Jim Baker: First, Let’s Kill All the Zombies

A very good comment by former Treasury Secretary James Baker in the Financial Times, “How Washington can prevent ‘zombie banks’,” warns that the US is on its way to repeating the Japanese error of propping up dud banks and creating a moribund economy as a result.

His program has the merit of being simple (at least in concept). Unfortunately, now that the banking mess has become highly (as opposed to somewhat) politicized, any new program has to fit within the confined of soundbite-constrained communications if it is to have a hope of being considered.

Many of its elements will be familiar to readers of this blog: doing triage on the banks, closing the hopeless ones, haircutting or wiping out bondholders. And it is noteworthy that Reagan Republicans see nationalization (or receivership, or pre-privatization, if more business friendly branding makes the medicine easier to swallow) as less bad than the alternatives.

In all of these proposals, the element that is generally ignored is what to do with the underlying borrowers. A similar triage need to be done there. This crisis will not be on the mend until we see large scale writeoffs and restructurings.

As readers may have inferred, I am distressed at the reluctance to tackle methods to restructure or unwind structured vehicles, which could require legislative fiat. Admittedly, the will to take radical action of any sort is notably absent in DC, along with the awareness that the provisions of most structured deals effectively prohibit debt restructuring/renegotiation, which is normal for traditional loans and bond deals. It is not much of an exaggeration to say that the economy is being held hostage by these vehicles, yet it is somehow unacceptable to even contemplate cutting this Gordian knot.

From the Financial Times:

We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios….

Yves here. That is Washington-speak for “the stress tests are inadequate.” Back to the article:

Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.

To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.

This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.

After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.

The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.

To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.

This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.

Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.

Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.

Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.

During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.

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29 comments

  1. David

    Yves,
    I agree with you on moral grounds that it seems right to puts banks into receivership and give the bond holders a haircut. Believe me, no one would be happier than me than to see Bill Gross lose his shirt. But I wonder if this is really at all practical.

    For example, by my last calculation, US commercial banks and finance companies have $2.74T in debts. Who do you think owns these? Obviously, most of it is owned by other commercial banks and financial institutions. So if you haircut the bond holders, you inflict another round of damage on the financial sector which may cause more failures and hence more bondholder haircuts. It is not clear to me where this stop or if it stops at all.

    Some of the damage will got to highly leveraged European banks. So then it becomes a issue of international politics.

    I am sure the Europeans and probably everyone else is telling Washington to clean up their F#?cking banking system in order to prevent more damage from being exported overseas. Giving them lectures on moral hazard is probably not the right tactic. The capitalistic system has been tested and it has failed. There is no need to test it again. It is time to contain the damage and move on.

  2. Anonymous

    Baker doesn’t realize this is not 1980.

    Why should private managers be more effective than government ones? The crisis was caused by thousands of scummy executives carrying out dubious (at the time) methods for securing the not so dubious certainty of lining their own pockets.

    Has Jesus come back? Why should any executive in the US today be trusted to do anything but milk these banks for every penny they can get. And that includes destroying the banks if will help an outside concern in it’s objectives.

    These managers will be temporary and ‘revolve’ into positions with more stable firms ASAP.

    American citizens should treat any member of the public with an MBA (we can throw in economists), as a potential weapon of mass destruction.

    We are at the point where we can say with absolute certainty that the these people are pure evil.

  3. Steve

    Any proposal that doesn’t address the issue of off-shore deposits for the biggest banks ain’t a solution. The U.S. can’t do an Iceland. And existing law prohibits the U.S. from insuring off-shore deposits. We’re talking trillions in off-shore deposits. Receiverships and bridge banks are out for multi-national bank holding companies. Even a change-of-control event will trigger a mess with foreign deposit-taking subsidiaires. Baker is wrong: D.C. does have a comprehensive plan, but it’s for a problem nobody wants to discuss.

  4. alex black

    Any foreign entity that is stupid enough to have an uninsured deposit at Citi deserves to have it vaporized. Maybe an excaption can be arranged for anyone who has been in a coma for the last 6 months.

