I would like to recommend another article on bank accounting practices. This is the article by Michael Rapoport in the Monday’s Wall Street Journal titled “’Toxic’ Assets Still Lurking At Banks.” (http://professional.wsj.com/article/SB10001424052748704570104576124701144189910.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) I don’t want to repeat all that is in the article because I would just copy the article. So, I highly suggest you read the whole thing. But, the issue has to do with when and how do you recognize the value of loans and securities on the balance sheet of a bank.
How does one know what value should be placed on a commercial bank franchise?
The answer: in the current environment, one doesn’t.
I have had my say (once again) on the “mark-to-market” controversy: see “Risk Management: Key in Future Economic Performance for Banks. (http://seekingalpha.com/article/249440-risk-management-key-in-future-economic-performance-for-banks)
In my mind, not only are bankers attempting to fool the regulators and the investment community…they are trying as hard as they can to fool themselves.
Rapoport quotes the banking expert Bert Ely: "In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will”
Bankers are notorious for “deluding “ themselves.
“The sun will come out…tomorrow…bet your bottom dollar…that tomorrow…”
But, Rapoport just discusses information from the top 10 banks in asset size and the data come from the September 30 financial reports.
As readers of this blog know, much of my concern has been with the banks that are smaller than the biggest 10 banks…or the biggest 25 banks.
We just don’t have any idea how deep the pool of trouble is for most of the banking system.
We get some encouragement from a recent Congressional study. Quoting from another Wall Street Journal article: “ A year ago, Elizabeth Warren, who headed the congressional panel overseeing the Troubled Asset Relief Program, predicted a "tidal wave of commercial-loan failures." On Friday, at a follow-up hearing on commercial real estate held by the same oversight panel, Patrick Parkinson, a Federal Reserve official, said that "worst-case scenarios are becoming increasingly unlikely." (http://professional.wsj.com/article/SB10001424052748704843304576126442295848066.html?mod=ITP_pageone_1&mg=reno-wsj)
One year ago, Elizabeth Warren stated at a Congressional hearing that 3,000 commercial banks were going to experience serious problems in their portfolio of commercial real estate. I am glad to hear that “worst-case scenarios are becoming increasingly unlikely.”
So, how many commercial banks are going to experience serious problems in their commercial loan portfolios? How many more are going to experience more problems in their securities portfolios? How many more have not recognized on their balance sheets assets that are still “toxic” or “troubled”?
In order to obtain some idea of how bad the condition is of the “smaller” banks, I look at the behavior of the bank regulators that should know.
First, the Federal Reserve System: the Federal Reserve System has put over $1.1 trillion in excess reserve into the commercial banking system and is still engaging in “quantitative easing” to “get banks to start lending again.” However, the “smaller” banks are still not lending.
Second, the behavior of the Federal Deposit Insurance Corporation: the FDIC continues to close 3 banks per week and it looks as if it will continue to close 3 banks a week for the indefinite future. And, this does not include the banks that disappear from the system because they have been acquired.
These are the two government agencies that really should know how bad off the banking system is...and they are acting in this way?
The Fed is providing funds to keep a lot of commercial banks open so that they can either be closed in an orderly fashion by the FDIC or be acquired outright by another bank, domestically or by a foreign source.
The problem is that because of the accounting rules, investors, regulators, and even bankers don’t know what shape the banking system is in. But, every quarter we seem to get several “surprises”, banks being taken over or acquired because of their financial condition. And, no one seems to have seen these “surprises” coming. How many more Wilmington Trust’s are there out there?
Showing posts with label toxic assets. Show all posts
Showing posts with label toxic assets. Show all posts
Tuesday, February 8, 2011
Thursday, May 28, 2009
"Problem" Banks and the Economic Recovery
Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, released the latest information on “problem” banks on Wednesday. The list now includes 305 institutions, up from 252 at the end of 2008. We have had 36 bank failures this year and if no more than a quarter of the “problem” institutions fail, we will be over 110 bank failures for the year. This is nowhere near a record and the cumulative number of failures since the beginning of the recession in December 2007 is minimal compared with what happened in the 1988 to 1991 period.
This raises a question about how many more financial institutions are going to merge or close in the next two to three years. If the historical record is any indication, one could argue that a minimum of 100 banks or thrift institutions will close each year for the next two years. Bank closures are not a leading indicator of economic health and can continue for some time even after the economy begins to recover.
The basic scenario that we are looking at for the next two to three years or so is a stagnant economy for much of the time. Economic growth is supposed to be tepid for an extended period of time. Mohamed El-Erian of the bond fund PIMCO stated the other day that PIMCO was expecting the United States economy to grow by no more than 2% or less in the near term. Given that potential real GDP will only be growing at a crawl during this time, unemployment will stay around 8% or above, something similar to the period from January 1975 through to February 1977 where the unemployment rate was at 7.5% or above and the period from October 1981 through to January 1984 where the unemployment rate was above 8.0%. Thus, from January 1975 through to January 1984, unemployment averaged more than 8%.
