Published: February 17, 2009
The pessimistic predictions of Nouriel Roubini, professor at NYU Stern Business School and founder of RGE Monitor, have been proved uncannily accurate. Here, he says that the US and UK banking sectors are mainly insolvent, and that rather than propping up ‘zombie banks’, it may soon be time to nationalise most of the sector.
A year ago I predicted that losses by US financial institutions would be at least US$1tn, and possibly as high as US$2tn. At that time the consensus was that such estimates were grossly exaggerated, as the naïve optimists had in mind about US$200bn of expected subprime mortgage losses.
But, as I pointed out then, losses would rapidly mount well beyond subprime mortgages as the US and global economy would spin into a most severe financial crisis and an ugly recession. I then argued that we would see rising losses on subprime, near prime and prime mortgages; commercial real estate; credit cards, auto loans, student loans; industrial and commercial loans; corporate bonds; sovereign bonds and state and local government bonds; and massive losses on all of the assets (CDOs, CLOs, ABS, and the entire alphabet of credit derivatives) that had securitised such loans.
By now, write-downs by US banks have already passed the US$1tn mark (my floor estimate of losses) and now institutions such as the IMF and Goldman Sachs predict losses of over US$2tn (close to my original expected ceiling for such losses).
But if you think that US$2tn figure is already huge, our latest estimates at RGE Monitor suggest that total losses on loans made by US financial firms and the fall in the market value of the assets they are holding will peak at about US$3.6tn.
US banks and broker dealers are exposed to half of this figure, or US$1.8tn; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was, last fall, only US$1.4tn, leaving the US banking system some US$400bn in the hole, or close to zero even after the government and private sector recapitalisation of such banks.
Thus, another US$1.4tn will be needed to brink back the capital of banks to the level they had before the crisis; and such massive additional recapitalisation is needed to resolve the credit crunch and restore lending to the private sector. So these figures suggests that the US banking system is effectively insolvent in the aggregate; most of the UK banking system looks insolvent too; and many other banks in continental Europe are also insolvent.
The four possible approaches
There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:
1. re-capitalisation together with the purchase by a government “bad bank” of the toxic assets;
2. re-capitalisation together with government guarantees – after a first loss by the banks – of the toxic assets;
3. private purchase of toxic assets with a government guarantee and/or – semi-equivalently - provision of public capital to set up a public-private bad bank where private investors participate in the purchase of such assets (something similar to the US government plan presented by Tim Geithner in February for a Public-Private Investment Fund);
4. outright government takeover (call it nationalisation or ‘receivership’ if you don’t like the dirty N-word) of insolvent banks to be cleaned after takeover and then resold to the private sector.
Of the four options the first three have serious flaws: in the bad bank model the government may overpay for the bad assets – at a high cost for the taxpayer - as the true value of them is uncertain; and if it does not overpay for the assets many banks are bust as the mark-to-market haircut they need to recognize is too large for them to bear.
Even in the guarantee (after first loss) model there are massive valuation problems and there can be very expensive risk for the tax-payer (an excessive guarantee that is not properly priced by the first loss of the bank, the fees paid and the value of equity that that the government receives for the guarantee) as the true value of the assets is as uncertain as in the purchase of bad assets model. The shady guarantee deals recently done by Citi and Bank of America were even less transparent than an outright government purchase of bad assets, as the bad asset purchase model at least has the advantage of transparency of the price paid for toxic assets.
In the bad bank model the government has the additional problem of having to manage all the bad assets it purchased, something that the government does not have much expertise in. At least in the guarantee model the assets stay with the banks and the banks know better how to manage and have a greater incentive than the government to eventually work out such bad assets.
The very cumbersome US Treasury proposal to dispose of toxic assets can be best understood (subject to the large fog of uncertainty about its many details) as combining taking the toxic asset off the banks’ balance sheet with providing government guarantees to those private investors that will purchase them (and/or public capital provision to fund a public-private bad bank that would purchase such assets). But this plan is so non-transparent and complicated that it received a thumbs down by the markets as soon as it was announced in February, as all major US equity indices went sharply down the day it was announced.
If the US government pays fair value for toxic assets, the banks go under
The Treasury plan in some ways resembles the deal between Merrill Lynch and Lone Star, and shares some of its flaws: Merrill sold its CDOs to Lone Star for 22 cents on the dollar; and even in that case Merrill remained on the hook in case the value of the assets were to fall below 22, as Lone Star paid initially only 11 cents, so Merrill guaranteed the Lone Star downside risk
But today a bank like Citi has similar CDOs that, until recently, were still sitting on its books, at a deluded and fake value of 60 cents. So, since the government knows that no one in the private sector would buy those most toxic assets at 60 cents, it may have to promise a guarantee, formally or informally, by putting capital into a public-private bad bank that will receive extra lending from the private sector, to limit the downside risk to private investors from purchasing such assets.
