The Balance Sheet Future

Why Banks Want to Return TARP Funds

The Government's financial system bailout/rescue plan focuses on the lack of lending to consumers and businesses as  banks in the country preserve cash to repair their balance sheets.  The TARP's Capital Assistance Program designed under former Treasury Secretary Hank Paulson provided (and perhaps forced) capital to banks of all sizes, beginning with eight institutions in late October 2008.  Recently, JPMorgan, Goldman Sachs, Bank of America and other TARP recipients expressed their intention to promptly return the taxpayer capital and remove government influence and scrutiny over their businesses.  If these institutions are drowning in loan losses and desperately need capital to improve their balance sheets how can they afford to repay the TARP money?

A review of last week's updated FDIC Quarterly Banking Profile (QBP) for the fourth quarter of 2008 provides several reasons why the banks can afford to repay the TARP capital.  Despite posting an industry-wide quarterly loss of $32.1 billion and continued deterioration in asset qualify, the industry's cash flow position improved during the crisis:

Total deposits increased by $307.9 billion (3.5 percent) in the fourth quarter, the largest percentage increase in a quarter in ten years.  Banks' balances at Federal Reserve Banks increased by $342 billion in the quarter.  While 1,069 banks (out of 8,305) reported increases in reserve balances during the quarter, five banks accounted for more than half of the entire industry increase. 

So banks flush with cash due to the surge in deposits are parking the money at the Fed instead of making loans.  Got it, that explains the government's frustration with banks for not lending.  Wait a second, reading further into the QBP shows that most institutions actually increased their loans:

Three large banks accounted for all of the decline in the industry’s loans during the fourth quarter; most institutions grew their loan balances in the quarter. Almost two-thirds of all institutions (64.7 percent) reported increases in their loans and leases, while only about half as many institutions (2,865 institutions, or 34.5 percent of all reporters) had declines in their loan portfolios.

Most banks increased their loan portfolios?  Three large, over-leveraged banks restructured their loan portfolios while 64.7% of banks increased lending.  Banks simply do not need additional capital to meet demand for loans to qualified borrowers.  Furthermore, TARP capital costs banks 5% annually and comes with incredible intrusion into their business decisions.  With strong deposit growth most institutions have sufficient cash to meet their funding needs and it should come as no surprise that many want to return the TARP funds promptly.  Perhaps the Fed and Treasury, in the face of declining credit growth, have lost sight on the real reason for the lack of bank lending: a lack of demand by businesses and consumers.  No bailout or new Fed lending acronym will spur demand, only time will heal these wounds.

Note: Please do not take this post as an endorsement to invest in financial stocks as many significant risks remain.

 

Investigating AIG

Former NY Governor Eliot Spitzer investigates the nature of the AIG bailout in two stories at Slate.com.  The second piece, The Real AIG Scandal, Continued,  looks at Goldman Sach's comments regarding the additional capital requested by Goldman to secure its credit default swap trades with AIG.

I particularly agree with this comment regarding the Government's response to the AIG bonus payments:

Maybe one or two of the more than two dozen government entities now beating their chests about bonuses can redirect their energies to this much larger issue confronting us: Who signed off on this $80 billion bailout—now approaching $200 billion—and why?

Check out Spitzer's articles on AIG, they discuss a side that received little press coverage.  Spitzer focuses on the decision to pay 100% on the credit default swaps (CDS) that AIG wrote on mortgage backed securities and corporate debt using the taxpayer bailout funds is important. 

CDS are agreements between two parties without the benefit of a clearinghouse guarenteeing performance.  Therefore, counterparty risk a factor in determining the price set by the parties of the CDS contract.  The decision to pay the full value on the CDS contracts (using taxpayer money) when AIG was insolvent was made without debate.  In a bankruptcy/restructuring  of AIG the CDS counterparty would certainly received less than 100% of the insured value.  This decision makes the AIG bailout of $173 billion look more like another broad financial system bailout.

FASB Unlikely to Suspend Mark to Market Rules

The debate over mark to market (or model) accounting and its role in the financial crisis made its way to Congress today.  The concern is that banks will not incur the losses booked per mark to market accounting as asset values recover over time from today’s clearance sale prices.

