One of the premises of the bailout bill is that the banking industry must have government help to get back on its feet.
A banking industry expert, Bert Ely, who has a stellar track record in predicting crises and calling false alarms says that the banking industry can handle this mess internally and does not need subsidies.
The comments from Bert come in an interview at Institutional Risk Analytics (the entire newsletter is wide-ranging and very much worth reading), First, IRA’s recap of Ely’s qualifications:
To get some perspective on the evolution of the last remaining large investment banks into commercial banks, we now turn to Bert Ely, one of the leading experts on banking and finance in the Washington policy community. An accountant by training, Ely has specialized in deposit insurance and banking structure issues since 1981. In 1986, he became an early predictor of the S&L crisis and a taxpayer bailout of the FSLIC. In 1991, he was the first person to correctly predict the non crisis in commercial banking. In 1992, he predicted an eventual taxpayer bailout of the Japanese banking system.
Here are the excerpts that relate to whether the banks need government intervention:
The IRA: And if our internal estimates at IRA are correct about the magnitude of the losses facing the industry, then the banks may not have the resources to deal with the problems alone. What then?
Ely: That is of course the trillion dollar question. I have run the numbers looking at the capacity of the industry to pay the tab. Assuming that bank insolvency losses don’t get way out of line, which I don’t think they will, then the industry can handle it. It’s not going to be cheap, but the banks can handle it and clean up their own mess. The losses will feed back through the industry to depositors and borrowers in the form of lower rates on deposits and higher cost of loans….
The IRA: So you oppose the idea of the government putting preferred equity into solvent but troubled banks that cannot raise capital on reasonable terms?
Ely: Yes, it is not necessary, even now. There is absolutely no need for the Treasury to have the authority, as you suggested, to “inject capital into solvent banks that are temporarily unable to raise new capital.” If a bank truly is solvent, it can raise additional capital or sell itself, if its present owners are realistic about what their bank is worth. The reason solvent banks have a problem raising capital, or selling themselves to a stronger bank, is that they set their price too high, as did AIG. As an aside, I am glad to see AIG’s shareholders getting whacked by the warrants associated with the Fed’s taxpayer’s loan to AIG. There is absolutely no need for the taxpayer to subsidize banks so they can stay independent, provided no barriers are erected to prevent new entrants into bank or specific banking markets.
The IRA: Agreed. We were referring to banks that could not be recapitalized or sold. A sale is obviously the first, best choice. So you would let the banks resolve their problems privately. Would you agree with Ernie Patrikis (‘A Change in Bank Control: Interview With Ernest Patrikis’, July 9, 2008′) that the Fed needs to loosen the restrictions on bank ownership in order to facilitate this process?
Ely: I fully agree that restrictions limiting investors from taking significant positions in banks should be lifted. Not only is the belief in separating banking from commerce invalid in an open, competitive economy, but we need to get ruthless investors inside troubled banks to get these banks and their bad assets cleaned up and/or sold. That is what should have happened at AIG, but unfortunately did not.
The IRA: Precisely. We want to see the bad assets remain in private hands, not in a government warehouse for toxic waste. But why then should anyone support Paulson’s proposal to place these toxic assets in the hands of the government? Chairman Frank seems to want to declare the jubilee and engage in mass loan forgiveness in order to ensure his permanent re-election. Maybe we can just all stay home instead of going to work and Barney Frank will just mail everyone a check.
Ely: Look, all of the fallout we are seeing in the markets today is part of clearing the detritus from the last speculative bubble. The housing bubble has to be allowed to collapse in order to clear the markets. We have a very necessary correction process underway. But this process creates a lot of pain and loss. I don’t like that, but we have to clean up the mess and take the pain in order to get the economy back into balance. In collapsing bubbles you have collapsing companies. Japan tried to muddle through and they had a lost decade. I hope we are not going to do that…
The IRA: But that is precisely the point. Why should Washington use taxpayer funds to rescue people who deliberately made bad business decisions?
Ely: This is the question that comes up frequently about Dick Fuld at Lehman and Kerry Killinger at WM. When these guys were contemplating life, did they have any second thoughts, any doubts about these decisions? Did hushed discussions among the top folks in their organizations, with the senior managers and directors, include deliberations such as these or were they too arrogant, too isolated from reality?…
The IRA: How do you see the Paulson plan unfolding? What should the markets expect in the next couple of weeks and months?
