Blog on the Run: Reloaded

Wednesday, August 24, 2011 8:17 pm

What happens when you don’t let too-big-to-fail banks fail

Filed under: I want my money back. — Lex @ 8:17 pm
Tags: ,

Barry Ritholtz explains:

Consider what was actually done in 2008-09, and you will understand why none of the underlying problems have been repaired:

• Bank holdings: Remain stuffed with declining assets, primarily in Housing and Derivative holdings. Another leg down in Housing could be nearly fatal.

• Transparency: Balance sheets are unnecessarily Opaque; Eliminating Fair value accounting via FASB 157 did not fix balance sheet problems, but instead allowed banks to hide them.

• Capitalization:  Remains too thin; leverage should be mandated back to the pre-2005 rule change of no more than 12 to 1; As we have learned, management does not keep adequate capital unless mandated to do so (sufficient capital reserves cuts into profits);

• Misaligned Incentives: Compensation and bonus schemes were not significantly changed after bailouts, except during loan repayments. Thus, management and traders still have the same upside to roll the dice, but do not have the downside risks, which remains on shareholders and taxpayers.

Ritholtz believes there’s good reason to think that the only way some of our biggest banks — Citi and Bank of America, particularly — will survive another housing downtown is with another government bailout. (And the news has not been good lately on the housing front.)

Whoopee. May I see the hands of everyone in the room who cares what the hell happens to Bank of America and Citi?

*crickets*

OK, then. What should we do? Well, Ritholtz helpfully imagines what things might look like today if we had done the right thing a couple of years ago:

Let’s use a counter-factual, a simple thought experiment of what would have been had we gone Swedish on banks like Citi and B of A, placing them into a prepackaged reorganization (that’s a polite phrase for “bankruptcy”).

The easy stuff: Senior management all gets fired. More than just the CEO — nearly the entire top floor at the bank, including the Board of Directors, gets canned. Equity shareholders get wiped out. Whatever is left over after all is said and done goes to the bondholders, typically, at about 25-50 cents on the dollar. (Note that in Sweden, bondholders got 100 cents on the Kroner, but that currency was significantly devalued — so the bondholders were not made whole, they lost between 50-75%).

Temporary nationalization is the play: Uncle Sam provides debtor-in-possession financing to keep operating. All of the bad holdings, mortgages, derivatives and other liabilities are pulled out, and auctioned off. This includes the REOs, the CDS/CDO book, defaulted mortgage obligations. Remember, there is no such thing as toxic assets, only toxic prices. At some valuation, these are worthwhile investments — just not 100 cents on the dollar. Let healthy buyers pay 15-30 cents.And anything that is worthless is written down to zero.

We recapitalize the parent bank, and spin off each division: IPO Merrill Lynch for $20 billion, spin out a clean  Countrywide at $8 billion, sell of all of the non depository bank pieces. What you have left over is a well capitalized bank, owned by Taxpayers, with well capitalized former divisions as stand-alone companies. All of the above have transparent balance sheets (No FASB 157 required to hide the garbage investments). Eventually, everything is spun out back to the public markets. Uncle Sam is repaid, and what is left over goes to the bondholders.

This would have created a transparent, unleveraged, adequately capitalized banking system that would be contributing to, rather than detracting from, the US economy.

But all that was a missed opportunity — for W and O alike. What we have today instead is an over concentrated set of banking behemoths, barely off life support. Many of these remain mortally wounded by the holdings — holdings that they would have to shed through a healthy reorg.

The recent downturn in the banking sector? I suspect it amounts to nothing more than a credible bet that these banks are not in any condition to withstand the next recession. (No, it was not Henry Blodget’s Fault). A rise in unemployment and another next leg down in Housing could very well be fatal.

If the banks come crawling back to Uncle Sam for another bailout, it will be proof that “rescuing” failing financial institutions that blow themselves up is the exact wrong strategy.

Real Capitalists know failure is part of the process. I suspect we may have another chance at a banking reorg. Let’s hope we do it correctly this time . . .

I have friends at Bank of America. I do not wish the company as a whole ill, although I choose not to do business with it because of the behavior of its officers and directors. That said, the bank is insolvent and needs to be treated as such. Regulatory capture so far has prevented the government from doing what needs to be done. How much more pain will taxpayers, bank employees outside the C-suite and the American economy in general have to suffer before the right people finally do the right thing?

Quite a lot, I suspect.

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