Wednesday, January 28, 2009

Tough love from Bair or tough luck for us

Institutional Risk Analyst
January 26, 2009

The term "bad bank" is being tossed around Washington dinner tables this week, a sign that the situation facing the largest banks is reaching a boiling point. It is amazing to us to see how little people understand the choices facing us with the big banks, how narrow those choices truly are and how the numbers in terms of losses are so BIG that they will ultimately force us to do the right thing. A couple of points:

First, IRA's estimate for accumulated bank charge offs for 2009 is in the neighborhood of $1 trillion vs. $1.5 trillion in Tier 1 Risk Based Capital at all US banks today. Good news, though, is that 2/3 to 3/4 of that loss number comes from the top 4 - Citigroup (NYSE:C), Bank of America (NYES:BAC), JPMorganChase (NYSE:JPM) and Wells Fargo (NYSE:WFC), in that order of risk profile. (Roubini says 1.8 trillion. - AM)

Since most of the toxicity in the banking system is concentrated among the larger banks, with perhaps US Bacorp (NYSE:USB) on down viable in the long run, perhaps we can rebuild the industry using the next round of TARP funds to bulk up these relatively smaller banks and thereby end up with 10-15 larger super regionals in the $300-$500 billion asset range. There may even be banks of this size still doing business under the current names of C, JPM, BAC, etc, but these new banks will have new owners and creditors.

Second, the Good Bank/Bad Bank debate is really a political battle between the large banks listed above plus Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) et al among the Sell Side survivors in NYC vs. the rest of the industry and the US economy. In preparing their plans for review by the White House, we hear that the Fed and OCC are supporting further bailouts for the larger banks, while the rest of the industry is being resolved and recapitalized a la Washington Mutual and Lehman Brothers.

Perhaps we ought to feed the "good bank" parts of the "too big to fail" crowd, a crowd prone to leverage and bad risk management, to the smaller and plain vanilla bankers that comprise the nominal majority of the industry. This would solve many things including reducing the lobbying power that Wall Street has in Washington. Come to think of it, President Obama should think about banning lobbying by any company participating in the TARP.

Remember that the entire banking industry stands in front of the taxpayers in terms of loss absorption at the FDIC, so you can understand why the smaller banks in the industry are SERIOUSLY PISSED OFF at the large banks and their minions in the Obama Administration like Tim Geithner and Robert Rubin. Oh, and don't forget Chairman Ben Bernanke and the entire Fed board of governors. These leading officials are increasingly talking the side of the large banks in the battle over limited financial resources, a fact that is causing the community bankers to rise in anger. Stay tuned.

Third, juxtapose the Fed/OCC position of 'let's bail out the big banks' (equity and debt) which Tim Geithner established in the Bear Stearns and AIG rescues, and reiterated in his confirmation testimony, with the modified "tough love" position of Sheila Bair, where she proposes to buy bad assets from the Big Four Zombies w/o a resolution. It seems clear that both sides of the equation in Washington are prepared to socialize the large bank losses and in particular subsidize the bond holders at public expense, an act of generosity that could cost the industry and taxpayers another $1 trillion before all is said and done.

But at least with the modified tough love proposed by Bair, the US government still would clearly end up as the explicit owner and the existing equity and preferred would be diluted out of existence as the quid pro quo for the bad asset purchases. That is the little detail people in Washington still don't understand. Indeed, if you think about C as perhaps accounting for one third of the $1 trillion IRA charge off estimate, then Washington must impose a haircut on debt or ask the banking industry and the taxpayer to subsidize the loss.

The better course for the economy outside NYC is to resolve these large institutions over the course of 2009 and beyond, first by diluting the equity (common and preferred) and effecting a conservatorship a la Fannie/Freddie. This eliminates the issue for the markets. A formal open bank assistance might be a default under the ISDA contract template, something the Fed's conflicted madarins would not initially accept, but when the charge-offs at C rise above total risk based capital and keep rising, perhaps minds in DC will begin to change. Then we can haircut the Big Four Bank debt in a negotiated deal pre-receivership, and sell the non M2M bank assets and liabilities to stronger hands. This is the traditional American way of dealing with insolvency in the absence of political meddling by the Fed and the Congress. Let Sheila Bair and the FDIC do the job and we can make the economy rebound with surprising speed. It only takes political courage. We have the money.

