Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.
The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.
The proposal resembles one announced on Wednesday in Britain. Under that plan, the British government would offer banks like the Royal Bank of Scotland, Barclays and HSBC Holdings up to $87 billion to shore up their capital in exchange for preference shares. It also would provide a guarantee of about $430 billion to help banks refinance debt.
The American recapitalization plan, officials say, has emerged as one of the most favored new options being discussed in Washington and on Wall Street. The appeal is that it would directly address the worries that banks have about lending to one another and to other customers.
Let's look at this plan. The US government essentially injects capital (money) directly into banking institutions. The US government gets some kind of ownership interest in the bank (usually preferred shares). The idea behind this is in giving the banks money the banks will turn around and make loans.
The primary benefit of this program is taxpayers will get an ownership interest in the banks. Therefore, when the banks become more profitable the taxpayers various interests will increase in value and therefore provide a return on the investment.
There are serious drawbacks to this plan:
1.) The US government becomes an owner of banks. How many owners are hands off? Not many. Is this a good idea?
2.) There is no reason to think this will be cheap. We've already seen over $500 billion in writedowns. With 1 in 6 US homeowners now underwater there is no reason to think the trend in writedowns will diminish anytime soon. In other words, if someone says this will be cheaper they're not seeing reality clearly. Any option is going to cost serious money.
3.) Why will banks magically start to lend? We're seeing increased problems according to the latest Quarterly Banking Profile from the FDIC:
The continued downturn in the credit cycle, combined with lingering weakness in financial markets and falling asset values, had a pronounced negative effect on banking industry performance in the second quarter. Insured commercial banks and savings institutions reported net income of $5.0 billion for the second quarter of 2008. This is the second-lowest quarterly total since 1991 and is $31.8 billion (86.5 percent) less than the industry earned in the second quarter of 2007. Higher loan-loss provisions were the most significant factor in the earnings decline. Loss provisions totaled $50.2 billion, more than four times the $11.4 billion quarterly total of a year ago. Second-quarter provisions absorbed almost one-third (31.9 percent) of the industry's net operating revenue (net interest income plus total noninterest income), the highest proportion since the third quarter of 1989. A year ago, provisions absorbed only 7.3 percent of industry revenue. The average return on assets (ROA) in the second quarter was 0.15 percent, compared to 1.21 percent a year earlier. Large institutions as a group had more substantial earnings erosion than smaller institutions, but downward earnings pressure was widely evident across the industry. At institutions with assets greater than $1 billion, the average ROA in the second quarter was 0.10 percent, down from 1.23 percent a year ago. At institutions with less than $1 billion in assets, the average second-quarter ROA was 0.57 percent, compared to 1.10 percent in the second quarter of 2007. More than half of all insured institutions (56.4 percent) reported year-over-year declines in quarterly net income, and almost two out of every three institutions (62.1 percent) reported lower ROAs. Almost 18 percent of all insured institutions were unprofitable in the second quarter, compared to only 9.8 percent in the second quarter of 2007.
In other words, this is not an environment where banks will start to make loans -- it's the natural time when banks start to slow down anyway. My guess is banks will use the cash to shore up their balance sheets.
Here's the real bottom line. There are no good answers to this problem. There are no magic bullets. The financial system is in serious trouble. The Feds are one step ahead of the latest domino falling. But the dominoes will continue to fall for awhile.
3 comments:
I posted here a few weeks back in defense of the idea to employ an RFC/recapitalization model, which I believe had been initially proposed by Sen. Schumer at the time. As then, I think your critiques of recapitalization are a bit awry. While it is certainly true that every solution out there is going to cost a lot of money, recapitalization is almost certainly a more cost-effective (and so yes, cheaper) mechanism than TARP's original purpose, or the McCain plan. And sadly, given all the barriers to the successful implementation of Hope for Homeowners (the HOLC plan that just launched in October after being enacted earlier in the summer), it is likely that recapitalization will have a bigger impact than proposals to refinance mortgages at the whole loan level as well.