    As far as “it would be irresponsible of us to not heed our own advice” that we dished out to others in the 1990’s, if I was a betting man (Hey! I am!) I’d bet on “irresponsible”. However much the US plans on taxing me or trashing my currency, I’ll make 5 times that amount shorting their long bonds.

    We’ll all grow very very old waiting for someone in DC to step up to the plate and do something “resposible”.

  5. Anonymous

    “Admittedly, the will to take radical action of any sort is notably absent in DC …”

    Funny how the will is influenced by campaign contributions. Why one isn’t even likely to exerience the slightest movement of the will in the presence of the kind of massive assistance the financial lobbies provided our dear savior during last year’s election campaign. Similarly paralysed has been the will to alter Middle Eastern policy. But you just buck-up, ya heah, Mr. Lincoln is employed by the American people.

  6. Anonymous

    Steve (March 2, 2009):

    “Any proposal that doesn’t address the issue of off-shore deposits for the biggest banks ain’t a solution. The U.S. can’t do an Iceland.”

    I do see your point – absolutely – but if we bail out trillions of dollars in foreign depositors we run a very real risk of destroying the dollar. I think we need to protect every full faith and credit obligation, which I think means FDIC insurance and Treasuries. Beyond that, the banks need to be put into receivership and the bankers tried in court, and likely imprisoned.

    Yes, this will be devastating. It’s going to be terrible no matter what. But we’d protect what’s left of the US’s once-deserved good reputation for legal and just capital markets.

    Anything else is likely to be tyranny, no matter how it gets labeled.

  7. Steve

    Anonymous of 1:15AM

    Is the alternative of a run on the dollar, expropriation of U.S. businesses abroad, collapse of trade, etc., really preferable? And how would failing on trillions of dollars of obligations restore the reputation of our capital markets?

    The U.S. has recklessly borrowed from abroad (deposits included) for a long time, and we don’t have the freedom of action we’d like to think we have.

    To my mind, the taxpayer is now faced with the consequences of regulatory and legislative decisions that were made over many years — and ignored by the public at the time. The tyranny I see is one of greed and stupidity, bankers who bought politicians, and citizens who couldn’t be bothered to inform themselves about what their politicians were doing. And now a nation of entertainment junkies is angry and can’t do anything about it without making their situation even worse.

  8. doc holiday

    Re: "As readers may have inferred, I am distressed at the reluctance to tackle methods to restructure or unwind structured vehicles" (I never, ever inferred that, but I can see where some people may have done so).

    > As to the point of restructuring, that's what Covered Bonds were gonna be used for, I sorta thought, e.g, the hype from Paulson, initially, was sung to this tune: "In Europe, public sector covered bonds are a centerpiece of infrastructure finance and an important investment vehicle for global investment funds and central banks."

    And it’s whispered that soon if we all call the tune
    Then the piper will lead us to reason.
    And a new day will dawn for those who stand long
    And the forests will echo with laughter.

  9. OSR

    It is not much of an exaggeration to say that the economy is being held hostage by these vehicles, yet it is somehow unacceptable to even contemplate cutting this Gordian knot.

    The tail has been wagging the dog for years. Why everyone thought that it would change, precisely when it matters the most, is beyond me.

  10. Anonymous

    It’s James Baker to you. And if he likes it, I hate it. God help us if we’re still relying on an idiot such as this.

  11. Anonymous

    Beans and rice are going to be considered luxuries after this mess sorts itself out.

    This system is shaking so bad that it just might implode soon. Asking for and receiving justice appears to be a pipe dream. Sad really.

  12. doc holiday

    I hate to go into a vituperative rant here, but I was just going over some CDO rating crap from Fitch, from about two years ago, and it really strikes me that nothing is changing, i.e, the same rating agencies are still busy at work, the same regulation people, same accounting firms, auditors, bankers and essentially, not a peep about accounting fraud, collusion, corruption or any slight hint that the systemic collapse that is under way — and cascading out of control — is the result of falsified or misleading information — by anyone, anywhere. That seems odd, considering that this collapse is gaining speed and size and I wonder if confidence has anything to do with this downward death spiral?

