horrible, if one inserts default and recovery rates using econometric data by Moody’s they look really horrible.

    This would allow a public debate in open court about the solvency of these big banks.

  21. M.G.

    I still contend that it may be inevitable to have good banks, the point being perhaps how to get there and by which appropriate procedure. Some big lemon banks are likely to become the LEMON BROTHERS as they are insolvent and need to be broken up. They will become old banks. I would like here to stress few more points: 1) about ownership of good banks, which can be non-state (public and private) as well as in the form of mutual and cooperative shareholding; 2) about “mirroring” the old banks, there is scope not only to create one bank for every insolvent one, but as they were deemed to be too big to fail, one could also break them up in smaller banks; 3) about debt holders some kind of debt for debt or debt for equity swaps in the new banks can be envisaged in addition to new loans; 4) about systemic and counterpart risk, I believe that we should know in advance who are the counterparts of the old banks would be insolvent to avoid a situation similar to AIG which seem to have been rescued because of the involvement as counterparts of others too big to fail banks. It goes without saying that if another bank also in another country would be at high counterpart risk of an insolvent bank it should go under the same procedure of break up and creation of good banks. I still contend that in the market of lemons, the systemic risk can be only eliminated or further reduced if you eliminate the lemons one by one. Normally it’s easy because you recognize them even without test, those lemons are quite big, too big to fail…On the other hand the financial markets will be definitely just relieved by just the announcement of the creation of good banks. The credit markets will start to work again with confidence and counterpart trust in a kind of self-fulfilling expectations.

  22. Anonymous

    “I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I’m involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn’t securitize or otherwise sell participations in the loan).”

    This is part of the so-called “shadow default rate”, meaning currently performing loans in name only that hired bk advisors, are paying default rates, have ratings of D or SD. I prefer tracking the shadow default rate to Moody’s econometric projection of default rates. Moody’s estimate is lagging.

    I hop and pray the arbs are running enough money to force price discovery by shorting bank stock and debt, and going long bank assets. If enough several hundred billion vote that way, the market will show everyone just how deeply insolvent the big banks really are. The Fed is just another trader, it can’t outvote the arbs.

  23. Early Withdrawal

    Financial Ninja argues the exit is underway due to prisoners dilemma

    http://benbittrolff.blogspot.com/2009/02/citigroup-bank-of-america-prisoners.html

    The big risk here is we won’t know there is a run on the bank until one actually detonates, and then its too late. I think the govt is playing with fire here with its slow ambiguous responses. If fear ever gets the best of Treasury then the situation will be out of hand. Seems like very high risk gambles by Treasury.

  24. Anonymous

    Very good contextual analysis.

    My impression is that nationalization cannot occur because we don’t have the resources to carry it out (well).

  25. Cix

    Anonymous February 22, 2009 4:58 AM
    said

    “It’s impossible to overstate how dis-interested Japanese consumers are in American products and brands.”

    Why so much American bashing, I’m pretty sure that most of the PCs in Japan run Windows Microsoft, that many Japanese teenager use Ipods and Itunes, that Google is their preferred search, this week 5 out of the first 10 movies at box office are from Hollywood, most of the music they listen to is American, I’m sure they wear Nike and drink Coca Cola while washing their teeths with Colgate smoking Malboro. And this can go on forever.
    Stop this nonsense US brands are the strongest in the world.
    I’m okay with being real, but this is too much.
    I’m European, by the way.

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