But that implicit or explicit guarantee would be hugely expensive if you need to induce private investors to buy at 60 cents what is worth only 20 or even 11. So the new Treasury plan may end up being again a royal rip-off of the taxpayer if the guarantee is excessive given the true value of the underlying assets.
And if instead the implicit or explicit guarantee is not excessive (if the public-private bank truly tries to discover the value of such assets as in the formal Treasury proposal) the banks need to sell the toxic assets at their true underlying value, which implies massive write-downs that will uncover the insolvency of such banks. The emperor has no clothes, and a true valuation of the bad assets – without a huge taxpayers’ bailout of the shareholders and unsecured creditors of banks – implies that banks are bankrupt and should be taken over by the government.
Thus all the schemes that have been so far proposed to deal with the toxic assets of the banks may be a big fudge that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.
Nationalisation may be best way forward
Thus, paradoxically, nationalisation may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – most certainly – even the unsecured creditors in case the bank insolvency hole is too large; it provides a fair upside to the tax-payer.
It can also resolve the problem of avoiding having the government manage the bad assets: if you are selling back all of the assets and deposits of the bank to new private shareholders after a clean-up of the bank together with a partial government guarantee of the bad assets (as was done in the resolution of the Indy Mac bank failure) you avoid having the government managing the bad assets.
Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold back in a re-privatisation scheme, the government could outsource the job of managing and working out such assets to private asset managers if it does not want to create its own RTC bank to work out such bad assets.
Nationalisation also resolves the too-big-to-fail problem of banks that are systemically important and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-to-fail problem as the current approach has led weak banks to take over even weaker banks.
Merging two zombie banks is like have two drunks trying to help each other to stand up. The JPMorgan takeover of insolvent Bear Stearns and WaMu; the Bank of America takeover of insolvent Countrywide and Merrill Lynch; and the Wells Fargo takeover of insolvent Wachovia show that the too-big-to-fail monster has become even bigger. In the Wachovia case you had two wounded institutions (Citi and Wells Fargo) bidding for a zombie insolvent one. Why? Because they both knew that becoming even bigger-to-fail was the right strategy to extract an even larger bailout from the government. Instead, with the nationalisation approach the government can break-up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller good banks.
This ‘nationalisation’ approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze. Japan ended up having a decade long near-depression because of its failure to clean up the banks and the bad debts. The US, the UK and other economies risk a similar near depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.
Nationalisation not yet politically feasible
So why is the US government temporizing and avoiding doing the right thing, i.e. taking over the insolvent banks? There are two reasons. First, there is still some small hope and a small probability that the economy will recover sooner than expected, that expected credit losses will be smaller than expected and that the current approach of recapping the banks and somehow working out the bad assets will work in due time.
Second, taking over the banks – call it nationalisation or, in a more politically correct way, ‘receivership’ – is a radical action that requires that most banks be clearly beyond the pale and insolvent. Today Citi and Bank of America clearly look near-insolvent and ready to be taken over, but JPMorgan and Wells Fargo do not yet. But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit, in a matter of six to 12 months even JPMorgan and Wells will likely look near-insolvent.
Thus, if the government were to take over only Citi and Bank of America today (and wipe out common and preferred shareholders and also force unsecured creditors to take a haircut) a panic may ensue for other banks and the Lehman fallout that resulted from having unsecured creditors taking losses on their bonds will be repeated again.
Instead, if, as likely, the current fudging strategy of temporizing and hoping that things will improve for the economy and the banks does not work, and in six to 12 months most banks (the major four and the a good part of the remaining regional banks) all look like clearly insolvent, then the government can take them all over, wipe out common shareholders and preferred shareholders and even force unsecured creditors to accept losses ( in the form of a conversion of debt into equity and / or haircut on the face value of their bond claims) as the losses will be so large that not treating such unsecured creditors would be fiscally too expensive.
So, the current strategy – Plan A - may not work and the Plan B (or better Plan N for nationalisation) may end up the way to go later this year. Wasting another six to 12 months to do the right thing may be a mistake, but the political constrains facing the new administration – and the remaining small probability that the current strategy may by some miracle work – suggest that Plan A should be first exhausted before there is a move to Plan N. Wasting another six to 12 months may risk turning a U-shaped recession into an L-shaped near depression but currently Plan N is not yet politically feasible.
But with the government forcing Citi to shed some of its units and assets, and the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC, the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.
You can expect a similar path and an eventual government takeover of most financial institutions in other countries – such as the UK – where many banks are effectively insolvent.
So while Plan A is now underway, the very negative market response to this Treasury plan suggest that it will not fly. Markets were expecting a more clear plan but also a plan that would bail out shareholders and creditors of insolvent banks. Unfortunately that is not politically and fiscally feasible. It is thus time to start to think and plan ahead for Plan N.