Last month the FASB initiated a project to improve guidance on determining fair value and on disclosure of fair value estimates.  The project was scheduled for the second quarter and includes determining when a market is active or inactive and applying fair value to hedge fund and private equity investments.  The project will now move forward sooner after House Panel gets FASB pledge on accounting rule.

A House panel wrung a pledge Thursday from the head of an accounting board to try to issue guidelines in three weeks that will ease rules that force banks to value assets at current prices.

The commitment by the chairman of the independent Financial Accounting Standards Board came amid a muscular display of congressional power at a hearing on the so-called mark-to-market accounting rules. The head of the House panel, Rep. Paul Kanjorski, D-Pa., had held out the threat of legislation to pressure the standard-setting board and the Securities and Exchange Commission to take steps that would give relief to battered banks.

Congressman Kanjorski’s threat of legislation should remain just a threat, as the free markets of the United States do not need politicians determining accounting standards.

"We may help save the jobs of several million Americans and help keep the country out of a worse economic situation" than the current one, Kanjorski said.

Moving accounting numbers around will not lead to consumer spending, job creation and growth.  It will serve to give financial companies a breather and time to recapitalize.

I agree that to mark the value of all the houses on a street to the price of the one foreclosed home is inappropriate.  On the way up these same companies (and their stocks) benefited from increasing asset values but now that the financial industry is at the edge of the cliff, these same rules look to strict.

The FASB Chairman did not put suspending mark to market accounting on the table.  In fact, Chairman Herz had this to say in his testimony:

We agree with the SEC’s conclusion that fair value did not cause banks to fail. Rather, its use can help to more promptly reveal underlying problems at financial institutions. We also agree with the SEC that suspending or eliminating the existing fair value requirements would not be advisable, would diminish the quality and transparency of reporting, and could adversely affect investors’ confidence in the markets.

Of course, good accounting and reporting can have economic consequences, including potentially leading to what some term as procyclical behavior. Highlighting and exposing the deteriorating financial condition of a financial institution can result in investors deciding to sell their stock in the entity and lenders refusing to lend to it, to the company trying to shed problem assets, and to regulators and the capital markets recognizing that the institution may be in danger of failing and need additional capital.

I believe these (procyclical behavior) concerns are more effectively and appropriately addressed through regulatory mechanisms and via fiscal and monetary policy, than by trying to suppress or alter the financial information reported to investors and the capital markets.

The last thing the market needs is less transparency and more difficulty understanding financial institution’s balance sheets. The FASB, under tremendous pressure from Congress and Wall Street, will likely relax the rules by providing better guidance allowing companies to rely on their models more but require additional detailed disclosure.  I hope Chairman Herz and the other FASB members find a good medium for fair value accounting that gives banks time to recapitalize and investor more detail about an institution’s holdings.

A Bank Plan: Get Back to Banking

The U.S. banking industry will be recapitalized in the next six months.  Whether through private capital or taxpayer money, the banking system will move on from its darkest hour.  In fact, old-fashioned banking has never been better. Total deposits at FDIC insured institutions grew by $307.9 billion or 3.5% during the fourth quarter of 2008, the largest percentage increase in ten years.  The increase in deposits comes when deposit spreads are widening as the interest rate paid to depositors dropped with the Fed’s rate cuts of the past two years.  The Fed wants banks to be profitable so they can internally generate capital to fill holes created by losses.

 

Once the deleveraging process is over smaller and mid-size banks with clean balance sheets and a renewed focus on offering traditional financial products to their business and consumer customers will be profitable.  The question is what will become of the largest banks; Citigroup, Bank of America, JP Morgan Chase, Goldman Sachs and other commercial institutions that have segments focused on “risk-prone capital market activities.”  Last week in his Testimony to the Joint Economic Committee, Paul Volcker discusses removing the “capital market activities” from the institutions that focus on “relationship oriented” financial services:

 

"Taken together these banking organizations (large systemic organizations) should be predominantly “relationship-oriented”, providing essential financial services to individuals, businesses of all sizes, and governments. To help assure their stability and continuity and limit potential conflicts of interest, strong restrictions on risk-prone capital market activities e.g. hedge funds, equity funds, and proprietary trading would be enforced.

