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Is Betting on the

Globe and Mail
Unlike the major Canadian banks, which did not fall prey to mountains of poorly supported derivatives and stratospheric leverage ratios, many U.S. financial institutions lost track of their risk-management disciplines and will be subjected to a new policy experiment. Next week, U.S. President Barack Obama’s administration will likely propose a program for a “bad bank” and other support measures that immunize banks from some bad loans and underwater assets.

Such a program will inevitably take from citizens who did not cause the problem and give to the institutions that overdid it. As with epidemics and disease, one tries to avoid the stigmatizing remedy of quarantine unless the situation is dire and the alternatives are thought to be ineffective. The reality is, the balance sheets and lending conditions that are driving this experiment are indeed “bad” and the current policies poor.

Banking analysts and policy-makers follow multiple metrics when evaluating the health of the credit industry. At the bank level, measures of capital adequacy, loan defaults and delinquencies, and reserve-to-loan ratios are watched. At the national level, where economic policy is made, these individual metrics are aggregated and reframed into broader issues of system solvency, liquidity, total credit issuance, confidence and growth capital availability. The government does not want banks to fail, and it wants the banks to lend money to viable businesses and credit-worthy consumers. Over and above the failures of Washington Mutual, IndyMac and Lehman Brothers, more failures of large banks would likely occur if policy doesn’t step in to assist.

George Soros recently reminded us that the problems are in some ways bigger than those faced by Franklin Roosevelt in the early 1930s. Total sources of credit outstanding rose to 260 per cent of GDP then, versus today’s aggregated indebtedness level of more than 360 per cent, and likely heading higher with the stimulus package. As to the 8,000 or so U.S banks the prospect of additional, system-threatening bankruptcies is real, unless something changes. While major capital ratios currently fall on the good side of regulatory guidelines, other indicators of bank solvency suggest things could get very rough in the months ahead. Tangible equity in the FDIC banks has been falling at an extraordinary rate, and with default rates rising quickly, some large U.S. banks are walking on thin reserve cushions. Without financial injections from the original Troubled Assets Relief Program, a few would have failed solvency tests.

This explains why numerous bank stocks fell more than 60 per cent last year. This equity erosion forced some banks to cut their dividends, some to build cash levels with TARP funding and some to accept capital from sovereign wealth funds. Without this capital, lending is necessarily constrained, bringing cost-cutting and deposit-gathering efforts to the forefront. As indicated by Robert Vokes of Novantas, a New York-based financial services consultancy:

“The top 10 banks are in much better shape with the TARP injections, but ongoing asset deterioration and liquidity needs to be watched closely. Consistent government policy AND smart moves by the banks are going to be required to avert more difficulty from here. Doable, but not easy.”

Assuming the most troubled bank executives will do what they can operationally, the question then is: What are the best policy actions government can take? Why is the “bad bank” concept the favourite?

There are five main options in play to reinforce the banking system:

  1. Allow the markets to take their course and hope the system does not implode as defaults rise and bank asset values get written off.
  2. Permit deposit-taking banks to operate temporarily with reduced capital bases.
  3. Remove toxic assets from bank balance sheets and place them in a dedicated “bad bank” from which they get worked out.
  4. Provide guarantees to absorb a certain percentage of bad loans and overvalued securities (and potentially compel or induce the banks to lend more freely).
  5. Take some of the institutions over, through some form of nationalized ownership, and have the government absorb losses directly.

A combination of ideology and lack of speed caused the U.S. government to watch from the sidelines as Lehman Brothers went under in the fall of 2008. Some sovereign wealth funds, a few large U.S. investment companies and a handful of sizable hedge funds injected equity capital into a few banks last year. They have seen most of their capital evaporate, and from a system perspective the private sector came in for too little, too late. More market-based equity injections of this sort are no longer forthcoming – the biggest and healthiest sources of private recapitalization funds are sitting still until a coherent and consistent government emerges.

Allowing deposit-taking banks to reduce their capital bases and tangible equity ratios on a temporary basis might sound superficially attractive. It is a little like spending into a recession when things need a boost. But this ultimately doesn’t work as it increases the overall risk in the banking system, rather than reducing it.

Alternatively, selective bank nationalizations are not palatable either. Europe has seen common equity injections in specific troubled banks, and the U.S. government has in many ways taken over the keys at Citi, Fannie Mae, Freddie Mac and AIG. However, the United States is culturally and philosophically unwilling to have the government run large swaths of the financial sector. Policy-makers want wise regulation but recognize the need for government to absorb some losses on a one-time basis.

For bank leaders to shore up their balance sheets ahead of growing bankruptcies and defaults across mortgage, commercial and consumer loans, they need to convince their shareholders and depositors that their asset values are stable, their reserves support their loan portfolios and liabilities, and businesses’ risks and operations are well managed. The third and fourth options, “bad bank” sequestrations of underwater loans and guarantees on the maximum amount of assets that could be lost to default, are more balanced methods for achieving those ends.

A key advantage of the “bad bank” option is that the poisoned bank may be cleansed fairly quickly of its hard-to-value loan assets. This makes it feasible for prospective third-party investors to inject additional capital in the bank, as they can now make rational assessments of the bank’s strengths and weaknesses. It also permits the senior executive of the bank to make more reasoned estimates of what its balance sheet might consist of in the months ahead.

The problem with this approach is the difficulty in determining what prices should be paid for these assets.

Is it better or worse to have the government pay high prices (and help the banks), or low prices (and theoretically help the taxpayers, but force the banks to take large losses)?

Who should run the “bad bank”? The ethics also look distorted. Why cleanse the ones who made the mess and penalize the taxpayer?

Guarantees are arguably a less expensive way to handle the issue. Plus, the government is not left to run a bank. Yet they do not as thoroughly whisk away the fog of uncertainty about the banks’ balance sheet. This problem was evident in the early days of various government undertakings for Citibank and Bank of America.

There are many ways to implement these approaches. Germany’s government took analogous steps by fostering individual “bad bank” units on a more decentralized basis. Perhaps this will work well. We don’t know how the Obama administration will construct the U.S. version. Nor do we have a good estimate on total costs to the taxpayer.

For more information, contact Novantas Marketing

+1 (212) 901-2772

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