Within such an environment, foreclosures and bankruptcies will continue to increase and more and more personal loans and mortgages will have to be charged off bank balance sheets. Furthermore, this environment will not be a good one for non-financial business and many more businesses will close their doors. The restructuring of industry will continue as businesses attempt to align themselves with the markets and technologies of the future. This will impact commercial and industrial loans and more of these will have to be charged off going forward.
There is great concern in the F. D. I. C. and beyond about the adequacy of current loan loss reserves in financial institutions. The underlying fear is that a lot of banks have not sufficiently reserved for the loan losses they will be facing in the near future. Bankers have a tendency to be slow in accepting the fact that so much of their loan portfolio is severely challenged. It is a historical fact that reserving for loan losses tends to lag behind the need to build up bank coffers for future charge offs. The present time is not an exception.
This is not a scenario that contains a lot of enthusiasm for producing loan growth. For one, the focus of the bankers should be upon cleaning up their balance sheets. Therefore, they should not be looking for new loans or new sources of loans. These bankers should be focused internally on what they already have on their books. They need to be focused on the performance of existing loans, on working out existing loans, and on charging off loans that are no longer performing.
As many analysts have stated, we still are anticipating increasing charge offs connected with credit cards, consumer loans and commercial real estate. Furthermore, we still have not reached the end of the problems connected with residential mortgages. And then there are the business loans to keep small and medium sized businesses going. The point of all this is that “we are not out of the words yet” in the banking sector.
Secondly, there is not going to be a lot of acceptable loan demand coming into the banks. Credit standards are higher now than they have been for a long time. Bankers are getting back to the idea that you don’t deserve a loan from them unless you are so well off that you don’t really need a loan from them. This has recently been referred to as “boring” banking. Boring, yes, but also prudent.
Some analysts are arguing that the trouble in the smaller banks is not as big a problem as that for the larger banks. Stuart Plesser, a banking analyst at Standard & Poor’s in New York has been quoted as saying that smaller banks were more vulnerable to a souring economy than larger institutions because they were more specialized or focused on a particular region. “But,” he continued, “the repercussions of the failures among the smaller institutions were not as severe for the overall economy as they would be if a larger bank stumbled because the big banks are more important to the economy. It’s not as big a hit if the small fail.”
This may be true in terms of the “systemic” risk in the banking system, but it is not true in terms of the impact of bank failures on “Main Street.” Because the small and medium sized banks are “more specialized or focused on a particular region,” their failure can contribute to the weakness in the local or regional areas they serve and, hence, can slow down any turnaround or recovery that might take place there.
For the past year or so, we have been focusing on big banks and the problem of systemic risk. Now we need to turn our attention to the rest of the banking sector for there is still much work to be done there. Bank failures are going to rise and remain at a relatively high level for an extended period of time. This is an adjustment process that the economic and financial system must go through. It will be a painful process, but there is little that the government could or should do to accelerate the restructuring.
One comment on recent discussions of the government’s P-PIP. Enthusiasm for this program is waning. As I have written, the problem with the toxic bank assets the government has been worrying about is not a “liquidity” problem. The problem is not that certain “legacy” loans or securities cannot be sold within a reasonable period of time. The problem has been that the value of the loans and securities has been in question because of the quality of the assets. The government has been trying to “force” a sale of these assets. But, this is not the problem. The problem is one of working out the value of the assets and the solvency of the banks themselves. An effort to “force” the sale of bank assets is only a program to “socialize” bank losses so that the government can transfer the losses from the banks to the tax payer and does not resolve the ultimate problem. As the banks are attempting to re-capitalize the solvency issue becomes less pressing and so the interest in the program drops off. Except in the case where the government allows the banking system to make a risk-free re-purchase of their own assets at a profit!
This raises a question about how many more financial institutions are going to merge or close in the next two to three years. If the historical record is any indication, one could argue that a minimum of 100 banks or thrift institutions will close each year for the next two years. Bank closures are not a leading indicator of economic health and can continue for some time even after the economy begins to recover.
The basic scenario that we are looking at for the next two to three years or so is a stagnant economy for much of the time. Economic growth is supposed to be tepid for an extended period of time. Mohamed El-Erian of the bond fund PIMCO stated the other day that PIMCO was expecting the United States economy to grow by no more than 2% or less in the near term. Given that potential real GDP will only be growing at a crawl during this time, unemployment will stay around 8% or above, something similar to the period from January 1975 through to February 1977 where the unemployment rate was at 7.5% or above and the period from October 1981 through to January 1984 where the unemployment rate was above 8.0%. Thus, from January 1975 through to January 1984, unemployment averaged more than 8%.