    Sure you can suggest that Madoff came forward, for some reason, almost as a weird symbolic gesture by an insane madman, but that whole mess already seems to be swept up and off the radar, and gosh, it wasn't that big of deal, really. It's over baby, relax and forget Buffett, he sells ice cream and candy to babies.

    Nonetheless, this line of thought makes me wonder why, in retrospect, the collapse of Enron, just a few short years ago, turned out the way it did, with poor old Ken Lay and his boytoy Skilling treated so badly, by so many? It doesn't make sense, to take that period of history as an example of corruption and then superimpose it onto our current situation, i.e, less than six years ago, there apparently was a different form of justice or legal practices that were far different than what exists in our society today, and thus, that doesn't make sense at all. Where is the continuity or the sustained connection to precedents that link logical thought to previous cases? It's as if five or six years of legal amnesia has morphed into a cancer that destroyed the foundations of laws that go back thousands of years. What the hell happened to this world and the people that are in it?

    Why was Enron not allowed to simply restructure their apparent accounting fraud and get bailed out for making a few errors in judgement — and what about firms like Arthur Andersen? Why was Arthur Andersen put through such abuse with an insult, suggesting they were involved in obstruction of justice — how could that be that they would be pulled into that mess and then be subjected to legal hocus pocus? I think people forget that it wasn't the corporation per say that was at fault then, or the people involved, it was simply the system that failed. We saw this type of twisted polarization at The Nuremberg Trial, where the system apparently failed — and then people wanted a process which brought about the dog-and-pony-show of fake-ass accountability to pin the tail on a few people that were trapped in a political ponzi scheme.

    Once again, the illusion of justice is in the eye of the beholder and the laws of the land are not immutable — but infinitely elastic. We are living in a time, when law has no meaning and justice is not served, and the fragmented voices of the people are unheard.

    Yet, we sit here blogging, thinking the worst of bankers, rating agencies and regulators, knowing damn well there is a long list of criminals that have acted together to create a patchwork quilt of collusion, corruption, fraud, dishonesty, lies and falsified information, and they are all innocent, because we are guilty of not demanding justice.

    FYI: Fitch assessed, in its cashflow analysis, the stressed price at which the pool could be sold or securitized by the trustee in a particularly severe economic environment. The agency has taken into account numerous assumptions in respect of, among others, the cost of funding for a potential buyer under an 'AAA' stress scenario.

    A dynamic asset coverage test (ACT) is calculated to ensure that sufficient overcollateralization is available to provide full repayment of the mortgage bonds in a 'AAA' stress scenario. The ACT requires that the asset percentage cannot exceed 93%, providing a minimum 7% credit enhancement at any time. The ACT only gives credit to the portion of the underlying mortgages up to 75% LTV.

    >> Bottom line, why is fraud allowed to thrive today? If this is the structure of society and if law has no meaning, what will America become in the next 5 years, other than a corrupt and chaotic implosion of dishonesty?

  13. Anonymous

    Why can’t we chop Citi and BofA to pieces?

    say 10 pieces one way or another. then nationalize it one by one. It maybe more expensive and slightly more complicated than outright nationalization. But at least it’s not Japanese style “do nothing and keep injecting money”

    look at the bright side:

    – the pieces of banks has to hire people to reconstitute its missing parts.

    – much smaller to clean up/inject fresh funds to these pieces than entire giants.

    – more people solving and working on the problem instead of highly concentrated “people upstairs”

    – no more too big to fail outfit.

  14. Marsha Keeffer

    Happy to supply the garlic, silver bullet or stake – whatever kills zombies. Enough already.

