European Bankers Balk at Big Write Downs

In my experience there are three ways for bankers with “bad” assets to move on.  First, the bank can “work out” the bad assets, but this takes time and in some cases a lot of luck.  The “lot of luck” component of this solution often refers to a recovery of the economy, local or national, that lifts up all asset values and brings the value of the “bad” assets more in line with the accounting values that exist on a banks’ balance sheet.

The second way is to get someone else to take over the “bad” assets.  Can the bankers find a “sucker” to acquire the “bad assets” at a price near book value and relieve the bank of the need to write down the value of the asset?  There are “suckers” out there, but the “suckers” then have the problem of having an overvalued asset on their balance sheet.  Of course, in some cases, the “sucker” turns out to be the government…or, should we say the “sucker” turns out to be the taxpayer. 

Third, the bank can write down the assets to a realistic value and get on with business. 

The first way is what bankers generally try to do.  Bankers are notorious for their optimism concerning the value of the assets on their balance sheets.  “We just need a little more time and everything will be fine.”  “The borrower just had some bad luck, but is getting things back in order.”  “The economy is improving and we just have to hold on until things get better.”  Of course, in the case of bonds on the balance sheet: “We plan to hold on to them until maturity.” 

In many cases, the old line applies: “People told to smile because things could be worse, so I smiled and sure enough things got worse.”

When the hole gets deeper the problem becomes more severe. 

I have successfully completed three bank turnarounds in my professional career and my general impression is that bankers tend to “look the other way” and postpone dealing with their problems, particularly when the problems pile up.  In many cases, the time runs out and the bank either has to be sold or taken over or has to be closed.

In terms of the second avenue, “suckers” are all around.  However, in the case of one bank “selling” a “bad asset” to another investor, the bank escapes the problem of dealing with an overvalued asset, but the “system” does not get rid of the overvalued asset.  It still has to be dealt with.  In the case of the government (Fannie Mae or Freddie Mac) buying the asset, or, as in the case of the FDIC closing a bank, or, in the case where the government “bails out” a company or an industry and sets up a company with the “bad assets, the government must absorb the difference between the accounting value of the asset and the market value of the asset.  The losses incurred in this way must be paid by the taxpayer over time. 

Admitting one made a mistake and writing down the value of assets is the only way for a bank to really get on with business.  This is a hard thing to do, but to recognize the problem early on and deal with the problem as soon as possible is the only way to allow the bank to get back to the business as usual.  If bankers take the first or second route mentioned above, they lose focus and their performance suffers. 

This is why I am such an advocate of banks marking their assets to market on a regular basis.  It forces them to address their problems as early as possible and after facing their problems head on, they can then turn their focus back to what they should be doing, making loans and building their customer base. 

Even in the case of the bankers buying long-term securities with short-term funds: bankers are doing this to increase the interest rate spread they earn.  They are intentionally taking on interest rate risk in order to improve their performance.  To me it is disingenuous for these bankers to act surprised and perplexed when interest rates rise and the market value of their long-term securities drop relative to their accounting value.

The problems bankers face related to overvalued assets can never really go away until the bankers fully embrace the situation and write down the value of their assets to realistic values.  The asset values must be written down to a level that, at least, eliminates the uncertainty about whether or not the bankers are fully recognizing the problem.

This is one of the freedoms of coming into a troubled situation to “turnaround” a bank.  The “turnaround” specialist can assume a “worst case” scenario and write down assets sufficiently to eliminate the uncertainty surrounding the value of the assets.  If the “turnaround” specialist does not do this, he or she is only creating further problems for themselves sometime down the road.  It is the only way to move on!

European banks still appear to be somewhere in the middle of these three paths to the future.  See, for example, the piece “Bankers Balk at EU push for Bigger Greek Losses” in Bloomberg this morning. (http://www.bloomberg.com/news/2011-10-16/bankers-balk-at-eu-push-for-bigger-greek-losses-higher-capital.html)

The problems faced by the European banks are huge.  The problems faced by European governments are huge.  The lack of fiscal discipline on the part of European governments for the past fifty years or so has caught up with both the governments and the banks that supported this deficiency.  Now, the governments and the banks find that they cannot continue to ignore the problem and hope for things to get better.  Furthermore, the governments and the banks cannot just push the problems off on the taxpayers.

Still they continue to hold out!

The only way the Europeans can resolve their current difficulties is to “bite the bullet” and accept the fact that several of the governments in Europe are insolvent and that the value of the sovereign debt issued by these governments must be written down to values that will eliminate the uncertainty pertaining to whether or not the governments are really accepting the severity of the problem. 

A difficulty inherent in this solution, however, is that the European Union may have to become more politically unified.  Letting the EU dissolve at this time is almost unthinkable and would end up, I believe, in an unconscionable banking catastrophe for the continent.  This may be the “unforeseen consequence” of the formation of the EU…that the crisis resulting from the way the union was initially set up may result in the nations of the EU forming a more unified political structure.  Imagine…

But, the financial problems will not go away as long as those running the governments of Europe continue to face up to the real issues and then deal with them.  The real issues relate to the fiscal irresponsibility of several of the European nations and the consequent insolvency that has resulted.  This insolvency is threatening the insolvency of the European banking system.

Unless this reality is accepted and acted upon, the crisis will just continue to play itself out. 

Thoughts on "The Plan"

Well, “The Plan” is becoming a reality. What exactly it is and whether or not it will be successful is still a mystery. That is not the issue at this point in time.

To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.

Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.

That is, the action had to be big enough to overwhelm the debt deflation going on.

This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.

This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.

The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.

Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!

The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.

If “The Plan” works will this be the end of the effort?

No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.

Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.

And, Congress should remember this and not try and make all sorts of additions to “The Plan”.

In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.

The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.

Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.