We don’t, however, have a lot of time to avoid the self-reinforcing contraction of the financial system that is the precursor of a depression. So while the philosophical and legal arguments over the next bank regulatory regime are being worked out, the American and European banking systems have to raise a lot of new capital, and raise it now.
It would appear that the scale of new capital issuance required for the banks is so large that some form of official sponsorship is required to make the effort work. The longer the capital-raising exercise is put off, the larger it will have to be, and the greater the degree of government sponsorship….
One of the interesting aspects of the crisis is how some mid-level and lower-level people in the financial institutions are far more coherent and direct than their leaders. It’s as if they’ve already given up waiting for upper management to give a sensible View from the Top. I could pick out a number of papers and documents from the various banks and dealers, but a pretty good example was published at the end of last month under the auspices of the US Monetary Policy Forum. Called “Leveraged Losses: Lessons from the Mortgage Market Meltdown”, it was co-authored by a group including David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyup of the University of Chicago, and Hyun Song Shin of Princeton.
Since the estimates were drawn up more than 15 minutes ago, they’re already out of date, but they’re not a bad place to start. The group estimates that the losses on mortgage paper will ultimately total about $400bn, with about half of that being incurred by “leveraged US institutions”. They go on to estimate that new equity raised so far from investors such as the sovereign wealth funds is of the order of $100bn. A series of calculations based on conventional banking economics leads them to estimate that “under this baseline scenario, the total contraction of balance sheets for the financial sector is $1,9800bn”.
This is before estimating any longer term increases in the losses incurred from lending to the corporate sector, or from other consumer lending such as auto loans or credit cards. Furthermore, it is before taking into account the cessation of much securitisation activity, and the consequent requirement for a shift to what the central bank people have described to me as “the new on-balance-sheet world”.
It does not, therefore, take much of a leap in imagination to suggest that the US banks need to raise well over $100bn in new Tier One capital, and perhaps more than $200bn. They also need to do it quickly, so as to avoid that spiralling destruction of capital.
Those are big numbers. Given that the mark-to-market theology would, without much of a stretch in interpretation, tell you that some major institutions would already have something less than the capital they need to support their business, one might reasonably ask why the investing public would give them more money. After all, you can buy big piles of mouldering securitised paper on the open market, without the management value subtracted offered by the Citigroup board.
The answer is the franchise value of the banks. Because they will be given positive yield curves, effective monopolies for making markets in government-sponsored securities, and will be cossetted with easier accounting rules in future, they are gigantic rent-paying machines in a risky age.
However, that point has to be driven home by the central bankers and regulators. So the hundred billion, or hundreds of billions, in new equity issues will need to be effectively co-sponsored by the Fed, along with a row of other eminent suits from the government.
Also, the issues will be so large that some queuing will have to be administered, or at least sanctioned, by someone with apparent independent authority.
None of this should be necessary. The bank boards should be able to take the lead on their own. But they can’t, without the legal and political cover that would be offered by effective and open government endorsement of new capital issues.
Yet it isn’t at all clear who will give them the dough. Private equity firms have never been keen about low-growth (in normal times) regulated businesses, and the major firms are pulling in their horns in the face of big losses.
We’ve reported sightings as of a month ago that sovereign wealth funds were turning down further requests for dough from struggling US banks, and no wonder. Their earlier infusions are under water. Worse, in China, there has been ongoing criticism of the governments $3 billion, whoops, now $1.5 billion stake in Blackstone. The fact that Citic invested in Bear Stearns, and now Bear is rumored to be at risk of insolvency, will not doubt lead to further public outcry. Thus, even if the powers that be thought a US financial player might make a good invest, they will be reluctant to pull the trigger. They’d have only personal and institutional downside.
Conventional wisdom is that sovereign wealth funds will increasingly invest in the US via private equity and hedge funds, in part because using those channels will reduce political opposition (the SWFs would be passive investors). But per above, with private equity firms getting headline for faltering results, and hedge funds blowing up on a regular basis, it’s a tad optimistic to think sovereign wealth funds are lining up to write checks for large US funds, Indeed, they are likely to regard emerging market as more promising venues for growth.
Thus, Dizard’s exhortation comes too late. It will take considerable US government arm-twisting for US financial institutions to raise the equity they need.
So look for government officials to act as investment bankers to the banking industry. However, it probably won’t happen under the Bush administration, which is wedded to the idea of private sector solutions. That means, per Dizard’s warning, the recapitalization will come late and therefore be more costly than it would have been otherwise.
It’s too bad that the Administration is ideologically opposed to having Hank Paulson play a role he’d be good at.