Some ideas on nationalization and TARP

Turn the news on or read a Roubini blog and you'll never hear the end of how we must nationalize our banks to get out of the mess we are in.  Even Krugman is saying Nationalize!

Stepping away from the immediately obvious deficit of shareholder equity in these insolvent bank  institutions, it is clear two things are happening independent of the status of bank valuation (yet perpetuating the feedback loop of insolvency): credit is tight, and asset values are thus forced down.

A true nationalization of a top 5 bank (or two), where debtholders are wiped out, would be less than optimal considering many debtholders are generally other banking institutions.  Here counterparty risk (ie AIG) is revisited.  Why force the issue?

The present Obama administration manifestation of TARP 1, one where money was blanketed over banks (instead of toxic assets being purchased above market), is being improved by the latest Treasury-Citibank agreement to convert preferred shares to common.  Without the banks possessing a payment liability (free of dividend), their equity position genuinely improves.

In the end, though, if the bad bank is still truely insolvent, it will not lend as it knows it is insufficiently capitalized.  Again I ask (from previous blogs), does it matter if Citi is technically bankrupt if it is somehow sustaining itself on a cashflow basis?  If its assets are actually worthless in the end and the business can not maintain cashflow, there will be a day where it will have no choice but to fail.  When the overall credit system is healthy enough (10 years from now?), I think it is reasonable to think we will be able to absorb a failure of Citi and allow an old-fashioned bankruptcy.  Right now, however, the system is too fragile.  So for now, we have a zombie bank.

Why can't we have zombie banks and healthy banks run concurrently?  Why push the issue of nationalization, causing more systemic risk and further asset writedowns (perpetuating the negative feedback loop) when the alternative may be to simply to leave the presently insolvent institutions alone?

We know two things: 1) Fed through its control of Fed funds or any other arbitrary credit device it creates can capitalize banks at will (if the Fed loaned $20T to Citi tommorow at 0% interest, it could quickly recapitalize at zero cost) and 2) Mark-to-market on long term bank assets just does not work, mainly because it serves to reinforce the negative feedback loop that we experience in downturns.  From an interesting linked paper below, William Isaac, head of FDIC under the Reagan administration says:

"If we had followed today’s approach during the 1980s, we would have nationalized nearly all of the largest banks in the country and thousands of additional banks and thrifts would have failed." (p.6)

Asset prices are a function of real aggregate money out there, and the credit multiplier is a key part of that.  Our entire financial system is based off of price relationships that are sustained by the total real money (credit+currency) being a certain amount.  We also know the Fed's mandate is towards price stability.  In the end, we have to collectively agree if we want the real effective credit multiplier back to where it used to be.  The Austrian "economists" calling for Schumpeterian creative destruction miss the point - the aggregate long run result will be less jobs, less real wealth, less trade, less consumption possibilities.  Labor and capital will all be victims of the slaughter.  The "creative" part of this type of destruction is just a misplaced ounce of optimism.  More, implicit through "creative," is not the result in any circumstance.

To fix the credit multiplier, I propose Fed/treasury will have to more aggressively fund banks, in the order of several trillion dollars more to completely offset the void created by current asset writedowns.  Although unpopular as it enriches the common shareholder if nationalization is to be avoided (to keep treasury under majority stakeholder), broad indiscriminate TARPing to increase common equity is probably the best way to do it.  I suggest broad because healthy banks will naturally lend the funds they receive, despite the insolvent ones holding onto the funds.   The TARPing needs to be broad to increase the multiplier effect as well.  Fractional reserve banking does not work if only 1 bank is viable.