Ely: It is likely that Congress will not pass the Paulson bailout legislation this week. However, whenever it is passed, it will be much more complex, and incorporate unwise punitive terms and conditions that will seriously impede the intent of the Paulson plan. Further, I believe the process of pricing the assets purchased under the legislation will be much more complex and contentious than many appreciate at this time, which means that this program will get off to a much slower start than many anticipate, just as the RTC started quite slowly. If the Paulson plan starts slowly, market forces may sweep past the plan. It will be extremely interesting to see how this plan evolves over the next year, particularly given that a new Administration will come to power on January 20.
There is a lot of meaty stuff in this article.
Note that this analysis, even if correct, does not conclusively disprove the need for a bailout bill. The Paulson proposal, as revised over the weekend, now extends to foreign banks and hedge funds. A hedge fund crisis, which Nouriel Roubiini says is the next shoe to fall, would hit prime brokers like Goldman and Morgan Stanley particularly hard. The Lehman bankruptcy nearly deep-sixed the financial system. Goldman and Morgan are bigger firms. If either were to look wobbly, even after their pending capital infusions, it would roil the markets.
But it sure puts a crimp in the thesis.
IMHO, I don’t think it was Lehman that nearly cratered the financial system, it was AIG. As you’ve mentioned before, AIG had many unbalanced CDS contracts, and so a rapid unwind of its positions (or its inability to honor its obligations) in a BK would have put an enormous stress on the financial world.
OTOH, Lehman’s BK seems to have been accepted without as much strife. If that’s the case, the markets may actually be able to handle Goldman or Morgan being impaired in the oncoming hedge fund collapse.
Anyone in the trenches in Wall St care to comment? Which one put more beads of sweat on your forehead last week? AIG or Lehman?
Actually, it was the Lehman BK that led the Reserve money market funds to break the buck (they held Lehman commercial paper) and the flight from money funds and commercial paper really almost did take the financial system down.
(Sorry for being too lazy to do the nice link thingie).
What did Ely say? That the plan is unneeded but it will pass and yet if it `starts slowly, market forces may sweep past it’? So it’s kinda maybe needed? Or maybe not? Or something to talk about, anyway?
Bert Ely is one of the tools at the Cato Institute whose free-market sloganeering and lobbying helped give us this mess.
The reason for featuring Ely is at least he appears to have done some sort of analysis and has a track record of being correct on this sort of thing. I hate the Cato crowd as much as you do, but even they can be correct upon occasion. And Paulson’s and Bernanke’s record on forecasting this mess has, by contrast, been awful.
I personally believe some sort of recapitalization is probably necessary. However, the industry now that stock values are depressed, has much to gain by making themselves sound like a basket case so as to garner maximum government goodies. Look at the intensity of lobbying over the weekend. Appalling.
It’s too bad he didn’t mention Credit Default Swaps, as that seems to be the giant elephant in the living room. Doesn’t the thesis about CDS go like this?: they can’t let a huge writer of CDS go under, or that would create a cascading waterfall of counter-party risk? Is this the real reason why the banks are getting bailed out?
Today at 1 A.M. Eastern Time The Fed made an infusion of $30B to the Central Banks of four countries:
$10B each to Australia and Sweden
and $5B each to Denmark and Norway. This comes across as a healthy move and well timed. It is similar to other standard co-infusions within the group of seven members.
I think this guy has the right end of the stick.
Face up to it, the banks have to be socialized and sold back in better times.
Thanks for the link. But I’m curious: now that those money market funds have had their near-death experience, I expect they’re rapidly taking all their money out of whatever commercial paper they’re holding and putting it in liquid t-bills. Because even a govt guarantee doesn’t fully protect you against a run, especially in these jittery times. This isn’t necessarily a bad thing to do, since their first priority is maintaining that $1 NAV and being able to meet redemptions.
If that’s the case, does the Fed intervention really do anything but buy an extra week or so? Are money markets actually going to roll their commercial paper as it comes due? And if they don’t, Armageddon will be coming soon regardless of the Fed…
Looking at failing financial firms, there are two classes of problems, and they are significantly different. In one class, we have essentially solvent firms who are having trouble rolling over short term debt and raising capital. In the other class, we have firms which have such massive locked in losses on their books that they are either already insolvent or will all but certainly become so.
I find it interesting that Bert Ely says of the first class, “Let ’em swim for it, they’ll make it.” He’s in a better position to know, and so the idea of lending in return for equity may actually _prevent_ those firms from selling themselves to private capital in the wings. I’d like to think he’s right on that.