At the same time, trading and transaction-oriented financial institutions operating primarily in capital markets could be less intensively regulated, although stronger registration and reporting requirements would be appropriate. In instances where the institutions are so large or otherwise so complex as to be “systemically” relevant, capital, leveraging and liquidity requirements would be imposed.”

 

Volcker’s idea of a banking system that provides for risk taking with truly private capital, not capital that is backstopped by the taxpayer, makes sense.  The current financial crisis clearly shows the problem of leveraged risk-taking; a business that public capital (through commercial bank deposits) should not be near.

 

The administration and Federal Reserve remain focused on recapitalization and trouble asset problems and will later address a new framework for the financial industry.  In his testimony to the Senate Budget Committee Chairman Bernanke asked congress to focus on restoring stability and away from long-term effects:

 

"Policymakers must remain prepared to take the actions necessary in the near term to restore stability to the financial system and to put the economy on a sustainable path to recovery. But the near-term imperative of achieving economic recovery and the longer-run desire to achieve programmatic objectives should not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances."

 

I hope the administration considers Mr. Volcker’s thoughts as it finalizes the bank bailout/recapitalization plan.  The administration’s current course of action focused around additional capital to cover losses does nothing to solve the deep-rooted problems of the financial system.  During restructurings business segments not core to the institution’s objectives are divested or wound-down.  I hope that as the financial industry restructures, leveraged risk taking is left to private capital and the taxpayer with their bank deposits better protected against future losses and bailouts.

Why Does Insolvency Not Equal Bankruptcy?

Another terrible day for financial stocks with the sector down more than 9%.  Even the institutions once considered stronger by some; JPMorgan, Wells Fargo and US Bancorp led the sector lower with declines of 14%, 16% and 18%, respectively.  Citigroup's shares fell below the $1 mark before closing at $1.02.  The market has voted and considers Citi (in terms of its common stock) insolvent.  For some reason the government feels that with more taxpayer money and time the company's solvency problem will resolve itself.  For the Government, insolvency does not equal bankruptcy.

Bernanke Says U.S. May Need to Expand Bank Rescue

Federal Reserve Chairman Ben S. Bernanke said policy makers may need to expand aid to the banking system beyond the $700 billion already approved and take other aggressive measures even at the cost of soaring fiscal deficits.

“Without a reasonable degree of financial stability, a sustainable recovery will not occur,” the Fed chairman said today in testimony prepared for the Senate Budget Committee. “Although progress has been made on the financial front since last fall, more needs to be done.”

Financial stability occurs when assets trade from weak hands to strong hands.  The government's solution to expand aid bailout funds to the financial system is delaying the recovery.  The Fed and Treasury cannot guarantee or buy every asset in the US financial system.  Losses must be realized and weak institutions let fail so the strong can survive and eventually grow.

The government instead focuses on the lack of lending by institutions to businesses and consumers.  Businesses and consumers are not borrowing because they do not need to borrow more money.  Businesses are cutting expenses and focusing on cash flow.  Consumers, who overspent coming into the downturn, are tapped out and now focus on saving.

Promote Recapitalization

The massive asset price bubble that took place due to freely available credit and leverage has burst . We will not see the previous price levels for decades.  Asset owners throughout the world must recapitalize based on new prices and leverage ratios.  This recapitalization will result in additional losses in the banks, commercial real estate and insurance companies. Those institutions without the cash needed to recapitalize will sell assets to the institutions with stronger balance sheets and the system will be strong again.

How the Bush and Obama administrations missed this point is beyond me.  The government should not give bailout money to institutions that need to plug holes on their balance sheets while they wait for asset prices to come back.  The answer is not a suspension of mark to market accounting.  Balance sheets must be reset with weak institutions left to market forces.  To achieve financial stability the government needs to promote recapitalization.