  15. killben

    “Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing”

    What is he saying … leave the same guys who created the mess and did not see what is coming, to clean it up .. just as you sack the management of a company made sick by them, these guys should also be given the boot … The regulators with Greenspan as the ring leader should be finger-pointed .. comeon what is wrong in that … finger-pointing is construed with inaction here … point fingers, sack the guys, get guys who saw the picture and have an idea on tacking it!!

    This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach”

    Obviously .. that is why I am saying we need a new team … not the same guys who created the mess and did not see the crisis coming

  16. Anonymous

    The cure for a depression is a depression, these clowns can’t stop this and the only thing they will do is make it worse. Buckle up!

  17. Anonymous

    I’m sure that Jim Baker, Bush Bum Boy Extrordinaire, doesn’t have an angle here and won’t be walking away with any Loot.

    Thank God we have such dedicated and sage ex-Public Servants to look after and advise us. This is what makes America the great country it is.

  18. Anonymous

    as much as one needs to avoid collateral damage so too one needs to avoid collateral benefit. Hair cutting the bond holders will probably cause more problems to some financial institutions and pensions -including increased government support of the PBGC. However, better that rather than picking up the whole tab which allows wealthy investors (both domestic and foreign) along with foreign institutions to escape without paying a price/

  19. Edwardo

    Mr. Baker is way way late chiming in. Even if they put a halt to all of this looting, excuse me, bailing out of entities like AIG today, it is almost certainly too late to avert a Depression. My view is that the only way we are going see genuinely meaningful change with respect to how we engage with this and other particularly difficult problems is via revolution, broadly defined. In fact, the path that the nation, and specifically the nation’s government are on, all but guarantees that we will have a revolution since the government is set to fail miserably going forward.

  20. Anonymous

    And if he likes it, I hate it. God help us if we’re still relying on an idiot such as this.

    I hate Baker, but I don’t think he is an idiot. However, the Republican Party has devolved so far into Limpbag-led know-nothingism that Baker is irrelevant. His editorial will sway approximately nobody.

  21. Larry

    I believe that recent posts by Mish and Brad Setser provide the key to understanding why the administration has delayed nationalizing the banks. It’s a foreign-policy issue. In the case of Citi, for example, the “private capital” that’s supposed to follow the US govt in converting preferred to common stock belongs the sovereign wealth funds of Singapore and other wealthy statelets.

    The idea here is to slowly pull foreign governments toward accepting the fact that they’re going to get a haircut (even shorter than the one they’ve already had).

    The other issue is that the US has to ramp up the staffing to run the nationalized entities. This is a non-trivial problem.

  22. Anonymous

    If you’re going to use movie metaphors like “Zombies”, you have to realize that zombies can’t be killed.

  23. Anonymous

    Agenda and self interest are out in full force. Now it’s not the time to think about your pocket book, now it’s not the time to pass moral judgment, too late for that. Now it’s time to think about the future of the USA and her place in this world. It’s all perspective.

  24. Eric L. Prentis

    The US economy will hit bottom, it is only a question of when. Stock and bond holders will be wiped out, period, inflicting much pain. Better to keep powder dry to pick up the pieces once we find out what’s what than to squander taxpayer money now in a futile attempt to make the banking system whole. Once we reach bottom economically, we can begin to build again on a solid foundation.

  25. Ken

    David wrote: “For example, by my last calculation, US commercial banks and finance companies have $2.74T in debts. Who do you think owns these? Obviously, most of it is owned by other commercial banks and financial institutions.”

    I’ve never understood why big banks get away with things that don’t pass the sniff test at smaller scales. Imagine if the local bakery claimed they were worth $10 million, because the dry cleaner owed them that much; and the dry cleaner in turn held the note for the used bookstore; and finally the used bookstore was worth ten million because the bakery owed it to them. No one would take these claims seriously, least of all the banks if any of these business went to them for a loan.

  26. David

    Ken, you make a very good point. Banking is general is somewhat of a scam but especially when they can borrow from the capital markets. I don’t know why we don’t restrict banks to just raising deposits.

