It’s not just about mortgages, but capital
Much attention has been focused on the failure of the bailout, the market’s subsequent 777 point decline and 485 point bounce, and what lies in the future as a result. While we think that the Treasury’s proposal to buy impaired mortgage securities is a good and probably profitable move, it doesn’t solve the more fundamental problem of a lack of capital in the system. The $2.2 billion Citigroup takeover of Wachovia, by contrast, seems to be a reasonable template of addressing the bad loan and the capital issue at the same time. WSJ:
The Wachovia takeover was what regulators call an “open bank” transaction, the first in the current panic. In other words, the regulators didn’t wait around for the bank to fail before swooping in and picking up the pieces. Instead, they acted creatively and in concert with a private buyer to remove an ailing bank while minimizing the collateral damage and taxpayer exposure.
In exchange for getting Citi to step in before a collapse, the FDIC agreed to take on some of the risk on $312 billion worth of Wachovia assets. Under the terms announced early Monday morning, Citigroup will be on the line for the first $42 billion in losses in that portfolio. The FDIC would be on the hook for any deeper losses. Citi will give the FDIC $12 billion in preferred stock and warrants as the price for that downside protection. That mix of public and private risk may not be by the book, but the FDIC would have been stuck with the deposit-insurance bill anyway…the FDIC had to get approval from the Treasury, the President and the Federal Reserve under the 1991 FDICIA statute…
because it was an “open bank” transaction, Citi will assume $53 billion in Wachovia debt, rather than sending the creditors to a workout session with the FDIC after the assets have been sold off. Shareholders may not end up with much, although the holding company and a couple of nonbanking businesses were left out of the deal.
Meanwhile, Citi executives said Monday that they would cut their dividend to preserve capital — an overdue move — and seek to raise $10 billion in additional capital and sell some assets to shore up its balance sheet. J.P. Morgan completed a similar capital raise after buying Washington Mutual’s banking operations from the FDIC last week.
So the Citibank/Wachovia deal not only (a) provides a ceiling after the first $42 billion in losses, but (b) entails raising $22 billion in new capital. The Paulson bailout plan addressed the issue of losses but not issue of capital, unless it intended to fudge the capital issue by buying bank assets at above market prices. In that sense the Paulson bailout represents only part of a solution — if indeed it is ever enacted.
Almost 20 years ago, in the aftermath of the collapse of the junk bond market and Drexel Burnham, similar problems afflicted the banking industry, in particular the segment called Savings and Loans. You will recall Columbia Savings, the Beverly Hills S&L that once advertised itself as the most profitable and best capitalized institution of its kind — until, suddenly in 1990, it went from best to bust as the value of its assets fell by nearly half.
Today’s situation is a larger replay of that drama, but with a couple of essential differences. In the 1990 version, the RTC was set up to buy and recycle the impaired real estate and financial assets of many institutions — and those institutions just disappeared. By contrast, today’s problem afflicts not just a subset of the S&L industry, but a number of the largest banks in the country, holders of not only great numbers of mortgages, but even greater numbers of scarier securities.
Unlike 1990, letting everyone’s hometown mortgage lender fail and disappear is really not a practical solution, particularly after there’s already been such consolidation in the banking industry. The Paulson bailout plan goes part of the way down a path of addressing the issue, but it’s hard to see how this problem will be over until the banks can raise the additional capital they apparently need. Although some have observed that Tier I capital levels of the banks are still adequate, we would point out that (1) further losses lie ahead, and perhaps more importantly (2) capital ratios deteriorate every time a weaker bank is forced to merge into another entity at a low price. As in the case of Citi/Wachovia, more equity would appear to be needed in the system before stability is restored.
October 1st, 2008 at 6:33 pm
Please read this from Bill Conerly of Businomics Blog:
“The second issue is capital capacity. Bank shareholders have to have some skin in the game. If the value of the bank’s assets falls, then the capital of the bank falls. At some point, capital might become insufficient for the size of the bank. The bank then must either sell more stock, or shrink its assets, such as by refusing to make new loans.
What’s the condition of banks? As of the end of last quarter, commercial banks and thrifts had core (Tier 1) capital equal to 7.89% of their assets. Is this a lot? It’s down from a year prior, but here’s the requirement: to be “well capitalized” a bank needs six percent. So the industry as a whole was well above standards. The FDIC Quarterly Banking Profile reports that over 99% of the assets of banks and thrifts were in well capitalized banks. Banks that are under six percent but over four percent are called “adequately capitalized,” but despite the title operate under some restrictions. With less than four percent capital banks need a plan to pull themselves up to adequate capitalization.
We don’t know how the summer’s market turmoil is hitting banks. We’ll certainly have a number of banks drop in capital when the Sept. 30 report is published. However, I think we’ll still have adequate capitalization overall.”
Well? Are you right? Is Conerly right? Is effing anybody “right?” Your blog entry and Conerly’s what appears to be completely contradictory entry are the reason most of us laymen are so frustrated and pissed off with this so-called response to the problem. Sheesh!