Why?
1) The Fed and other central banks are already doing all they can to provide liquidity. Liquidity is not the problem here. The problem is that every bank out there has too many hidden writedowns on their portfolios, and not enough capital to cover these writedowns. As a result, as was the case in Japan in the 1990s, this credit crisis is long and drawn out. Banks will continue to a) drag out their writedowns of bad loans/MBS/CDOs as long as possible (this was the crux of their coordinated effort to end mark to market accounting); and b) hoard every available spare dollar that is offered to them so they'll have as much capital as possible when they are forced to take writedowns.
A brief history of TARP is in order. TARP was initially presented to Congress by Paulson as a slush fund, with no oversight. And the reason for that, I strongly believe, is because Paulson became convinced that the fastest way to fix the credit crisis was simply to buy the MBS/CDO/whole loans at par value off the books of these banks. And that certainly would have eased the credit crunch, although at unthinkable cost to the taxpayer.
But once Congress stepped in and put in restrictions requiring Paulson to pay some semblance of fair or market value, and lots of oversight to ensure that Paulson would do just that, TARP became a non-starter. Quite simply, banks cannot afford to sell distressed assets at market value because banks cannot afford to take the writedowns. They are holding these assets on their books for like $0.90 on the dollar, whereas the market value is closer to $0.25 on the dollar. Even assuming a hefty premium paid by TARP, the fact remains that banks just cannot sell at these prices, because they are fictiously listing them at overvalued prices, and a sale for less than those prices would force them to recognize losses.
The reason that recapitalization will be more successful than other types of proposals is that it addresses the root cause of the banking problem: that there is no available capital out there. The foreign SWFs have all stopped investing in American banks. So have foreign and domestic funds. In short, there's no available pipeline for capital to these banks. But adding $700 billion in new potential capital will change that equation a ton. And because capital is used against the leverage ratio, that $700 billion will actually have an exponential impact of 8-1 or 10-1 as far as facilitating new lending.
In other words, if a bank is holding overvalued assets on its book, in an environment where new capital is unavailable except on the most onerous terms, and then only for the best and safest banks (see Warren Buffett's investment in Goldman), there are two ways to restore lending.
1) You clear their bad loans off their books (TARP).
2) You provide them with new capital so that they can afford to take the writedowns we all know are coming (recapitalization).
But in short, we cannot expect any sort of long-term end to the credit crisis until losses are fully recognized. And banks will not do this until they are assured that they can find capital to offset their losses.
Finally, to end a long long comment, I am very very sympathetic to HOLC proposals. But they ignore the fact that most loans, particularly subprime and Alt-A loans, are securitized, and often have a second lien. These are major obstacles to home refinancing. I hope that Hope for Homeowners will be able to overcome these obstacles for as many homeowners as possible. But HfH will not be the same panacea as it was in the 30s, unless we can figure out ways to overcome the fact that a single mortgage may have multiple legal owners, all of whom have legal rights that may be impinged by the reduction in principal/interest that is necessary for a meaningful refinancing of the loan. Bankruptcy modification is one such avenue, which is why the Dems have been pushing it so hard.
oh yes, and Sweden and the RFC both employed the recapitalization model quite successfully.
You don't seem very optimistic today. I truly believe a PPT artificially propped up prices and they finally ran out of money. Now the decline will be higher than warranted--and very fast--unobstructed gravity works that way with potential energy.
I don't know how this can be done, but the only solution is raising wages of the middle class. The country has controlled prices, I want them to inflate salaries instead. Until homeowners are in income appropriate housing, this sucker is going down.
Also, we need to have confiscatory taxes on super sized incomes. During Ike's terms, income taxes were much more graduated, and must be that way again. Inheritance taxes must be increased, not eliminated as McCain advocates. National healthcare would save GM. Just pumping villainous banks won't cut it--just makes all of us "suckers."
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