    Banks can raise short term deposits or borrow from the capital markets longer term depending on rates and their lending time frames. Now their debt is selling at huge discounts to face value and they can’t borrow from the capital markets. No worries. The Fed has lowered rates to zero and promised to keep it there for some time. So banks can now raise deposits at close to zero rates and the fact that they are short term is no longer a worry because the Fed has basically promised to keep rolling them over for years. The banks can now invest in higher yielding assets including their own bonds.

    So it is basically a giant handout from savers to the banks which mostly stays under the radar. People are more focused on the capital injections but the ZIRP policy is probably the bigger wealth transfer. When combined with cheap capital injections, it is even more so.

    A brief calculation look like this. The Fed gives the bank 5% yielding preferred shares as capital. The bank then raises deposits at 0.5% leveraged at 10 times capital. It buys back it own bonds at 8% yield. It is making 7.5% ROA and 75% return on this new capital or 70% return on capital after the preferred dividends. Since it will book losses for years, it won’t pay any taxes so this will compound for 3 years or so at 70% which is a factor of 4.9. The upshot is that a $1B preferred capital injection turned into a $4.9B profit to the bank simply by replacing its bonds with fake deposits which is really just money printed by the Fed. In total the $350B of TARP injections could turn into $1.7T of earnings for the banks over the next three years and this will in part offset the loan loss provisions. This is why you don’t want to bet against the big banks especially ones like BAC and WFC. C may be too far gone.

  27. Jim T

    OK, we go around and around the real problem (DERIVATIVES) and that is exactly why the problem doesn't get resolved.

    WHAT IS A (Derivative)? Simplistic Answer: It's a bet (just like in Vegas) it's a bet that acts like insurance for the lender, in case the borrower defaults on the debt. That was the original concept anyway, but like in Vegas at a craps table, other parties other then the "Casino" and the "ROLLER" can also get in on the betting for or against the Casino or Roller.

    So let's say CitiGroup sells $10 Billion of its debt to the Saudis. Well the Saudis would obviously buy derivatives to insure the repayment of that debt. Then CitiGroup starts showing signs of weakness and a lot more (hundreds or even thousands)of other parties believe CitiGroup will default on that debt too and they place their bets against CitiGroup. Someone takes those bets (AIG, JP Morgan, Wells Fargo, B of A, UBS, Lloyds, HSBC, RBS etc…)

    OK CitiGroup is noe insolvent on life support from the Federal Goverment, but technically still paying its debts, so no triggering of the outstanding "Derivatives" yet! That is why our government will not Nationalize or let the bank go Bankrupt because once they do the BOND HOLDERS GET WIPED OUT! And they then want to collect on their Derivatives and so does every other player that bought Derivatives betting against CitiGroup.

    Now the original debt to the Saudis was only $10 Billion and NO BIG DEAL TO COVER THAT DEBT, BUT LETS SAY 1,000 OTHER PLAYERS TOOK THAT BET TOO. Well now we have a much bigger problem because that $10 Billion just became $10 Trillion, that somebody somewhere needs to pay and that is the problem! If CitiGroup goes down JP Morgan and other probably go with it.

    When Lehman went down (Henry & Ben) thought they were pretty smug until Monday when they got a call from JP Morgan. With Lehman going down, JP Morgan had to make good on $139 Billion of Derivatives, so by the end of the day a lot of money changed hands, but the end result was Lehman was bankrupt, paid JP Morgan $139 Billion which JP Morgan gave Lehman that morning and then the Government also gave JP Morgan another $139 Billion to pay its Derivative accounts.

    Not 100% sure why the money traveled around the way it did, but at the end of the day. You and I paid $139 Billion Dollars to JP Morgan and Lehman to settle derivatives or I'm sure JP Morgan would have come very close to BK itself.

    Just you watch, Jamie Dimon and JP Morgan have been holding themselves out as the Good Healthy Bank, but like someone riddled with CANCER they only have months to live!

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