What Ely does not seem to well address is the problem of the second class, those firms which really _are_ insolvent, and which aren’t going to make it in any form. Unfortunately, many of the big, bad problems we have seen so far reflect really-o, truly-o BK lenders. As has been mentioned elsewhere, these failed firms failed because they had severely excessive leverage, and have failed very nearly in order of the scale of their leverage, so really this should make for no surprises. And what we do NOT need for insolvent firms are debt-for-equity infusions, because if they go broke their equity is as worthless to the public as it would be to the private capitalists who are refusing to hazard their wealth presently.
What we need to resolve the latter class is a rapid seizure of over-leveraged and insolvent firms. The problem with Lehman wasn’t really letting it fail in terms of its losses, but that the failure was disorderly, with sidewise impacts. It would be better for here on out if the firms are simply seized and the wrap ups supervised by a public authority: that is a far better guarantee to avoid market panics than post facto heaving of money bales at shrieking banks and funds which is what Paulson is good for (*yechhh*). —And it is _exactly_ such a procedure which is completely absent from the Paulson Proposal, the Dodd Proposal, or public debate, other than Hussman’s Open Letter which may be beginning to get some traction.
Soooo all of our present proposals fail to focus on the one form of intervention which is _most_ needed to avoid systemic crisis and sudden illiquidity. How smart is that?
AIG has locked on the $85B. Now we need to get her well and shipped home for R&R and then marry her off so she can get working again.
We do not need to be in the insurance or banking business.
“The IRA: So you oppose the idea of the government putting preferred equity into solvent but troubled banks that cannot raise capital on reasonable terms?”
“Ely: Yes, it is not necessary, even now. If a bank truly is solvent, it can raise additional capital or sell itself …”
“Yves Smith: If [Goldman or Morgan] were to look wobbly, even after their pending capital infusions, it would roil the markets.”
Goldman is not looking wobbly this morning, with the shares up on Buffett’s equity infusion. But his terms are stunning: a ten (10) percent dividend on the perpetual preferred, and instant dilution via common share warrants with a BELOW MARKET strike price.
Are these not DESPERATION terms? Is Goldman in THAT much trouble?
I mean, even today, I can borrow on a mortgage, a HELOC, or even a credit card at lower rate than that, and without ceding an equity stake. So I’m a stronger credit than Goldman Sachs? Man, are we in trouble now. Because like Goldman, I’ve got some criminal tendencies.
Like Ely, I resolutely oppose the bailout plan. But if they’re gonna do it, the Buffett-Goldman deal suggests that similar terms should apply to any entity availing itself of the TARP: namely, a grant of below-market strike price warrants which provide an instant profit to the Treasury, plus the appreciation potential to cover the amount exchanged, even if the toxic assets go to zero.
Punitive? Sure. But Goldman Sachs voluntarily entered into these terms. And many of the supplicants are going to be more troubled credits than Goldman.
Me so bearish …
Can’t the Treasury get the same terms for their shareholders as Buffet does for his???
The main argument for the bailout is that it will prevent a recession. Why is it necessarily a good thing?
The root of all this mess is not as much the housing bubble but the credit bubble, which allowed the American consumer spend more than he earned almost indefinitely. This has to change, and for that one needs a recession! I understand the argument of not falling into a great depression, but it does not mean avoiding a recession at all costs.
When a person is sick, his body temperature is raising as the immune system goes into overdrive. Yes, too high a fever is dangerous, but keeping the temperature artificially low is also bad.
Whoah! Time to fire up my Systran language translator….
What’s confusing to me is Ely’s opposition to the Treasury Slush Fund coupled with his criticism that Congress will make it so onerous that it will not be used.
Being onerous and unused should be a good thing. What should we do, give them a free toaster with every billion dollar bailed out?
This is the first I’ve heard that the bill is going to include hedge funds. That’s really the last straw. Those 2 and 20% guys have made themselves obscenely rich in the last decade, and THEY’RE going to be helped out? That’s not moral rot, that’s insanity. I truly hope this bill does not pass.
“Can’t the Treasury get the same terms for their shareholders as Buffet does for his???”
Well, Warren Buffet does work for his shareholders.
Who does Paulson work for? Really? Since he is so willing to put forth taxpayer’s capital before the capital of the bondholders troubled firms , one has to give this question some serious consideration, no?
Everyone seems to agree this bailout was begun on Wall St. I am not so sure. Wall Street is just a transmission belt for Washington to world capital markets.
