Doing my part to help the economy, I upgraded my TV package and now I have Bloomberg. This is a recoup of watching Bloomberg all weekend.
How Bad It Is and How Much Is Needed
Financial Risks of A Bank
The bank business seems to have more potential troubles. Besides the operating risks like any other businesses, a bank has financial risks of its own kind: namely liquidity risk (funding risk), interest mismatch and credit risk.
We have seen bank runs and bank failures due largely to the funding, which has eased up by the regulators supplies of emergency funding and guarantees.
The main problem today is credit losses – significant market devaluation of MBS, corporate debt, and mortgage and commercial loan losses.
Balance Sheet, Losses and Recapitalization
On the Fed’s Flow of Fund Matrix, the U.S. financial sector at the end of 3Q 2008 has a combined balance of financial assets of over $60 trillion (figure below). Note that hedge funds and private equity funds are not included.
All of them hold big trunks of financial assets, so when the financial markets tumble all of them are in trouble of one kind or the other, depending on the nature of their businesses and what types are on the books.
Here’s an estimated total loss for the U.S. financial sector (shown in the figure below). For convenience, I made up the % loss numbers.
Since banks hold mainly credit instruments, insurance companies treasury and GSE-backed securities, the pension funds (with a heavy portion in stocks) may have hurt the most. But that seems another issue, staying out of public discussion.
As for the banks, GSEs and brokers/dealers, the accumulated loss is $1 trillion something. The loss is worldwide thanks to global financial integration. Bloomberg reported that until January 26, 2009, total bank writedowns was $792 bn, and replenished capital $826 bn (including $380 bn public money).
The credit loss will escalate up to $2.2 trillion (a Mark-to-Market number), according to IMF’s Global Financial Stability Report (GFSR) Market Update, as of January, 2009.
“The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.- originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities), especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”
How Much is Needed
If only talking about what is required to save the banking system, it is still a hard-to-know since the number depends on the design of the rescue plan, though it seems at least $1 trillion will be necessary.
Objectives, Issues and Challenges
The objective is to establish a capital base solid enough to restore the confidence of capital adequacy as well as encourage the banks to provide adequate credits to the economy. To achieve this, several issues must be solved or taken full consideration.
· Trust / Valuation
I see the phenomenon in large part a valuation issue. Facing a troubled bank, the first thing is to go through its book and assess the situation, but it is said to be an impossible task.
There are several factors. First, as they say that the financial statement is an opinion, it is more so for a financial institution because the future earning streams have to be estimated. Secondly, if you resort to market price (thus the Mark-to-Market accounting), some say that the market price is depressed today and doesn’t reflects the true asset value (which no one knows for sure because of so much other macro uncertainties), if a comparable market price is available. Besides, the innovative financial instruments (CDOs, CDS, etc.) have increased the difficulties many folds. It takes the rating agencies’ super computer running two days to rate a structured product.
The obscurity (plus the malpractices) leads to a lost of confidence that deters the much needed private capitals from financial institutions.
· Investors’ interest vs. tax payers’ money
How to balance these two seems the paradoxical issue the government is facing. On the one hand, any sign of a loss of tax payers’ money would be a disaster (instead of considering the dedicated government resource a necessary support, the public takes it more like a spending, gone already), but a gain that would be realized much later would not be an achievement; On the other hand, it takes a fair answer to the existing bond holders and shareholders of the banks at hand, who would rather prefer a liquidation.
All these becomes near impossible considering the valuation issue above. Any approach may very much produce a result that leaves each party equally unhappy.
· Moral hazard
As important as it is, the moral hazard issue is increasingly a side issue.
· Fairness: one big vs. A hundred small
The so called too big to fail. I don’t know how to play on this one. One thing is certain: the average size of banks will become bigger.
The Alternatives
Based on the stated objectives, here are the ways to go:
· Common, Preferred and Guarantees
To inject equity (common or preferred) or provide guarantees to bank assets is to reestablish the capital base and secure funding. Preferred and guarantee (and warranty) have been the common practice till today. I believe the reason that purchasing common shares has not been used is because of pricing/valuation talked above.
In other words, the authorities want a clear exit strategy, trying to prevent unexpected loss and stay out of the management process. The existing bond/equity holders are thus protected, though after taking significant loss.
The key question is how much money would be needed. Will another $1 trillion be enough?
· Nationalization
To nationalize major banks is based on the view that it is really, really bad – banks are deep under and it needs much more than $1 trillion. Still, the question of where the money comes from needs to be answered.
Think for a minute on how the government would nationalize and run a nationalized bank. Shareholders would probably be wiped out; management replaced by a banking czar, as well as some or all of board members; massive accounting writedowns are also expected.
But how the bank would be managed differently is another issue. Also, the government needs to figure out how to do an IPO after recovery.
· Aggregate Bank, Good Bank/Bad Bank
I don’t know exactly how this one works, but I believe the gist is to take the so-called bad assets off from the balance sheet into another (aggregated) bank, so that: a) it makes the cleared banks more transparent, safer and cleaner, and b) the established asset pool will be held to maturity and realize a better value than what the current market price declares them to be.
Several key issues need to be addressed. First, pricing or pricing mechanism (e.g., auctioning). Again it is a valuation issue and I doubt any pricing mechanism would work better than what is available. Second, what are qualified bad assets? When the economy is in a downward spiral, nothing is completely safe except treasury bills (which are questionable according to some). Third, it seems it would take a lot more money. It is purchasing the assets outright vs. covering the loss (part of the asset value).
What to Expect
Regardless of the rescue approach, we should expect that:
· Many banks have failed, and many more will.
I don’t want to repeat the list of the failed, but to make a prediction of the incoming wave I would refer to the Saving and Loans Crisis in the 80s and early 90s in the United States: 1617 banks (9.14% of total) with assets of $206 bn (8.98% of total) failed.
Whether we should compare now and then or if so whether it is worse this time is for you to answer. It is bad enough if the same happens today.
· A lot of public money has been spent, and a lot more is necessary
I don’t have to repeat the public record of the public money already involved, but I would say at least $1 trillion more would be needed. I was surprised when Geithner spelled out the 1 trillion number, now I wonder if it is going to be enough.
· Regulatory resources would be under serious pressure
All that said, take a look at the balance sheet of Department of Treasury, Fed, FDIC, and PBGC…
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