FDIC Raises Fees on Banks to Prevent Fund Insolvency

After 16 failed banks to date in 2009, the FDIC raised fees and assessments on member banks to prevent insolvency later this year due to its forecast for more bank failures.

FDIC Chairman Sheila Bair Says Insurance Fund Could Be Insolvent This Year

“Without these assessments, the deposit insurance fund could become insolvent this year,” Bair wrote in a March 2 letter to the industry. U.S. community banks plan to flood the FDIC with about 5,000 letters in protest of the fees, according to a trade group.

“A large number” of bank failures may occur through 2010 because of “rapidly deteriorating economic conditions,” Bair said in the letter. “Without substantial amounts of additional assessment revenue in the near future, current projections indicate that the fund balance will approach zero or even become negative.”

How many bank failures defines a "large number"?  The 16 failures in the first two months of 2009 is tracking well above the total of 30 during all of 2008.  A look back over the history of the FDIC shows the current rate of bank failures is not that large a number when compared to history.

Decade*	Institutions
30's	312
40's	99
50's	28
60's	44
70's	79
80's	2,036
90's	925
00's	78

*Data from 1934 - 2009.

Source: FDIC

Bair recognizes the jump in bank failures to come and is adjusting fees accordingly.  The FDIC fund lost $33.5 billion last year and stood at $18.9 billion at the end of 2008.  Will the increase in fees on member banks cover the cost of the large number of bank failures to come or will government support/bailout be necessary? 

No Taxpayer Funds

Bair rejected arguments that the agency should use government aid to rebuild the fund. The FDIC has authority to tap a $30 billion line of credit at the Treasury Department and legislation pending in Congress would boost the amount to $100 billion.

“Banks, not taxpayers, are expected to fund the system,” Bair said. Asking for taxpayer support “could paint all banks with the ‘bailout’ brush.”

I applaud Bair for not turning first to the taxpayers to build the fund.  Banks must be held responsible for their actions.  The FDIC performs the necessary role of removing bad banks from the system and selling the good assets to a strong bank. See more of my throughts on the government's response in Cleaning Out the System.

During today's rally many financials did not participate:  JPMorgan (JPM) was down 8% and Wells Fargo (WFC) was down 9% on news of a potential downgrade from Moody's. The Dow Jones Regional Bank Index (IAT) was down 3.9% while the overall financial sector (XLF) was down 1.3%.  If today's rally is to continue the financials look to remain weak as the loan losses and bank failures increase.

AIG - Center of the Financial Universe?

AIG reported a loss totaling $99.3 billion for 2008.  More staggering than company's loss is news of the restructured increased taxpayer bailout to a total of $163 billion.  Looking through the details of the govrenment's release yields no silver lining, only signs of more stress throughout the financial system.  How the government agencies call the bailout a restructuring plan is appalling.

AIG Restructuring Plan

The U.S. Treasury Department and the Federal Reserve Board today announced a restructuring of the government's assistance to AIG in order to stabilize this systemically important company in a manner that best protects the U.S. taxpayer. Specifically, the government's restructuring is designed to enhance the company's capital and liquidity in order to facilitate the orderly completion of the company's global divestiture program.

The company continues to face significant challenges, driven by the rapid deterioration in certain financial markets in the last two months of the year and continued turbulence in the markets generally. The additional resources will help stabilize the company, and in doing so help to stabilize the financial system. 

As significantly, the restructuring components of the government's assistance begin to separate the major non-core businesses of AIG, as well as strengthen the company's finances. The long-term solution for the company, its customers, the U.S. taxpayer, and the financial system is the orderly restructuring and refocusing of the firm. This will take time and possibly further government support, if markets do not stabilize and improve. 

By bailing out AIG the government is bailing out the rest of the financial system as AIG is a large credit default swap counterparty to most of the top 20 financial instutions.  To let AIG fail would mean losses throughout the financial system as AIG defaults on not only its corporate debt but also its credit default swaps (CDS) portfolio. How much risk is in the portfolio?

The Mighty Unit that Gutted AIG

The firm had $2.7 trillion worth of swap contracts and positions; nearly 50,000 outstanding trades; 2,000 firms involved on the other side of those trades; and 450 employees in six offices around the world.