This is about protecting the empire, and that requires a fall in American standards of living. The other alternative is the dismantling of most of the US military.
This bailout is being sold just as NSC-68 was sold: with the use of language that is “clearer than truth.” I suggest you read this document by Steven Casey: http://www.lse.ac.uk/collections/CWSC/pdf/selling_nsc_68.pdf
Note how on message Schumer has been. He has adopted the silly analogy of Paulson – “the credit market is clogged and the patient will have a heart attack” – on CNBC this morning. All the central players have used this language – Frank, Dodd, Schumer, etc.
This is being oversold, and the talking points are clearly designed to strike fear into middle America, who they believe are stupid, untutored, and easily panicked.. Just how the credit markets are “clogged” is never explained, nor is it explained how they can be “unclogged” by stuffing $700Bn in new capital into them.
We are being scammed, brothers and sisters!
In addition to many of the concerns listed here and elsewhere, I have three concerns that have not received much, if any, attention.
First, if anyone at a securitizing firm, let’s call the fictitious firm Silverman, knew of fraudulent activity anywhere in the pipeline, would the investor that purchased the security have legal recourse against Silverman? Could the hedge funds and other investors that purchased Silverman mortgage backed securities force them to purchase the securities back at par because they had knowledge of fraudulent activities? Would this problem disappear if Treasury purchased these securities at inflated prices from everyone?
Second, did Silverman market these securities to investors while taking opposite positions for the institution? As we saw with auction rate securities, some investment banks were selling the securities to customers while the banks liquidated their own positions. Once that was apparent, the investment banks were forced to buy the securities back due to the misrepresentation. So, did Silverman sell these securities to investors at the same time as they were shorting, liquidating, or purchasing CDSs on these same securities? If so, would the investor have legal recourse?
Third, would banks and other financial institutions be allowed to act as conduits to hedge funds selling these securities? If the bill had an equity position or limits on executive compensation, the conduit scenario would be less likely and would therefore be opposed if the intention was to include hedge funds (or any investor anywhere).
It seems like Paulson could have chosen a much more efficient path to achieve the same result. This inefficient path may produce the same result at the end of the day but cost the taxpayer three times as much. Could there be any motivation to choose the inefficient path?
Paulson/Bernanke have been shot down by Berkshire’s buy in to Goldman.
Once the banks gets into serious trouble they will start shopping for private bail out money and offer terms that the market requires to get a deal done. The alternative for the bank is BK. BK means no possible chance for big paydays for bankers going forward.
Isn’t it amazing how fast a deal was done with Berkshire once it became apparent to Goldman that a bailout was not going to happen this week?
Reserve Funds of NY broke the buck when they went after paper-something they never traded in before 2006. They went from $86B to $8B in a few days. They notified the big investors in time. Everyone else is frozen in place. Lehman cost them 785M and that was what broke the buck.
I just wonder. Do any of you folks have any idea what you are talking about or do you just sit and BLOG all day?????????
Ano from Japan:
My Japanese is not that good but the comment about Silver amd Gold in the Qing Dynasty Imperial Court caught my attention.
Provided Yves permits me to say so, being naked without being offensive is more like an art:
I came to a similar conclusion after contemplating the LTCM vs. Bear unwindings: “But, enough with the prelude: Why have we put up any public funds whatever to financial firms? (Short answer: It is not clear.)”
Nice post Yves, from a worthwhile source.
It is true that the money market funds situation has been stabilized over the shorter term.
However, there is another sector about which the authorities seem to be quite worried.
Yet NOBODY in the financial press is reporting it, for some unknown reason.
The Pension Benefit Guaranty Corporation. This is a biggie.
You heard it here first.
check out this post on jeff matthews:
“how is it that Warren Buffett can cut a better deal with the best-run financial company in America than the U.S. Treasury can ask from the worst-run financial companies in America?”
Can we ask Burt if the GSE bailout was necessary? Bet he says no.
Buffett coming into GS with a second $5B for warrants. first $5B covered GS $5B write down.
Sumitomo Mitsui Japan may be coming into GS soon.
Buffett wants The PP.
I was only kidding yesterday when I posted this:
Here’s an idea – why does Paulson have to worry about whether the banks will be willing to sell the assets at a price that makes sense for taxpayers? MAKE THEM DO IT, Hank! Take Ben with you and walk into C headquarters and tell Vikram Pandit that he is fired and that C is now under government supervision. THe government has decided that C will sell all its problem assets to Treasury for next to nothing. In exchange for this “rescue” of C, the government will also take 80% of the equity in C.