Here is an idea to perhaps improve (or simplify) on the latest manifestation of TARP:   Treasury agrees to buy 'common shares' above market price of the bank, maintaining minority stake (as in the Citi deal we just saw).  In 10 years (or laddered) treasury must sell its 'common shares' back to the bank at the same price (or a negligibly higher one, to include a small amount of interest, ie 1%/year).   Think of it as a reverse repo with a 10 year duration at below market price,  but kept on bank balance sheet as simple common equity.  This accomplishes capitalization, does not nationalize the bank (avoiding instability and wipeout of stockholders), and self-neutralizes the money giveaway.  Because of this, the TARP money should come from the Fed creating a new liability ("printing"), versus the treasury selling debt.  This will help avoid tying up investment capital at a time we need more money in the system, not less.  When the credit multiplier is judged to be at target levels, the TARP money can be pulled back in.

The next Volkswagen blowup

An interesting analysis of why shorting Citi common against Citi long preferred may be the next VW/Porsche trade.

The World Death Spiral. And Another Bailout.

Right before the stimulus passed, I wrote a proposal and sent it off to my government. It was my civic duty, and I hope someone read it. I've received no reply, but perhaps someone meaningful is taking these ideas to heart if they haven't seen them already. This was part of a letter sent on February 1st to the White House, offering up a solution to US banking system's woes. Between this and a mark to model suggestion that enables banks to value assets based on present cashflows as opposed to mark-to-market of liquidation, I think we may have something viable.

The markdowns of commercial properties are an extension of this story: without the ability to refi balloons coming due, properties will be forced to liquidate that will result in supply inventory levels we've never seen in our lifetimes. Are those liquidation prices justifiable marks for bank balance sheets? I think not. As we see in real life, price of an asset is directly correlated to the amount of credit available for that asset (which is minimal now). If we all had to sell all of our stock in the market tommorow at the same time, all of our assets would be worth near nothing by this same liquidation methodology. So should we mark all of our stock portfolios to nothing with that in mind? Mark to model, to a reasonable model the investing market trusts, is the only solution that makes sense. The model needs to be appropriately sold to the accounting community, on the basis of better logic.

What we need now most is to stop the self reinforcing spiral, and worry less about asset prices, instead focusing on the issue of cashflow. If no bank will lend, factoring in lack of a securitization market, then the Fed must step in (now) and perform the role as the bidder for new CMBS deals going forward. Bernanke already sees this need and considers CMBS a strong candidate for the TALF program. A successful implementation of this should help stop the spiral in that part of the market.

We need no nationalization of existing banks. We instead need paydown of debt, a vast increase in money supply (to facilitate that), and finally the Fed to more aggressively become a lender of primary resort (on an intermediate term basis). Bernanke needs to stop with this ridiculous politically correct (amongst free market capitalists) assertion that he does not want to support asset prices. Of course he wants to support asset prices - otherwise he wouldn't have price stability as part of his mandate.

No matter the policy choice (nationalization, money printing, or an Austrian forest fire), there is an implicit transfer of wealth that will occur. The virtue of avoiding another bailout will not result in the poor or middle class collectively gaining any more wealth, simply because sacrificing bank debtholders (as Chris Whalen suggests here) via some form of nationalization will bring us another leg down of credit contraction. It is an impossible outcome to suggest that increasing bank losses via forced nationalization will result in more bank lending. The outcome will instead be less economic activity, less jobs, and in the end the only ones around to pick up the pieces will be ones with massive war chests of cash. The wealthy will get wealthier. The poor will get angrier. Wealth disparities in the global society will widen as the collateral damage grows.

If the banks can't cashflow, they are broken. The Citigroups and Bank of Americas of the world, while insolvent from a mark-to-market approach, are definitely not from a cashflow approach. Let the fed solve the near term credit problem, and change the accounting rules.

Finally, European banks are seeing the same problems driven by the self-reinforcing spiral that correlation in finance brings. Between bad central and eastern European debt held by western European banks, and satellite Eurozone countries unable to raise debt denominated in euros for any meaningful duration, it appears the half-hatched brilliance of a smaller country relinquishing control of monetary policy to a central economic power isn't quite brilliant. Neither is borrowing in foreign currencies to fund local debts (with the example of Poland using swiss francs to fund mortgage debt). These lessons should have been learned from the southeast Asian financial crisis a la 1998. All these countries need to resolve the spiral is resumption of old trade balances (dictated by much higher economic activity), previous exchange rates, and hundreds of other conditions that seem impossible to meet in the real world. Just as dollar holders in America will likely have to sacrifice some real value in their currency holdings, I imagine European central banks will have to cooperate and dilute to resolve these troubles.

