Bank insolvency: tips & tricks
So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that’s a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.
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Never, ever feed the zombies!
Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at “hold to maturity” values. Just say no! A healthy financial system cannot be run by zombies. “Rescuing” insolvent banks makes about as much sense as tying string to the arms of a loved one’s corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it’s sure to smell really bad, and it’s gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.
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Help private individuals save good banks.
A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:
The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed… to produce fair accounts for Gotham. Ten weeks should do it… The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank’s viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can’t or won’t fund the bank in full knowledge of its position then it is nationalised.
The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank’s shares until the loan was fully paid.
In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks’ viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is “illiquid but not insolvent”, since the government has offered liquidity on generous terms to help get the deal done.
(For the record, I view this procedure as too generous. As far as I’m concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people’s heebeegeebies about the government owning what it pays for, I’d put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)
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Nationalize, reorganize,
privatizespin-off to taxpayers.Insolvent banks become wards of the state. They are nationalized. The “N-word”, as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn’t change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about “nationalizing”, say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.
Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too “systemically important” to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.
Henry Blodget suggests we
refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn’t appropriate for people to get paid.
But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO “pop” goes to flippers, not to the firm or its original shareholders. There’s a deep literature on the phenomenon of “IPO underpricing”.)
Here’s an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they’d quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value “toxic” assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.
This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild “stimulus” — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it’s far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.
Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. “Compare and contrast” is a fruitful exercise. The spin-off idea owes something to this perspective.
I lived through the S&L crisis, 1979-86. What we are doing in saving “Zombie Banks” now is much worse. The Megabanks should all be forced into bankruptcy. Their senior managers should all be indicted for securities fraud. We don’t need these monsters.
February 1st, 2009 at 9:14 am PST
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The main problem with not winding down the failures is that the government support simply allows them to suck the remaining life out of the banks that were still solvent. The same thing is happening to Ford in the auto business (even though I think Ford would go down anyway, it is going down faster now that GM and Chrysler have accessed federal funds), along with the foreign transplants. The failure of weak, money-losing competitors strengthens the strong remainders.
February 1st, 2009 at 12:08 pm PST
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Steve —
Thank you for another thoughtful piece.
I would be curious to know what you think of the “good bank” proposal which is also making the rounds.
February 1st, 2009 at 12:33 pm PST
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Nemo — I’d be fine with it, just like I’d really be fine with simple nationalization. But I don’t think addresses the problem that has people nervous about nationalization.
The bad banks are just asset management companies. If the bad assets are mostly financial assets and the management doesn’t want to play trader and time the market, the work of a bad bank is to sit around, “hold to maturity”, see how much its assets turn out to be worth, and distribute the proceeds down the right side of its balance sheet. Nobody cares who owns bad banks, because they don’t do anything. Historically bad banks have usually been state owned, and nobody cried “nationalization!”, “socialism!”. (Bad banks activities are a bit more complex when there are a lot of foreclosed nonfinancial assets. These have to be disposed of in negotiated sales that are liable to error or corruption.)
It is the good banks whose operations involve ongoing discretionary lending choices that can shape the direction of business activity. The arguably legitimate complaint about nationalization is that if the government manages credit allocation, it will be unable to restrain itself from skewing the credit allocation process, and that government directed credit would do a poorer job than profit-motivated bankers at managing this important piece of aggregate investment. Recent history should have shaken people’s faith that banker-directed credit is necessarily much better than state-directed credit, but still. It’s probably right that if we fixed bankers’ incentives — made sure they were on the hook for deals they originated or bought into for a long period of time — bankers would be better lenders than senators.
So, the only legitimate complaint about nationalization concerns who runs the “good banks”, the on-going credit allocators. If state micromanagement of Buiter’s good banks could be adequate limited as he suggests, then there is no reason not to just nationalize, restructure, and then do all the things he suggests to promote banker independence.
So, I don’t think the “good bank” really solves any problem. It’s a way of nationalizing while pretending not to nationalize, kind of the flip side of asset guarantees and underpriced capital injections, which are ways of giving away public money while pretending not be to giving it away. It’s possible that the sneakiness of the “good bank” proposal would fool enough people to overcome knee-jerk opposition to nationalization, and make “doing the right thing” politically more palatable. But I doubt it. The broad, uninformed public isn’t the source of the resistance. Nationalization may be a dirty word, but spin it as taking down the banks and there’s tons of street support. The binding resistance to nationalization comes from the banking community, which will resist as if its livelihood depended upon it, and from fellow travelers who are genuinely concerned with the state-management of credit allocation. Neither group would be fooled by the “good banks” proposal.
