I do believe we should be doing something as a nation, through our government, to avoid the not insignificant chance of a total financial meltdown. I have seen several things proposed that I find interesting, and I will get into them and other longer term issues in coming days. I had hoped to address this all comprehensively, but time just isn’t allowing that, so let us do so piecemeal.
Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.
John Hussman (a long time favorite of mine) has written an open letter to Congress that unfortunately few Congressman or women are likely to read, and it reminds me of the Chilean experience McQ posted about here. Nor is it being debated in the press. This is sad, so hopefully whether the new bailout bill passes or not, we can see our approach restructured along these lines eventually:
1) Public funds must function to increase the capital of distressed financial companies, not simply to take bad assets off of the balance sheet at market value (which may improve the “quality” of the balance sheet, but does nothing to improve the capital cushion and therefore little to avoid future runs on the institution).
2) In return for these funds, the government should NOT take equity (which is a subordinate claim and also creates potential conflicts of interest), but instead should take a SENIOR claim that precedes not only the stockholders but also the senior bondholders in the event the company defaults anyway. Congress may need to make some modification to existing bankruptcy law or provide for expedited bondholder approval to do this, but essentially, the government’s claim should be subordinate only to customers in the event of default, and senior to both stockholders and bondholders. However, it should also be countable as capital for the purposes of satisfying bank capital requirements.
3) Ideally, the rate of interest on such funds should be relatively high (which will encourage these firms to substitute private financing as soon as possible), but actual payment should be made once the firms are again profitable so that the payment burden does not weaken them during the present recession.
4) The bill should allow for expedited bankruptcy resolution for these institutions, so that in the event of failure, the “good” bank (all assets and customer liabilities, but excluding debt to bondholders) can be cut away and liquidated to an acquirer as a “whole bank” sale. For nearly all of these institutions, the debt to bondholders is far more than sufficient to absorb any losses even in the event of bankruptcy. The current difficulty is that the bankruptcy process itself draws out the process of taking receivership, cutting away the good bank so that it can be sold to an acquirer, and delivering the proceeds as a residual to bondholders. Streamlining that process is one of the best ways to ensure that the failure of one institution does not have “systemic” effects.
5) To assist homeowners, the bill should allow for a reduction of mortgage principal during foreclosure, but the mortgage lender should also receive a Property Appreciation Right (PAR) that gives the original lender a claim on future property appreciation up to that original mortgage amount. In other words, the homeowner receives a substantially lower mortgage balance and payment burden now, but the lender stands to be made whole over time through property appreciation rather than immediate burdens on the homeowner to make payments.
I think number 5 is key. It helps people who want to stay in their home, but the PAR allows for the bank to have a more valuable asset on their books than the value of the renegotiated mortgage itself. Note: the PAR needs to stay with the property, so if it is sold the buyer still owes the mortgage company. It would be an assumption in other words. This way the pain is shared by homeowners and financial institutions, while market pricing still is allowed to work.
One of the issues which has bothered me throughout this crisis has been the bailout of senior bond holders in most of the interventions so far. The rationale has been that customers and counterparties were being protected, bond holders merely were being brought along for the ride. Lucky them.
However, that has not been true in any of these bailouts with the possible exception of AIG. If these institutions had been liquidated in an orderly manner there were more than enough assets to cover counterparties and deposits. John does a good job of educating us as to why that is true and expands upon that in his letter, so read the whole thing. More on that can be found here in, September 29, 2008 – You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet:
1) as the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;
2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;
3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;
4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.
Let’s return to the basic balance sheet of a typical financial company before the writedowns:
Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100Now let’s write down the questionable assets – not all the way to zero, but to $2:
Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy. The concern has been that continuing bankruptcies would throw the whole financial system into disarray, especially for investment banks having lots of counterparty relationships with other institutions. But the reality is that for nearly all of these institutions, the cushion of debt to bondholders has always been more than sufficient to protect customers from losses even in the event of bankruptcy.
What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the “good bank” (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that’s exactly how it works for regulated banks. What investors overlooked in last week’s panic was that we actually saw the largest bank failure in history – Washington Mutual – with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders. Snap – just like that.
Now, let’s go back to the previous balance sheet. The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here’s the result:
Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the “quality” of the balance sheet, but you’ve provided no additional capital. At best, you’ve allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.
The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.
Hussman also makes a good point about Warren Buffett’s investment in Goldman Sachs:
As a side note, a lot has been made of Warren Buffett’s investment in the senior preferred stock of Goldman Sachs. But it’s notable that Buffett invested in Goldman only upon the conversion of Goldman to a bank holding company, which puts it under a different regulatory structure that gives it access to the Fed window. Goldman’s balance sheet has $40 billion of shareholder equity that would have to be drilled through before getting at the preferred. Evidently, Buffett believes that Goldman’s asset mix is diversified enough, and light enough in mortgage assets, that Goldman won’t take a major haircut on its entire (largely hedged) portfolio of assets.
Buffett’s investment may reflect confidence in Goldman, particularly with a government backstop on whatever questionable assets it does own, but if anything, it suggests that the government should have gone the same route – namely, provide capital in return for a financially viable security that is senior to common shareholder equity, have it accrue a relatively high rate of interest, and allow it to be repaid early (Buffett’s preferred is callable by Goldman) as soon as the financial institution can secure cheaper financing.
Instead, the government is taking on financially non-viable securities and warrants on common equity, while failing to improve the capital position of these financial companies at all (unless it overpays). Taxpayers will not make money here.
As Congressman Scott Garrett noted to taxpayers on Sunday, “This morning we should be very much alarmed. Obviously, Washington is not listening to your wishes. Those who used to work for Goldman Sachs will support this deal. Those who have blocked reform in the past will support this deal. I will not support this deal.” I couldn’t agree more. This is not a good deal, because it will waste taxpayer money without addressing the fundamental solvency problems.
That last comment is very important. There are many problems with the current approach from a ethical, ideological (from all parts of the spectrum) and long term viewpoint. All of which might make sense anyway of the plan were in any way likely to be a good short term solution. The problem is that it isn’t.
I’ll put up a few twists on John’s proposal in the coming days, which some will find more or less appealing. However, it should be cautioned, none of this will likely avoid pain, a recession or poor asset performance for some time. This will be years in the fixing, and it will be a drag on growth for some time. Shuffling the burdens to allow for price discovery and functioning markets will avoid disaster, closing weak institutions, which needs to begin in earnest, will allow healthier institutions and new market participants room to grow. It will not change the fact that the losses exist, that they will have to be paid for, that the nominal and real wealth of the US will have shrunk, that consumers and our own economy will need to delever (reduce debt) and all the pain which that entails.
