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In Search of One Bold Stroke to Save the Banks


Excerpt:

When is it going to end? Because of declining asset values, the original bailout money has largely disappeared. “It’s like putting money in a pothole that keeps getting bigger,” said Daniel Alpert, the managing partner at Westwood Capital. And it’s not over yet. Goldman Sachs says the world banking system has absorbed about $1 trillion in losses — but there is likely to be another $1.1 trillion yet to go.

The response has got to stop being so haphazard. Think about it: Citigroup is slimming down. Bank of America is bulking up. The government is essentially backing both approaches. It makes no sense.

I started wondering if there is a better approach — something that doesn’t feel like plugging holes in a leaky dike. Perhaps this new idea being discussed in Washington of creating a government bank to buy up toxic assets might do the trick. It turns out I’m not the only one who’s been asking this question lately.

“I don’t want to have to do any more of these one-offs,” said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation, in an interview on Friday. “Nobody does.” She was referring to the Bank of America deal, which had been completed just days before. But she could just as well have been talking about the Bush administration’s entire approach to the financial crisis.

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Do you remember the original idea for the TARP money? The government was going to use funds from the Troubled Asset Relief Program to buy up bad assets from banks and other institutions, thus taking them off the balance sheets and keeping them from dragging down the institutions. But by the time TARP became law, two things had become clear. The first was that nobody in Washington — or on Wall Street, for that matter — had a clear idea of how to value the toxic assets the government was proposing to buy. And second, the banking system had deteriorated so badly that most of that first $350 billion had to be shoveled into the banking system as recapitalizations. In addition, Ms. Bair and others forced the sale of insolvent institutions like Washington Mutual and Wachovia to healthier banks.

That initial recapitalization was necessary. Without that government-financed capital, many more banks would have been insolvent, or would have been hoarding capital, fearing future asset write-downs. But the underlying problem has never gone away. The toxic assets are still on the books. Banks still don’t really know what they are worth, so they continue to be written down in piecemeal fashion. And now, with the recession getting worse by the day, other assets, like commercial real estate and credit card loans, are going south as well. “It’s a rolling problem that gets worse as conditions worsen,” the banking consultant Bert Ely said.

(A quick reminder for readers who wonder why the banks shouldn’t be allowed to go bankrupt, like any other company that made the kinds of mistakes banks made. The answer is that the banking system is the engine of the economy; if banks stop functioning, economic activity will grind to a halt. Indeed, at least some of the pain we are going through now is the result of the banking system’s not functioning properly.)

The key point here is that any systemic solution has to deal with the bad assets, once and for all. They need to be properly valued and they need to be isolated. “How do you know how big the hole is on the balance sheet of Citi until you have a decent valuation?” asks the Princeton economist Alan Blinder. That is the primary reason the banking system can’t attract private capital and has to rely on the government — no prospective investor has any idea how deep the hole is. That will only start to become clear when these assets are either written down to zero (unlikely) or start trading again.

Comment: Around the corner ... more ARM resets, credit card defaults, commercial loan defaults, etc.

More from Financial Times:

Governments eye new tools for credit crisis

But the real problem facing policymakers is that, despite spending or committing hundreds of billions of dollars, the banking system is still not distributing credit to the economy. Consumers and companies are being starved of credit, raising the prospect of a continuing downward economic spiral.

As a result, governments are reaching for several new tools to tackle the crisis. British officials were on Friday putting the finishing touches to measures that will attach government guarantees to instruments such as mortgage-backed securities and corporate debt.

This represents an effort to stimulate the financial markets to again accept loans that would otherwise have to sit on banks’ constrained balance sheets.

Yet these measures are limited to encouraging new lending. They do not deal with the continuing problem of legacy loans that are still on banks’ balance sheets.

These loans are rapidly turning bad as companies and consumers struggle to service debts they took on when credit was cheap and plentiful.

What is more, new banking regulations are making matters worse. The Basel II framework for measuring banks’ capital, adopted by much of the world at the beginning of last year, was supposed to provide a more sophisticated way for measuring the risks attached to different loans.

As losses mount, however, bankers are concerned they will be forced to hold ever-increasing amounts of capital to support existing assets. Until they have a clear idea of how much capital they need for old loans, banks are understandably reluctant to commit to new lending.

As a result, policymakers have changed tack. Bank capital ratios are essentially a fraction where the numerator is the total amount of capital a bank holds while the denominator is the sum of a bank’s assets, adjusted for their perceived riskiness.

Wholesale bank recapitalisations launched last autumn were an attempt to improve the ratio by increasing the numerator.

Now, governments and regulators are attempting to achieve the same result by shrinking the denominator. In other words, they want to reduce banks’ risk-weighted assets.

Since most banks cannot sell assets without incurring huge losses, this can be achieved in two ways. The first is for governments to buy bad assets from banks in return for cash. This was the US government’s original plan under the troubled asset relief programme.

The alternative is for bad assets to remain on banks’ balance sheets, but for the government to insure them against large future losses. The US took this approach with both Citigroup and BofA, and other governments are expected to follow suit.

Whatever the approach, removing bad assets from banks’ balance sheets should end the uncertainty about future capital requirements, allowing the banks to resume lending.