naked capitalism

Buiter, in a very good and lengthy post, addresses various issues related to banking, such as the question of “too big to fail” and the future, or more accurately, the lack thereof, of cross border banking. I recommend reading it in its entirety, and wanted to focus on his most controversial argument, but one where I suspect he will be proven right.

Buiter says the Treasury does not have the bucks to implement the banking policies it has adopted, namely, refusing to have bondholders take any pain:

There is just one way to make the US government’s policy towards the banks work. That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks – $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital. The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero.

There is no real money left in the original $700 bn TARP facility – somewhere between $ 100 bn and 150 bn – to do more than stabilise a couple of pawn shops. The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of the Fed. The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars. Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars.

In addition to looking for money in off-budget and off-balance sheet places (and out of sight of Congress), the US Treasury has also tried to hide true extent of the problems of the US banks. In addition to supporting the FASB’s recent proposals for increasing managerial discretion as to the way illiquid assets are accounted for (that is, condoning the issuance of another license to lie), the Treasury appears to be using the ‘Stress Tests’ announced as part of the Financial Stability Plan, as a mechanism to play for time and gamble for resurrection.[1] I base this on what I have been picking up about the reality of these Stress Tests.

1. The actual decline of the real economy thus far is already steeper and deeper than assumed in the Stress Tests.

2. The Stress Tests focus on the 40% of the banks’ balance sheets consisting of securities, rather than on the 60% consisting of conventional loans. The securities (including the toxic waste) is where most of the old problems of the banking sector are concentrated, that is the problems incurred as a result of the pre-August 2007 speculative frenzy. The loan book contains the stuff that will go bad as a result of the steep and deep contraction in real economic activity the US has been in since Q4, but that will not show up in the banks’ reports until this summer at the earliest.

3. The bulk of the information provided to the authorities by the banks is private information to the banks that is virtually impossible to verify independently. Too many banks have lied about their exposure too many times for me to feel confident about the quality of the information the banks have been providing as part of these Stress Tests.

As a result I now expect a clean bill of health for the banks from the Stress Tests. For most banks this will turn out to be incorrect before the end of the year. At that point, the de facto insolvency of much of the US border-crossing banking system will become so self-evident, that even the joint and several obfuscation of banks and Treasury will be unable to deny the obvious. There still will be no fiscal resources available to sanitise the banks’ balance sheets by purchasing or guaranteeing the old toxic assets and new bad assets….

Yves here, It has been noted in the New York Times and elsewhere that no banks will “fail” the stress test; the double-speak is that they have to go get more capital, either from the market or the Treasury. This sounds suspiciously like the modern vogue for not giving children bad grades because it might wound their precious self-esteem. Back to the post:

At that point, only the ‘good bank solution’, which requires either a serious hair cut for unsecured creditors or a mandatory conversion of debt into equity will be viable, simply because the bad bank solution requires additional public money which isn’t there. (You creating a new good bank out of the assets of the old bank and the insured deposits and counterparty claims on the old bank, leaving the unsecured creditors of the old bank with a claim on the equity in the new good bank; a bad bank requires funds to buy the toxic and bad assets from the old bank and addition resources to capitalise the bad bank).

Yves here. The “good bank” idea is one of Buiter’s hobbyhorses; Stiglitz has similar ideas. As elegant as it is in concept, it is no where near as tidy to implement with large firms with global trading operations, which is the case for at least some of the badly impaired banks. Back to Buiter:

We will have wasted a lot of time – the good bank solution and the slaughter of the unsecured creditors should have been pursued actively as soon as it became clear that most of the US border-crossing banking system was insolvent, but for past, present and anticipated future tax payer support. If the Treasury can be pushed into a pro-active policy by declaring, just before the beginning of the weekend, that most of the banks undergoing the Stress Test have failed them and moving these wonky institutions straight into the FDIC’s special resolution regime where they can be restructured according to the good bank model, we could have well-capitalised banks capable of new lending and borrowing by the beginning of next week.

The same policy should be pursued wherever banks have failed: it never makes sense to put the interests of the unsecured creditors before those of the tax payers. It is bad economics in the short run and in the long run. And it is political poison. I fear, however, that only in those countries where there is no fiscal spare capacity (as in the US, for political reasons or in Iceland, for economic reasons), the right solution to bank restructuring will be adopted. Elsewhere the unsecured creditors will continue to feed off the carcases of the tax payers and the beneficiaries of public spending programs that will have to be sacrificed to foot the bill.

There is still some dispute as to how sick the banks really are. One comment yesterday (unfortunately also laced with ad hominem attacks) questioned the contention in the John Dizard article I featured yesterday, which said Citi’s days are numbered. The comment contended that Citi post its pending common for preferred exchange would have $150 billion in equity and $30 billion in loan loss reserves on a $1.8 trillion balance sheet (this individual managed to omit the $1 trillion in off balance sheet exposures, not a trivial matter). With that plus $35 billion in subordinated debt, things will be hunky-dory. I ran the observations by Dizard and got this reply:

Again, whatever I say about Citi’s condition, look at what others implicitly think. Several European governments have been cutting Citi off their list of approved counterparties for state companies— all this after the reported “news”. Possibly they know something. Citi has already been organizing, internally, for a forced good bank/ bad bank restructuring. Anon’s positive view is a minority one among investors in bank paper….

The numbers for Citi’s assets and liabilities are suspect, apart from the off balance sheet liabilities you mention. Why does Anon think that Citi has been disposing only of the bad paper, not the good stuff for which there has been a market? What happens to their CRE book, or their leveraged loan book, or, for that matter, their consumer loan book? Does he think he knows the marks for those assets? How do those marks compare to those of others who hold those assets? I would say they are not…more conservative. And no, Citi is not representative of the U.S. banking system as a whole. It is a fundamentally dysfunctional institution run by terrible, self-serving senior managers. Dismembering it would be a good thing for the system as a whole. If Anon thinks the reorganization is working, just wait until the fourth quarter, or even the third, and then think again.

Citigroup also has the dubious distinction of being on an FDIC list of “Failures and Assistance“.

Do read the rest of Buiter’s piece.