Executives at Financial Products viewed the swaps as "free money" because computer models showed almost no chance of ever having to pay out. But the swaps contracts included provisions requiring the company to put up cash as collateral if AIG's Triple A credit rating ever fell.

"AIG bet the ranch on a business that wasn't part of our core business," current AIG chairman Edward Liddy said. "And when things seized up, we paid a hell of a price."

But the failure to prepare for the collateral calls had proved a fatal miscalculation. The firm had written contracts that lasted 50, even 70 years, but had not adequately guarded against the volatility that could bankrupt it along the way.

AIG used their computer models to determine risk and pricing for the swap agreements. Those models were clearly wrong.  There is no "free money." The CDS wasn't car insurance where there is no risk of all policyholders making claims at once.  In events of default and bankruptcy  notational value becomes real value.  Need an example?

Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. will have to pay 91.375 cents on the dollar to settle the contracts, setting up the biggest-ever payout in the $55 trillion market.

Notice the total size of the CDS market.  $55 trillion.  AIG, who has not received $163 billion from the taxpayers, with their $2.7 trillion CDS portfolio is only 4.9% of the market.  Which closet will the other skeleton's come out of?  The Fed and Treasury need to work on the CDS problem.  Most of these agreements are not traded on an exchange nor processed through a central clearing house (like futures markets) that would step in to guarantee in the case of a counterparty's inability to make payment.

AIG will require further taxpayer/governement support.  The Fed and the Treasury made clear in their statement today that they stand ready to provide additional funds (bold sentence above).  I hope they realize that they can't bailout the entire CDS market.  The sooner they realize the problems cannot be solved by filling holes in financial institutions balance sheets the sooner we can start recovering from the current deflationary death spiral.

Clean Out the System

More details of the government's new improved bank bailout plan were released today.  As with the previous versions, what this version has in vision and ideas, it lacks in details and transparency.  The plan will not clean out the system, it delays taking losses and prolongs the recovery period.

Obama Seeks to ‘Clean Out the System’ With Bank Test

President Barack Obama aims to dispel the cloud over U.S. banks that has driven their shares to a two- decade low by subjecting them to rigorous reviews and reviving the market for their toxic assets.

Officials will begin so-called stress tests of about 20 of the nation’s largest banks tomorrow with the aim of ensuring they have sufficient capital to withstand the toughest of economic times. Institutions that aren’t able to raise needed capital privately will get taxpayer money, regulators said yesterday.

Good news, these 20 institutions that are 'too big not to bailout' will undergo rigorous testing!  If the bank is determined to not be able to withstand the continuing economic downturn, we will just give them more money and everything will be fine in the long run.  At least with this test we will get a good picture of what the banks are holding on their books.  Nope:

While U.S. regulators don’t intend to publish the details of their stress tests, the results will effectively become known once it is determined how much capital each bank is required to raise, either from investors or the government. The more capital needed, the worse off the bank.

“These examiners begin the stress test with already a deep understanding of the institution” because they are in effect residents at the firms they oversee, said Bob Bench, a former deputy comptroller of the currency.

“In the normal course of business, bank regulators tend not to look over the horizon,” said Bench, a senior fellow at the Morin Center for Banking and Financial Law at Boston University. The new reviews will do so, he said.

Great, now the regulators who, with their deep understanding of the institutions, saw many of these problems coming will now properly identify future risks.  Sounds good.

One part of the plan I like is the private/public partnership idea of having private capital come in to purchase the troubled assets from the banks with the government providing the financing at a certain leverage ratio.

By putting a market-determined price on the assets, Treasury Secretary Timothy Geithner hopes to address doubts about what the assets are worth and, in the process, provide investors with a clearer picture of banks’ balance sheets.

A better plan is to let the bad banks fail/take over insolvent institutions, clean up them up and sell them off to the private market; just like the FDIC already does for smaller financial institutions every week.  Why are we unable to admit that these institutions are too big and carry to much risk that they cannot manage properly?  The longer we delay, the longer we wait for the recovery.