In fact, cooperation amongst all of these banks and governments will be the only solution to bear any meaningful fruit. Until that happens, the protectionist tendency we find (all of) ourselves naturally returning to is simply repeating the mistakes that worsened the Great depression. Cooperation requires the sacrifice of some pride and a leap of faith - seemingly impossible commodities to find nowadays.

Now for the proposal (written and sent February 1st) sans a suggestion to change bankruptcy law:

Create a "National Refinance Bank." In many ways, this could be analogized to a "bad bank," but the plan is simpler and not just targeting "bad assets." The idea is to create a one stop shop to refinance all residential mortgage debt at a fixed rate of best choice, perhaps 3-4%. It would refinance indiscriminately, no matter the present income qualifications or the amount underwater a property might potentially be. This solves a big present problem that self-reinforces the housing rout we are in, where homeowners on the margin cannot get loans. We must eliminate the negative feedback loop if we are to make progress. This refinance process would pay off all loans to the originating banks (and/or Federal agencies Fannie Mae or Freddie Mac effectively), making all mortgage and home equity loan assets held on bank balance sheets worth par. As well, all derivatives (ie credit default swaps on such debt) would likely beneficially change in value as well. The National Refinance Bank would hold every refinanced security to final payoff. At payoff (in 30 years), the national refinance bank as well as the money the fed created for it to lend would cease to exist.

There is an additional macroeconomic benefit of much lower interest rate payments for borrowers (3%, lets say) as acting as a stimulus itself, as personal disposable incomes, especially within the middle class, will increase equivalent to a tax cut.

Additionally, a sister program should be created similarly to refinance all commercial real estate debt coming due in a similar fashion, regardless of current credit status, extending balloon mortgage periods for another decade. This would prevent an ensuing crash in commercial real estate, and stop the self-reinforcing spiral of losses banks are currently dealing with.

Where would the money come from? Much of it would have to be created out of thin air, just as the Federal Reserve will do with the present program to buy $500B of agency securities. Plenty of this refinancing will make Fannie Mae loans whole, returning these agency investors their funds, so it is sensible that an equal amount of US treasury debt will be able to be created without crowding out investment for other asset classes. This is important, as investment flows must not be crowded out.

With this proposal, banks would be made whole on most assets worth zero or near it, and would now be sufficiently capitalized to lend. In fact, much of previous TARP funds will be able to be paid back to the treasury (as the new source of capitalization will give banks no incentive to keep preferred obligations on their books). The loans and excess money the government prints to do this, while being inflationary, will be structured to disappear as borrowers pay off their obligations. Just as much of new Federal reserve credit programs are "self-mopping" as the obligations are paid off by borrowers, so is this plan. It just requires a massive scale of lending, which as we all know is clearly necessary to stabilize and fix this problem. Since a final effective solution to this crisis will provide confidence in our system to foreign and local investors, I believe it will not destabilize the dollar nor result in a treasury selloff.

Insurance of 'Bad Assets' = Mark to Model

A quick note before the big news tommorow:  Word is that the treasury will create a program to insure bad assets to stimulate private capital to buy them off banks.  'Insurance' could mean anything from principal protection to cashflow guarantee.   This insurance adds a free married put to anything previously considered garbage, and lets the government carry trillions of dollars of risk off balance sheet without printing a dollar.

Regardless, this is a workaround to revalue assets up higher than the market would clear at.  It achieves the same end essentially as shifting to a mark to model for banks, but with the benefit of more inherent trust in the system.  Capital requirements will be instantly met, and with market clearing above previous values (as the new treasury insurance program adds value) we should see an upward revaluation within the financial sector.  Lending should flow with a little more ease as well.

This seems like a buy for financials on all counts.