February 1st, 2009 at 2:40 pm PST
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I proposed in October 11th, 2008 the “good bank” solution. The idea is to create a parallel banking system. You do not nationalize bad banks you just create new ones whose ownership and management arrangements can be discussed. I am sure you could also find private investors. The mission of this system: start lending again qnd quickly under sound conditions and trust.
February 1st, 2009 at 3:07 pm PST
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Now we’re getting somewhere. It is indeed a political problem. Perhaps even a more basic problem of social/tribal dynamics. How do you break up a ruling group of people?
If say Obama wanted to “fix” this issue, he would have the FBI do a network chart the 200-300 individuals in question depicting their known relations in terms of fraternities, cross personal loans, family relations and marriage, etc. He would find the weakest relational faults running through that network, and start to pry and prod. He would have to start now, because if undertaken a few years before the next general presidential election, he would not even be representing his own party when it came around.
But alas, he is probably part of the club now.
Until this crony cross-banking-governmental group is broken up, no major banks will go down, no one will be held accountable, no real progress will be made, and no trust will return.
The game that is the economy cannot be played to the benefit of all if the losers keep changing the rules so they are the winners, and refuse to let anyone else play. The board and playing pieces need to be thrown in the air.
February 1st, 2009 at 3:48 pm PST
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Nemo, SRW
Bugger Buiter! Read the original.
(with apologies to MG if your Oct 11 idea is the same)
February 1st, 2009 at 6:10 pm PST
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“The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them.”
I know I shouldn’t be such a pessimist, but I see rampant fraud come calling. There will be funny ads saying that the shares can only be sold to X, redeemed by Y. Also, you won’t be happy with who ends up owning these shares. Do they then control the banks again?
I know that it shouldn’t, but it also reminds me of schemes whereby reservations were split up into parcels or shares, only to end up leaving the tribe homeless.
You’d need a massive education campaign and lots of advisers to make sure that people weren’t shafted. Hell, we can’t even stop mortgage renegotiation fraud going on right now!
February 1st, 2009 at 6:48 pm PST
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nobody is going to invest in insolvent banks unless their aim is to front run the US govt. however, we desperately need a financial sector which attracts investment.
that means we either have to make the current banks solvent (by nationalizing losses in some way) or we have to create new entities and give them capital to take over the businesses of the old entities while we let the old entities die more or less slowly.
so why can’t we have new banks as a way of firing the old banks? can’t we use this crisis as a way to get a new start, as opposed to just a recapitalization?
February 1st, 2009 at 7:57 pm PST
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Thanks, Interfluidity!
But a nagging doubt… I attribute most of the malfeasance to lack of effective adult supervision of bank managers. After all, it is the role of Boards to approve compensation, broad strategy such as 30:1 leverage, creation of huge, off-the-books SIVs which generate earnings but no obvious balance sheet entries, etc. Managers were merely doing what they should, which is to try to make as much money for themselves and to follow corporate strategy.
So if we give each American citizen one share each (why didn’t Russia do the same?), that could very quickly morph into insiders running these newly re-capitalized entities right back into the ground. As Akerlof &Romer put it, a strategy of intentionally “going broke” — making “loans” that had no hope of ever being repaid — rather than “going for broke,” a high-risk strategy with other people’s money, which would be bad enough.
Any good ideas about fixing the Corporate Governance fiasco that, given our hunger for debt, allowed the bubble to bulge so badly?
February 2nd, 2009 at 1:03 am PST
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Walt:
In my opinion people talk of “corporate governance” when they don’t know what to do. I say, taking a page from FDR’s book, “We will indict and indict and convict and convict and imprison and imprison”. Once we’ve sent enough of our banksters to federal prisons for long terms and gotten civil forfeitures of their assets, this nonsense will stop as the “heads I get bonuses, tails the public bails my bank out” game will end. I suggest starting with: Fuld, Blankfein, Pandit, Mozzillo and Rubin for a start.
February 2nd, 2009 at 2:40 am PST
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At first sight, I liked the idea of giving everyone their share of nationalised banks instead of selling them. I have to say though that, here in the UK, many mutual mortgage banks (building societies) distributed shares widely to their customers when they converted to limited companies, and it did not prove successful. The fact that the shares were so widely spread that shareholders were unable to control their management may explain why these banks lent recklessly to expand their businesses. I believe that none of them now remains in business independently. Perhaps the example that is best known outside the UK was Northern Rock!
February 2nd, 2009 at 4:33 am PST
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I agree with Independent Accountant: the zombie banks should be forced into bankruptcy and the loans and deposits given to banks with managements that have proven competent. The big question now is, “How do we break the grip of the plutocracy on the Government [and increasingly, it seems, on President Obama]?”
BTW, I invite my Interfluidity colleagues to visit my new blog, animalspiritspage.blogspot.com, which is dedicated to furtherance of the arcane theories on confidence of an obscure economist I found at arxiv.org. The first post is a bit “wonkish,” as they say.
