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.

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  1. Anonymous

    There simply is not the political will to implement the necessary changes and take the strong medicine.
    The “privatize gains, socialize losses” cartel has the reigns and they do not intend to let go anytime soon. They have about 6 months left to completely bankrupt the country and by golly they just might do it. The only end result I can see at this moment is a back door nationalized banking system, a highly devalued dollar, and wall street socialism at its finest. Let the second gilded age begin!

  2. a

    I’m not sure the problem is “political will.” I think most people in Authority – politicians, government officials, economists, the Fed – just don’t get it. They don’t get it because they look at the economy over the past fifty years; their theories and their experiences are based on that economy and date from that period. Unfortunately, the American economy has a systematic bias over that time – more and more indebtedness. But now we’re at a point when more debt won’t be supported. And so all those fine theories and experiences don’t amount to a hill of beans in what will be a new dynamic.

    Let’s take one example. A lot of economists think the solution to America’s problems is to spend more money – fiscal stimulus. It’s worked in the past, it will work again, right? But the Federal government has just taken on its book a few hundred or more billion dollars of losses from Fannie and Freddie. It probably will have to bail out the FDIC next year – for several hundred or more billion dollars. It bailed out Bear Stearns, it will need to bail out Lehman, and so on. That begins to be serious money; by the time the government is through, it *will* be very serious money. And now the government is also supposed to spend money to “stimulate” the economy. Am I mistaken, or do many if not most economists really think money grows on trees? Or if they think that the Fed *can* really make money grow on trees, that people who have real goods and real services are idiots and will take tree-grown money in payment for their real goods and services?

  3. Richard Kline

    No wait, the ‘second Gilded Age’ is just _ending_: What you are heralding on, Anon, is a New McKinleyism.

    I agree with all the assessments of this post. The banking system is involvent. The Fed went the Easy Rate route and told Mr. Market, “It’s your problem.” Mr. Market is saying, “Rap-rap, no taps back.” But we are already well into the ‘forebearance phase,’ an interesting and apt concept. That’s what all the Fed auction windows are, in reality, pretensions of solvency, with the Fed draping it’s skirts over various corpses in the vaults. We go to the _next_ phase when somebody quits pretending; clearly that ‘someone’ will not be anyone in public authority. They will be the _last_ to give in to reality.

  4. Anonymous

    I believe the games will continue untill some outside influence forces the hand of the Fed. One possibility is a serious slowing of ‘foreign dollars’ flowing back to the US via treasury offerings. If this happens the games will stop immediately. How long will foreign governments be willing to fund US consumption and ill advised US foreign wars? Anybody’s guess, but imo the foreigners will tire of the nonesense treasury offerings well below inflation, a weak dollar that is debasing SWFs, and shipping commodities and value added goods to the US for questionable paper.


  5. Independent Accountant

    I agree with you. Until foreign central banks pull the plug on the dollar, the game will go on. It may even continue after that and we will follow Zimbabwe into hyperinflation.

  6. Escariot

    “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.”

    FWIW I work for a developer (CRE) and we have been pounding the pavement for 6 months to fund a project (passes the smell test, product still has demand, plenty of room in the pro forma to absorb even a 30% reduction in price) to no avail. Nada, nothing, no interest.

    That is until this week…three LOI in three days, site visits, FedEx deliveries, I mean someone turned the spigots open.

    My superiors are content. I am a little suspicious. Anyway, it seems someone got a memo to start writing new paper. For the record the company is lean and mean, runs out of a trailer, no fancy corporate offices, and the land is not leveraged at all, so the fundamentals are OK. Unless of course, the world as we know it completely collapses, but no one is safe in that scenario.

    My resume is still getting updated, but it looks like I still have a job this month.

  7. DownSouth


    I agree with you.

    There is absolutely no political will to take the tough medicine that is necessary to upright this ship. The impetus for any financial reform will have to come from without.

    It will probably take the form of a bailout package. The United States will be treated just like a third-world country. There will be a devaluation of the dollar, but debtors will not absorb any of these losses because, if the U.S. wants the bailout, prior to the devaluation loans will be re-denominated in some other currency that has real, stable value. Government spending will be slashed to the core–no more deficits. Unemployment will soar and there will be several years of economic contraction.

    Another possibility is that the U.S. will reject these terms and credit will be cut off. Then the U.S. will have to start living on what it produces. Run-away inflation would probably ensue, but however it spins out, living standards of Americans will decline significantly.

    These are the only two possible scenarios I see. Either way, it will be extremely painful for Americans, and the pain could spread to many other parts of the world.

  8. GeorgeNYC

    a said

    “Am I mistaken, or do many if not most economists really think money grows on trees? Or if they think that the Fed *can* really make money grow on trees, that people who have real goods and real services are idiots and will take tree-grown money in payment for their real goods and services?”

