A year ago I predicted that losses by U.S. financial institutions would be at least $1 trillion and possibly as high as $2 trillion.
At that time, the consensus was that such estimates were gross exaggerations--the naïve optimists had in mind about $200 billion of expected subprime mortgage losses. But, as I pointed out, losses would rapidly mount well beyond subprime mortgages as the U.S. and global economy spun into a severe financial crisis and ugly recession.
I argued that we would see rising losses on subprime, near-prime and prime mortgages; commercial real estate; credit cards, auto loans and student loans; industrial and commercial loans; corporate bonds, sovereign bonds and state and local government bonds; and massive losses on all of the assets--collateralized debt obligations (CDOs), collateralized loan obligations, asset-backed securities and the entire alphabet of credit derivatives--that had securitized such loans.
By now, write-downs by U.S. banks have already passed the $1 trillion mark (my floor estimate of losses), and institutions such as the International Monetary Fund and Goldman Sachs predict losses over $2 trillion (close to my original expected ceiling for such losses).
But if you think $2 trillion is already huge, our latest estimates at RGE Monitor (available in a paper for our clients) suggest that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding will be, at their peak, about $3.6 trillion. The U.S. banks and broker-dealers are exposed to half of this much, or $1.8 trillion; the rest is borne by other financial institutions in the U.S. and abroad.
The capital backing the banks' assets was just $1.4 trillion (last fall), leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private-sector recapitalization of such banks. Thus, another $1.4 trillion will be needed to bring back the capital of banks to the level it had before the crisis, and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.
These figures suggests the U.S. banking system is effectively insolvent in the aggregate; most of the U.K. banking system looks insolvent, too, and many other banks in continental Europe are also insolvent.
There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:
No. 1: Recapitalization together with the purchase by a government "bad bank" of the toxic assets;
No. 2: Recapitalization together with government guarantees--after a first loss by the banks--of the toxic assets;
No. 3: Private purchase of toxic assets with a government guarantee and/or--semi-equivalently (a 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 U.S. government plan presented by Treasury Secretary Timothy Geithner for a public-private investment fund);
No. 4: Outright government takeover (call it nationalization--or "receivership" if you don't like the 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 first, above) the government may overpay for the bad assets, at a high cost for the taxpayer, as their true value is uncertain; 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 (No. 2 above), there are massive valuation problems, and there can be very expensive risk for the taxpayer, as the true value of the assets is as uncertain (as in the purchase of bad assets model).
The shady guarantee deals recently done with Citigroup 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 it does not have much expertise in. At least in the guarantee model, the assets stay with the banks. The banks know better how to manage--and also have a greater incentive than the government to eventually work out such bad assets.
The very cumbersome U.S. Treasury proposal to dispose of toxic assets, presented by Geithner, taking the toxic asset off the banks' balance sheets as well as providing government guarantees to the 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 it got a thumbs-down from the markets as soon as it was announced. All major U.S. equity indexes dropped sharply.
The main problem with the Treasury plan--that in some ways may resemble the deal between Merrill Lynch and Lone Star--is the following: Merrill sold its CDOs to Lone Star for 22 cents on the dollar. Even in that case, Merrill remained on the hook in case the value of the assets were to fall below 22 cents, as Lone Star paid initially only 11 cents (i.e., 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 value of 60 cents.
Since the government knows no one in the private sector would buy those most toxic assets at 60 cents, it may have to make a guarantee (formally or informally) to limit the downside risk to private investors from purchasing such assets. But that guarantee would be hugely expensive if you needed to convince private folks to buy at 60 cents assets that are worth only 20--or even 11--cents.
So the new Treasury plan would end up being again a royal rip-off of the taxpayer if the guarantee is excessive in relation to the true value of the underlying assets. And if, instead, the guarantee is not excessive, the banks need to sell the toxic assets at their true underlying value, implying that the emperor has no clothes.
A true valuation of the bad assets--without a huge taxpayer 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 so far been proposed to deal with the toxic assets of the banks may be a big fudge--one that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.
So, paradoxically, nationalization may be a more market-friendly solution to 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 also provides a fair upside to the taxpayer.
Nationalization can also resolve the problem of the government managing the bad assets: If you're selling back all the banks' assets and deposits to new private shareholders after a clean-up, 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 manage 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, through a reprivatization scheme, the government could outsource the job of managing these assets to private asset managers. In this way, the government can avoid creating its own Resolution Trust Corp. bank to work out such bad assets.
Nationalization 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-than-too-big-to-fail problem, as the current approach has led weak banks to take over even weaker banks.
Merging two zombie banks is like having two drunks trying to help each other stand up. The JPMorgan Chase 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, all 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? They both knew that becoming even bigger than too big to fail was the right strategy to extract an even greater bailout from the government. Instead, with the nationalization approach, the government can break up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller (better) banks.
This "nationalization" approach was successfully undertaken by Sweden, while the current U.S. and U.K. 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 wound up with a decade-long near-depression because of its failure to clean up the banks and the bad debts. The U.S., U.K. 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.
So why is the U.S. 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--whether you call it nationalization or, in a more politically correct way, "receivership"--is a radical action that requires most banks be clearly beyond the pale. Today, Citi and Bank of America look blatantly near-insolvent and ready to be taken over, but JPMorgan and Wells Fargo as yet do not.
But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit, even JPMorgan and Wells will likely look near-insolvent in six to 12 months (as suggested by Chris Whalen, one of the leading independent analysts of the banking system).
Thus, if the government were to take over only Citi and Bank of America today, wiping out common and preferred shareholders and forcing 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.
On the other hand, if, as is likely, the current "fudging" strategy does not work, and most banks--the major four and the a good number of the remaining regional banks--all look clearly insolvent in six to 12 months, you can then take them all over, wipe out common and preferred shareholders and even force unsecured creditors to accept losses.
So, the current strategy--Plan A-- may not work, and Plan B (or better, "Plan N," for nationalization) may end up the way to go later this year. Wasting another six to 12 months may risk turning a U-shaped recession into an L-shaped near-depression.
The political constraints the new administration faces--and the remaining small probability that the current strategy may, by some miracle or luck, work--suggest Plan A should be first exhausted before there is a move to Plan N.
But with the government forcing Citi to shed some of its units and assets, and starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the Federal Deposit Insurance Corp., the administration is laying the groundwork for the eventual, necessary takeover of the insolvent banks.
So while Plan A is now underway, the very negative market response to this Treasury plan suggests it will not fly. Markets were expecting a more clear plan, but also one that would bail out shareholders and creditors of insolvent banks. Unfortunately, that is politically and fiscally unfeasible. It is time to start to think and plan ahead for for Plan N.