That’s nuts! The government can’t do that, can it?
Sure it can. Ask FNM and FRE shareholders.
But today the WSJ is calling for the FDIC to take over banks that have NOT failed, inject public money into them, throw out management, and take preferred equity or warrants. This is from the WSJ, whose motto is “Free Markets, Free People”???
If even the WSJ is urging hasty, ill-considered government bailouts on a massive scale, I have to believe Paulson is going to get what he wants, or something close to it.
We will look back later and wonder why we acted in such a panic and why the media failed us with a lack of skepticism.
In 2001, administration asked for war authorization, media reported WMD were certainly in Iraq, and Congress gave the ok. Supposedly some in congress thought the administration would not really use the authority it had been given.
Summer 2008, administration asks for a bazooka to use against GSE panic, but leaves question about whether it will use it. Media reports this is essential, GSEs are failing, no doubt about it. A few weeks later Paulson uses the bazooka, and congresspeople express surprise that he pulled the trigger.
Fall 2008, Paulson now wants nukes instead of a bazooka. Media is certain major action of this scale is necessary. Gotta do it fast, just like with Iraq, just like with the bazooka. Paulson says he might not have to use most of the nukes…
Haven’t we already spent something in the neighborhood of 700 bil already (according to a republican senator yesterday)And it just bought a little time. That seems to be an empirical test of throwing money at the problem.
As mentioned above the housing market is going to fall. So the inflated mortgages will never be worth nearly as much as Frank etc fantasize. Paulson etc et remind me of King Canute telling the tide not to come in.
Maybe he should reread Humpty Dumpty
The Treasury would have to sell 700 billion in bonds to raise cash for their purchases. The buyer I assume would be the Fed. Then could the Fed exchange these bonds with banks for more junk? Then wouldn’t the total stimulus be 1.4 trillion?
“Fratto insisted that the plan was not slapped together and had been drawn up as a contingency over previous months and weeks by administration officials. He acknowledged lawmakers were getting only days to peruse it, but he said this should be enough.”
FYI, related to taxpayers being treated as if they have preferred share ownership in a bailout:
The core right is that of preference in the payment of dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied.
Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends on preferred shares may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR.
Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit.
“Note that this analysis, even if correct, does not conclusively disprove the need for a bailout bill.”
The burden of proof lays with those calling for the bailout, not on those of us who oppose it.
There is no authority in the constitution for the Federal government to be in the business of rescuing incompetent businessmen. Mr. Paulson and his cronies can go to hell.
Surely Buffett is only investing due to the Bail out money guarenteeing him a great return with almost no risk. what happens if the bail out doesnt happen berkshire is on the hook.Buffett must be sure it is happening
What’s the purpose of this revelation?
If Yves wants to make certain issues public, certainly Yves can do so within this blog’s dedicated space. Otherwise, I believe we need to respect the reasons for doing otherwise.
Anon of 9:45 PM,
I suggest you do your homework before making baseless insinuations.
Being a speaker at the Milken Institute Global Conference does not mean one supports their policies or their views. For instance, one of the speakers was Lisa Randall, a world-renown physicist, who is just about as uninvolved in economics as they come. Another speaker was the head of the biggest labor union in the world.
I was on a panel with Mark Thoma, Felix Salmon, and Paul Kedrosky on econoblogging. None of us are advocates of the Milken conservative party line. For instance, Thoma is at least as liberal as I am. But rather than looking further at the website which described our talk, at the video of our session, or my own posts on the conference, you jump to a conclusion.
And I made myself persona non grata there with this post, “Hubris, Denial, and the Financial Services Culture,” and this follow up. “Milken Institute Takes Issue With My Post.” I assure you I will never be invited there again.
Fascinating that the ethical question of taking $10,000 from each American household to fix the recklessness of private greed was never raised.
I guess that’s an implicit recognition that such a munificent piece of arm-twisting has no merit – but would be acceptable anyway.
I like the Warren Buffett-style solution for fixing the financial mess. Instead of a taxpayer bailout, let private investors infuse cash and try to turn these financial institutions around and make them profitable. Then give them a capital gains tax break for their services.
7 trillion or so knocked off the global market. No accountant willing or able to tell where it went.
ask only one question and one question only until it has been answered…..
WHERE’S THE MONEY????
Why do we need these highly paid “experts” being given outrageous bonuses for destroying a lot of great businesses and countries when an idiot could have done it for half the price??