    A economist is someone who believes that you can make a tree grow to the moon if you can give it enough money.

    My favorite quote but I am not sure who said it. But in the world of increasingly limited resources it reveals an important flaw in some economic thinking.

  9. John Stark

    Policymakers’ responses so far remind me of that scene in one of the Superman movies, where Superman makes time move backwards by pushing the whole planet backward one full revolution. (Actually this probably would not affect time at all, and would have alarming effects on tides and so forth, but never mind.)

    Trouble is, the government isn’t superman. They can’t go back and undo what has been done. House prices were driven to unsustainable levels in a very short time, and they still have a long way to fall.

    You can only keep the air in a broken balloon for so long before you pass out from hyperventilating.

    It’s pointless to discuss whether we are “willing to take our medicine.” Faulty metaphor. The medicine is going to take us. We won’t have much to say about it. All we can control is the details: When, where, and how. The bad consequences are coming.

    Maybe I’m wrong.

  10. Anonymous

    Does anyone know or comprehend the amount of debt involved here? Got a definitive number? If the US$ wasn’t the world’s reserve currency we’d be competing with the Zimbabwe $100 billion note.

    You tell me the absolute bottom line and I will tell you how many generations it will take to absorb because you can’t have a fully functioning banking system unless the exchange medium is stable/trusted.

  11. masaccio

    Isn’t Steve’s view consistent with the lessons from the Japanese experience? They did everything they could to keep their banks open, and see what it got them, the non-existent recovery.

    And, by the way, isn’t killing off regulation the way we got here in the first place?

  12. joebhed

    These are the times that try men’s souls.

    The banking system AND the American economy are insolvent and failing, respectively.

    They are insolvent BECAUSE of the actions taken by the FED bankers over the past twenty-five years, in the growing cover up of the first fifty years.

    We need an ever-growing economic/financial expansion and contraction in order to re-tool for the next bubble, which MUST always come or, we’re dead.

    There are some who say there is a lack of political will to accept 10 percent employment, using today’s definition of the word.

    That’s the best case scenario.

    The private bankers of the FED have abused the American worker and taxpayer to the point of their own demise.

    And I do mean the modern-day version, international capitalist, debt-money system.

    The only real solution is the one presented to FDR as the Chicago Plan. We need a debt-free money system, in this country and the world.

    Stop playing around the edges, with an occasional daring effort like this entire blog, in attempting to come up with a fix of the system.

    What is broke is the debt money system itself; it is impossible to maintain.

    We have gone broke and insolvent in trying to do so.

    Time for something new.

    Link up to

    Yes, it’s the money system.

  13. Anonymous

    forbearance is alive and well within the bank regulatory agencies. having worked with one where i was among a minority of economists/analysts to issue warnings as early as 2003 about the coming storm from the balance sheet concentrations in c&d, mortgage loans, etc. that were ignored by executives (who still hold their jobs). even back then, we predicated that the response would be forbearance and a japanese style response. so far, it is going to script. the only exception was the timing of the IMB failure as the liquidity event forced the ots/fdic hand. they will allow banks to operate with high levels of NPAs — the only trigger will be when they are no longer core earning viable or a liquidity event like IMB.

  14. Paul Davis

    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.

    Translation: Lets pretend, and perhaps someone else will be suckered in.

    It is exactly when marking to market begins in earnest that I’m going to be allocating capital to the sector. Until then, why would anyone come anywhere near it? These companies are in a not unfamiliar situation in which their goodwill and NPV of future cashflow may well be swamped by liabilities. The creditors have to take the hit because equity is gone. Then new equity can play.

    This goes for the US as a whole. It’s not until the debt is wiped out, or at least clearly serviceable, that I’m going to be allocating to the USD.

  15. brianfc

    i very much like this post. one thing though, you write:
    ‘Translation: they could afford to reflate and debase the currency. We can’t.’
    I certainly think that the politicians will not be willing to take tough measures, which would be necessary to bring the economy on a firm footing again, because of a) ignorance and unwillingness to acknowledge what is going on and b) being politicians they do not want to take any measures that, while necessary in the long run, have immediate effects that seem negative.

    that being said, a revaluation of the dollar seems unlikely in the short run. but what do you mean when you say the us cant afford reflating the currency? is there any choice here? as far as i can tell, it may be possible for the us by accumulating more debt and by using its political weight to pressure other countries into buying that debt to delay a revaluation. but is there any possible way that it will not happen eventually? i just dont see it. admittedly, a new asset bubble that would somehow emerge all of a sudden and get everybody out of their respective mess before they would have to deal with the consequences of the current situation could probably avoid it, but that seems simply impossible.

    again granted other countries will keep supporting the dollar for a while, how can a revaluation (and id mean a massive revaluation that would probably seriously damage us status as reserve currency) be avoided?

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