Roundtable: David Kotok & Josh Rosner

For additional perspective on this issue, The IRA spoke last week to Josh Rosner of Graham Fisher & Co and David Kotok of Cumberland Advisors:

The IRA: The basic question everyone's asking is what do we do with the big banks, particularly C and BAC and the growing tension between the cost of supporting the big banks w/o a resolution and the rest of the industry, which is being resolved according to the law. You can see our discussion of the issue and our view of loss rates above.

Rosner: First, I am very cautious about making loss estimates because your loss number could be very low. I can actually draw a scenario that gets us well above that level of charge offs, especially if we assume worsening macro conditions and their further impacts on ADC books, corporate defaults and other areas outside of the structured exposures.

The IRA: We shall so stipulate. Let's just say we all agree that the actual level of 2009 losses will probably not be below our 2x 1990 estimate.

Kotok: At the end of the day, what difference does it make? Either way, the path to a solution must deal with the number whatever it ends up to be.

Rosner: Yes and this is why I wanted to have this conversation. I am hearing very clearly from within the regulatory community that it is their primary concern that whatever they are planning is predicated on the notion that we must keep the large banks alive. But if we start off with saving the big banks as the point of departure, then there is no way we can marry that to an efficient or effective proposal. Lets define the solution based first on what is workable not by tying a hand behind our back with preconceptions.

Kotok: I am hearing the same thing. The motivation of keeping big banks alive is driven by a desire to avoid another Lehman on the Obama watch. I hear people saying that we cannot have another Lehman, therefore we cannot permit a failure…

The IRA: And by that we mean a good old fashioned failure of a publicly listed parent holding company a la Lehman or Washington Mutual, where the equity was entirely wiped out and the unsecured debt holders got pennies on the dollar?

Kotok: Yes, precisely. Hence, whatever it takes we must avoid it. It is the Lehman failure and the contagion that is driving this policy.

The IRA: Well this just confirms that nobody in Washington understand the problem. As we have heard from many people in the industry who did the diligence on Lehman, there was no way for a private buyer to do the deal, so bankruptcy was the only choice w/o a very large, several hundred billion public bailout. The fact that the Fed and Treasury professional staff support this type of idiocy, over time, will destabilize the political consensus in this country behind an independent central bank. We might as well just make the Fed part of Treasury now.

Kotok: It looks to me as well that we now have Paul Volcker saying that we cannot tolerate another Lehman failure. Maybe Chris has some thoughts on this?

The IRA: My conversations with Chairman Volcker are OTR unless he says otherwise.

Rosner: In the Lehman failure, we had the tree that came down in a windstorm that nobody had prepared to allow to fall. But when you fell a tree deliberately, that is another matter. Remember, even if you wipe out these banks, the debt holders are guaranteed under the new temporary FDIC powers so the tree can safely fall.

Kotok: If they can find a way to fell the tree without new risk of contagion, perhaps, but remember that the big banks are also the primary dealers of US government bonds and agency paper. Of the 16 primary dealers that remain, nine of them are foreign owned. Therein lies the other problem.

The IRA: So fine, we resolve C and sell the bank, the branches and the capital markets business to the new investors on the other side. Take a couple of years to complete the process for say C, BAC and JPM. Not sure if WFC will need a restructure. Look, Barclays bought the Lehman broker dealer on the other side of a bankruptcy and JPM bought a clean WaMu. This is the way to fix the problem. The loss rates coming out of C, then BAC, then JPM this year are going to be so large that a managed sale process is the only rational choice. The equity is impaired in economic terms. Thus the question comes, what do you do with the debt? I don't think Paul Volcker is embracing a subsidy for debt holders of banks, but maybe so.

Rosner: I think what you are going to see is, on the one hand, the Fed, Treasury and OCC put together a proposal for a continuing or institutionalization of the "insurance wrap" approach used with C and BAC. This is a useless approach, in my view, and as we saw in the case of C because it created greater market confusion, which assets were circled, etc. The market does not seem to be confident based on the performance of C stock. It is also unclear how it will be possible to get an independent view of the government's share of losses since they will be managed by the banks themselves.

The IRA: Nobody in the Congress or the White House wants to acknowledge that the policy prescriptions coming from the Fed and Treasury are badly flawed when it comes to bank solvency. The market liquidity measures have had success, but the "save the big banks" approach by the Fed is just more of the same nonsense that cause the problem in the first place.