Within such an environment, foreclosures and bankruptcies will continue to increase and more and more personal loans and mortgages will have to be charged off bank balance sheets. Furthermore, this environment will not be a good one for non-financial business and many more businesses will close their doors. The restructuring of industry will continue as businesses attempt to align themselves with the markets and technologies of the future. This will impact commercial and industrial loans and more of these will have to be charged off going forward.
There is great concern in the F. D. I. C. and beyond about the adequacy of current loan loss reserves in financial institutions. The underlying fear is that a lot of banks have not sufficiently reserved for the loan losses they will be facing in the near future. Bankers have a tendency to be slow in accepting the fact that so much of their loan portfolio is severely challenged. It is a historical fact that reserving for loan losses tends to lag behind the need to build up bank coffers for future charge offs. The present time is not an exception.
This is not a scenario that contains a lot of enthusiasm for producing loan growth. For one, the focus of the bankers should be upon cleaning up their balance sheets. Therefore, they should not be looking for new loans or new sources of loans. These bankers should be focused internally on what they already have on their books. They need to be focused on the performance of existing loans, on working out existing loans, and on charging off loans that are no longer performing.
As many analysts have stated, we still are anticipating increasing charge offs connected with credit cards, consumer loans and commercial real estate. Furthermore, we still have not reached the end of the problems connected with residential mortgages. And then there are the business loans to keep small and medium sized businesses going. The point of all this is that “we are not out of the words yet” in the banking sector.
Secondly, there is not going to be a lot of acceptable loan demand coming into the banks. Credit standards are higher now than they have been for a long time. Bankers are getting back to the idea that you don’t deserve a loan from them unless you are so well off that you don’t really need a loan from them. This has recently been referred to as “boring” banking. Boring, yes, but also prudent.
Some analysts are arguing that the trouble in the smaller banks is not as big a problem as that for the larger banks. Stuart Plesser, a banking analyst at Standard & Poor’s in New York has been quoted as saying that smaller banks were more vulnerable to a souring economy than larger institutions because they were more specialized or focused on a particular region. “But,” he continued, “the repercussions of the failures among the smaller institutions were not as severe for the overall economy as they would be if a larger bank stumbled because the big banks are more important to the economy. It’s not as big a hit if the small fail.”
This may be true in terms of the “systemic” risk in the banking system, but it is not true in terms of the impact of bank failures on “Main Street.” Because the small and medium sized banks are “more specialized or focused on a particular region,” their failure can contribute to the weakness in the local or regional areas they serve and, hence, can slow down any turnaround or recovery that might take place there.
For the past year or so, we have been focusing on big banks and the problem of systemic risk. Now we need to turn our attention to the rest of the banking sector for there is still much work to be done there. Bank failures are going to rise and remain at a relatively high level for an extended period of time. This is an adjustment process that the economic and financial system must go through. It will be a painful process, but there is little that the government could or should do to accelerate the restructuring.
One comment on recent discussions of the government’s P-PIP. Enthusiasm for this program is waning. As I have written, the problem with the toxic bank assets the government has been worrying about is not a “liquidity” problem. The problem is not that certain “legacy” loans or securities cannot be sold within a reasonable period of time. The problem has been that the value of the loans and securities has been in question because of the quality of the assets. The government has been trying to “force” a sale of these assets. But, this is not the problem. The problem is one of working out the value of the assets and the solvency of the banks themselves. An effort to “force” the sale of bank assets is only a program to “socialize” bank losses so that the government can transfer the losses from the banks to the tax payer and does not resolve the ultimate problem. As the banks are attempting to re-capitalize the solvency issue becomes less pressing and so the interest in the program drops off. Except in the case where the government allows the banking system to make a risk-free re-purchase of their own assets at a profit!
Thursday, April 9, 2009
The State of the Recession--a long way to go
Going into this holiday weekend, we need to take a little time to reflect on the state of the economy and the financial markets. I certainly don’t want what I write below to sound like a “rosy scenario” but I would like to try and put some perspective on where I think we are and what is ahead of us.
First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.
My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)
The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.
The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.
There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.
But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.
Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)
Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.
The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.
Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.
In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.
This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.
The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.
First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.
My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)
The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.
The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.
There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.
But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.
Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)
Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.
The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.
Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.
In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.
This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.
The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.
Tuesday, March 24, 2009
Liquidity or Solvency?
The debate over the Public-Private Investment Program (P-PIP) put forward by Treasury Secretary Timothy Geithner seems to be focusing upon a technical point concerning the condition of the market for troubled assets. In the eyes of some, the question relating to whether or not the program will work depends upon whether the problem being dealt with is a liquidity problem or a solvency problem.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
Sunday, February 8, 2009
Bail Out or Wimp Out?
The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
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