When are we being Chicken Littles?
Lance on Oct 01 2008 at 11:27 pm | Filed under: Domestic Politics, Economics, Lance's Page
Let us look at one of the ways that we are being panicked unnecessarily, and why incidentally we can help many of these financial institutions in the fashion I discussed in my post on a potential alternative plan. In my next post we will discuss ways in which we are not being misled, and why we in my mind should do something about this.
In my previous post I discussed the balance sheets of our most highly leveraged institutions. Let us look at them a little closer. Let us go back to Lehman Brothers as a textbook case of what has been happening and why some of what we are being told is exaggerated.
It is no accident that the dominoes in the investment banking world have fallen in precisely the order of their gross leverage. Bear Stearns, Lehman and then Merrill. The next domino is Morgan Stanley in terms of both leverage and market pressure. We see the same pattern in Europe.
So let us look at Lehman Brothers.
Just prior to their collapse Lehman reported 600 billion in assets. Think about that number and reflect on why our government buying 700 billion in assets is such a tiny number relative to the problems we are facing. This is just one institution.
So why would an institution with 600 billion in assets be in trouble?
First, what are those assets? They include mortgage backed securities, commercial real estate and a host of securities including treasury bonds and bills. Most of those assets were not going to disappear.
The problem is that Lehman had only 20 billion in shareholder equity. What does that mean? It means it had liabilities of approx. 580 billion! To put it in plain english, they owed that much to various creditors in the form of customer obligations, counterparties, preferred stock holders, subordinated debt and senior bondholders. To figure out how much equity that the common stockholders had in the company you take 600 billion, subtract 580 billion and you get 20 billion. Given what happened to their stock price, and the lack of buyers for the company investors felt that 600 billion in assets was a bit fishy, subsequent accounting seems to have borne that out.
That does not mean that the assets were not substantial. The problem is that when one has 600 billion in assets and only 20 billion in equity your leverage is 30 to 1 (600 divided by 20 equals 30.) Therefore if the assets were written down by only a bit more than 3% it would wipe out the equity and make them officially bankrupt (3.4% of 600 billion is 20.4 billion.) In fact, it seems they were bankrupt.
So, were customers or counterparties at risk? Should this have led to a systemic problem? Not really. Those 600 billion in assets are worth something, in fact they are worth quite a lot. In Lehman’s case the equity plus various bondholders added up to 143 billion. So, the markdowns would have to exceed 143 billion before customers or counterparties were at risk. That would be exceedingly unlikely. What our treasury was concerned about was not customers or counterparties, but the bondholders! The goal there, with Bear Stearns (and with far more justification, Fannie and Freddie) was to protect the bondholders from the risk of default.
That is right folks, that is who your tax dollars bailed out in Bear Stearns and each other case, bondholders. We should be sickened.
So what does an institution in Lehman’s case try and do to shore themselves up? Raise capital so that their assets are even larger than their liabilities. They can issue stock, sell preferred stock which pays interest but it is only paid if they have the cash to do so, etc. The problem with Lehman was they were so weak that investors wouldn’t pay them enough per share issued to raise the amount of capital they needed. Preferred stock is only attractive if people believe you will stay in business as well and you are likely to be able to pay the dividend. Lehman was pretty much shut out of all the traditional methods of raising capital.
Is this an institution the plan I proposed would apply to? Possibly not. The key would be to force them to mark their assets lock stock and barrel to market, possibly sell the problematic ones at fire sale prices and see if the resulting write downs left enough cushion of shareholder equity and debt holders to eat through to keep the capital injection safe in case of default. The key is that stock and bondholders before accepting such a deal would have to see that the action would improve their situation enough to risk being wiped out in the case of stockholders, and having to stand in line for payment in a default situation in bondholders case.
Stockholders would never agree to such a deal unless they felt there was no other way, so it would be the bondholders who would hold the key. If the capital would be sufficient to allow the company to survive, they would go along with it. If all it would accomplish was for a failing institution to go on losing money a while longer they would just ask for bankruptcy. The balance sheet would be the key.
From the taxpayers standpoint, the treasury would make the same calculation. If a sufficient amount of capital would leave too thin a cushion of bondholder liabilities to cover us in the case of default, we allow them to go into bankruptcy or call in the FDIC (for banks) to liquidate.
Let us go back to Hussman:
Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution’s capital would be for the government to overpay for those assets. Rather, the government should either a) provide new capital, taking a claim in front of the company’s bondholders and stockholders, or b) execute a receivership of the failed institution and immediately conduct a “whole bank” sale – selling the bank’s assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.
Let’s now look at Morgan Stanley:
For example, consider Morgan Stanley’s balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?
Why indeed?
The answer is the credit markets. When Lehman failed one systemic risk was a problem, that is the risk that without knowing who was in what kind of shape nobody wants to be the bondholder left holding the bag. Hence the run on money markets following Lehman’s collapse.
The answer isn’t to bail Lehman or others out, it is to clarify for the market who is and isn’t solvent. That however will have to wait for another post.
The key point to be made, is that the nonsense about systemic risk due to customers and counterparties not being made whole with a cascade of defaults is not true, and there is no excuse for our media, our politicians and others to try and panic us into believing otherwise. We can survive a large number of failed financial institutions, even if it is not pleasant.
I should also point out that our commercial banks are not as leveraged as the investment banks, so they are far less problematic.
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