Rosner: Exactly. In operational terms, there are no longer institutions that are too big to be resolved. As we discussed with the tree analogy, that is different from 'failing'. Any risk of a run on C or the other banks is now ameliorated. The recently enacted changes to guarantees on deposits, non-interest bearing transactions accounts, etc, addressed that issue. The other systemic issue was counterparty risk, but with the qualified financial contract rule just put in place by the FDIC that risk is also largely gone and you can resolve a bank's counterparty exposures into a good bank/bad bank configuration with little problem and without creating larger systemic risk. If the counterparty's financial contracts are adequately collateralized, then they can go with the good bank, but the FDIC must retain unilateral power as receiver to reject or accept contracts. The notion that we can't allow C to be wound down and broken up is a spurious argument. I think this arguement has less to with Lehman and more to do with the fact that the Fed of New York and the Board have always benefited from the failure of small institutions and the absorption of those assets by the big banks. There is no way that they can stomach seeing their regulatory power dissipated by those institutions now being broken up and sold. Perhaps we have to go back to the question of whether it makes sense for the Fed to be a regulator as well as a central bank.

The IRA: Especially to investors outside of the New York district and even outside the Fed's immediate jurisdiction, to foreign investors. But whether anyone at the Fed or Treasury likes it or not, we are talking about the absorption by the US Treasury of at least half a trillion in losses for the top three banks in the next 12-18 months if an FDIC resolution is to be avoided. Putting the ill-informed discussion in Washington aside, we see a continuation of the open bank assistance now in place for C, with asset sales and an eventual pre-pack for the debt holders, in a process that lasts years. The dealers will be kept open. If we use the power of time and changes in accounting rules, the C bond holders might see some recovery but make no mistake that the bond holders of C are the current owners in economic terms.

Rosner: If the FDIC, which is supposed to be the sole and non-politically motivated regulator in charge of winding down troubled institutions, play their cards right, they may come closer to what we all agree is good policy in terms of forcing a resolution. I would guess that the bad bank approach we have heard the FDIC float would be to buy the bad assets. You mark the assets to value (not market price) in a relatively fair way, closer to what a mark plus a reversal of the liquidity discount would suggest and then buy them. If the bank is then able to privately raise 50% of the capital that it would take to get them to CAMELS level 1 or 2 the government can invest the rest at the same terms. If they can't do it then they are out of luck. This is not nationalization, many of these banks are ill enough that in any other environment we would just resolve them. The government would probably take equity warrants or hopefully new preferred. Unfortunately, the FDIC can't own straight equity and I hate the idea of warrants. Warrants create a conflict where regulators can't resolve an unsafe institutions because lobbyists will say "if you resolve that institution you will be wiping out taxpayer assets." They also push off the day of dilution. People forget that Chrysler was bailed out in 1980 and after they returned to profitability they almost succeeded in having Congress rip up the warrants.

The IRA: The taxpayer equity in C is already gone, at least in economic terms. David, are you playing in this investment opportunity Rosner describes?

Kotok: No and I think that as soon as you do anything conditional it fails.

Rosner: Well, but understand the motive. The FDIC is essentially telling the markets what bad assets it will buy and then offers an opportunity for investors to participate. Banks that are able to raise money in this way are given another chance. Those that cannot, then the FDIC can go back to the Fed and Treasury and say "look, we tried, this bank needs to be resolved." Then we take all the assets into the FDIC.

Kotok: Tell me who sells this to whom and under what authorities does it occur?

Rosner: If the FDIC determined C is sick enough, were it not politically blocked by the Fed and OCC, then the FDIC has the authority to resolve C tomorrow.

The IRA: We are reminded of one of the drafts of the TARP legislation where somebody inserted language that would have allowed the FDIC unilateral authority to declare an institution insolvent without first getting a declaration of same from the primary regulator. Needless to say, the provision was not included in the final bill, but this illustrates the civil war that rages between the Fed and OCC, on the one hand, and the FDIC and the state regulators on the other. This issue of resolving the larger banks has been a political issue going back to Paul Volcker's day. Democracy is inefficient.

Kotok: The Fed has a problem here because it cannot function without the dealers. The lesson of Lehman was that a foreign government ended up making the decision about the failure of a primary dealer. I hear that the FSA and the Bank of England stopped Barclays from advancing a deal with Lehman and essentially the BOE, through Barclays, put requirements on the deal that the Fed could not swallow. Or Bernanke decided that he did to want to lose $180 billion of the taxpayers money and have to account for this to the Congress later. Because he couldn't explain it, nobody would believe him, but today if he said he needed $180 billion to prevent another Lehman they would give it to him. Bernanke changed his story on Lehman, don't forget, from saying that they did not bring us a plan at the NABE luncheon last year right after the Lehman bankruptcy to his current story which is "we did not have the legal authority." Geithner took the same "lack of authority" position in his testimony.

The IRA: Well, we were speaking to one investor who actually did the diligence and he said that the fact that Lehman had outsourced much of the record keeping for their MBS conduit and portfolio was a major obstacle to completing a deal. What is the view on Geithner? Looks like a confirmation?

Rosner: Yes, the conservative Republicans refuse to skewer this guy because they are afraid that there is a socialist in the wings.

The IRA: You mean Larry Summers? How could an avowed socialist be any worse than the statist policies followed by Geithner, Paulson and Bernanke today? We think the conservatives are making a big mistake turning their backs on the community bankers. The small banks will be paying higher insurance premiums for decades to offset the large bank losses to the DIF.

Kotok: Bill Dudley will go to the NY Fed presidency and he'll be fine from a policy perspective, but it remains to be seen if he can hammer out deals in the internal battles. Geithner is sufficiently wounded that he is not going to be a factor, so the drivers end up as Volcker and Summers, in my view. My question to you Chris, tell me if I am right, but Volcker is the elder statesman here. Volcker will propose, Obama will approve and Geithner will implement. Do you agree?

The IRA: Well, I don't think that the final battle internally between Rubin and Volcker has been decided. IMHO, Paul Volcker and Robert Rubin, and Larry Summers, represent very different and ultimately incompatible world views. Volcker is all about public service, transparency and fairness. Rubin and also Summers represent political duplicity and malfeasance on a grand scale, especially when you look at their role in blocking regulation of OTC derivatives and structured finance. Ultimately, one tendency or the other will prevail and if the winner is Volcker, then Rubin must be publicly rejected by Obama, especially as the situation at C unfolds and the true cost of the large bank rescue is made public. Otherwise the Democrats end up owning this mess politically.

Kotok: They will reject Rubin, but you have known Paul Volcker for a long time. Did you ever think you would see the day when he would go before the Congress and embrace a tax scofflaw?

The IRA: No, it is an indication of the fear and uncertainty that prevails within the Obama Administration and in our society. Our leaders including Volcker are grasping for straws and Geithner is a very slender reed indeed. There are some conservatives in the House who will be glad to see Geithner confirmed. They plan to use him as a punching bag, especially with conservative audience that are antithetical to the big New York banks and Wall Street. But Geithner seems to have Volcker's full support.

Rosner: I don't think that it is Volcker at this point, but rather Summers on a day-to-day basis that will be calling in the plays that Geithner will execute. Unlike Paulson, I expect Geithner will have to manage up and report back to Summers and the White House. He is expected to be on the team executing the President's policies and not creating his own. My only concern with Summers is that while he is a fine economist, he is not a financial markets guy either.

The IRA: We'd be happier with Summers if he would publicly acknowledge the policy mistakes of which he was a part. I'm not sure there is any hope of turning Larry Summers into a proponents of resolving the large banks.

Rosner: Summers is just as capable of being misdirected by the same Wall Street inputs as caused this mess. We need to somehow communicate to Summers et al, though the media if necessary, that the managed breakup of the big New York banks does not necessarily mean a systemic failure and another crisis. I believe that we can restructure these banks without a resolution, wipe the equity and maybe the preferred, and start from there.

The IRA: How do you avoid a haircut for the C bond holders if we see loss rates at 5-6% of total loans and leases? A 30% loss rate at C wipes out the equity several times.

Kotok: I agree. How do you restructure these banks without a bankruptcy for the parent, especially given the loss estimate from you and Chris among others?

Rosner: The answer is that the FDIC has the power to abrogate contracts and seize institutions, we have already guaranteed the debt holders. The Machiavellian mandarins at the Treasury and the Fed seem to have sold us on the notion of taking equity warrants. It means that if the FDIC comes in to do their jobs, they must wipe out the taxpayer equity.

Kotok: But the problem you have is how do you get the bond holders to agree? These are very loss-averse, well-organized investors. Why should they agree to a haircut? This is why the sub-debt of Fannie and Freddie has not been touched.

The IRA: At least not yet. As we've said before, the loss numbers from the GSEs and the large banks will be so large that we will no longer have a choice but to embrace a resolution and receivership. We'll leave it there. Thanks.

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