Cheers,
Benign
February 2nd, 2009 at 9:26 am PST
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Recent history should have shaken people’s faith that banker-directed credit is necessarily much better than state-directed credit, but still.
Firstly, I don’t see any reason why people should have faith about an empirical matter.
Secondly, economic policy making should be based on more than just recent history, otherwise we risk swinging from one extreme to another just based on whatever last happened. Economic cycles take several years to work their way through, changes in economic growth rates can take decades to become obvious. The problems with state-directed credit are still there, as they were before the credit crunch. Most dramatic is the differences between the growth rates of the market economies versus the communist economies. Another example is war – there are a number of examples of states starting an aggressive war, and getting their arses kicked, or states making terribly bad defensive decisions (eg France’s Maginot Line). If Governments make bad decisions in these areas, why shoulde anyone expect them to be good at making decisions about credit, especially in areas where failure is less obvious than in warfare?
Furthermore, state-directed credit forces savers to put their eggs into the government’s basket. If you disagree with the government’s view of the future (perhaps you think that nuclear power sux, and tidal current schemes are the way to go, and your government is planning to build heaps of new nuclear power stations), why shouldn’t you be able to invest in tidal current schemes? It provides diversity.
And what incentive does the government have to make better investment decisions? Yes, people were lending money like fools during the housing bubble, basically because lending money based on rising house prices had made them lots of money in the past. What makes government employees immune to that sort of learning effect – if it works keep doing it, ignore any downside risk? Indeed, this could explain Napolean’s wars, he kept winning by invading places and winning battles, so he kept solving problems by fighting battles, up to the invasion of Russia, where it all went belly-up. (I am picking on wars here because failures are extremely obvious). Another example is hyperinflation – caused by governments printing money at an ever-accelerating rate. Why do governments do this? Because a bit of inflation allows them to temporarily put off their fiscal problems without a severe political cost, and this attraction occasionally leads governments to go crazily into hyperinflation.
February 2nd, 2009 at 10:36 am PST
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Steve – I’d like to see an analysis of “who is going to pay” for all of this and how to structure investments to stay out of the crosshairs and to take advantage of the situation.
The bankers have “lent back the same money” so they aren’t ever going to be holding the bag… taxpayers always will until we get rid of fractional reserve banking.
There are 3 basic ways the government is going to finance this mess.
1 – print money, 2 – tax, 3 – borrow
1 – hits anyone receiving the new money last
2 – hits the ‘rich’ (but the rich don’t pay taxes if they earn money from the money printing machine … they simply return some of the new money back .. money which is given value by genuine producers of goods)
3 – hits those who have demand displaced by spending on gov bonds (any competing investment in capital goods). BTW, the idea that there is “no crowding out” is nonsense: that would mean the laws of supply and demand do not hold.
Ideally, startup banks would be offering great CD rates and buying up the distressed assets and forcing the top banks to sell to redeem deposits as the selling banks see their capital vanish.
The free market would have brought down all of the elite finance guys. There is still a play there and it’s being done now.
February 2nd, 2009 at 12:52 pm PST
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Why not just start a few mutual fund companies that would hold the various banks (dezombie-fied). These might be a bit better than what would happen if 100m people got C (new) as their first stock.
February 2nd, 2009 at 2:54 pm PST
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Actually, I believe financial policy makers and even many ordinary politicians understand that zombification is not an answer. I am pretty sure they also understand that nationalization and letting banks fail is the best option.
The real question is why aren’t they doing this. I can’t believe they are leading their own country to ruin just for the sake of campaign donations.
February 2nd, 2009 at 3:28 pm PST
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Boomka,
I don’t know if they realize what the best answer is, but they don’t allow the failures because the losses are widely and deeply spread throughout the electorate. Anyone that has paper assets has unrealized losses in 401K, IRAs, and money market savings accounts. Traditional pension plans, insurance products, college endowments all have unrecognized losses- losses that get recognized once we start winding down the insolvent financial sector.
February 2nd, 2009 at 5:45 pm PST
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Bank fixing process in 2 easy steps:
1) Use taxpayer money to ridiculously overpay for 1% of toxic assets
2) Use “Mark to Market” accounting rules to revalue the other 99%.
Presto, changeo, everybody’s OK!
February 2nd, 2009 at 5:51 pm PST
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I still think we’re all entirely misdiagnosing the problem. Lending was occurring in spades prior to 2007, sure, but much of it was serving only to support consumption and leveraged speculation.
The distributions of GDP growth and debt growth — hint, not private investment — throughout the boom tells the entire story. Corporations saw nothing better to do with record profits than buy back their own shares, and increased debt was merely used to lever up. Private investment — which is typically funded out of retained earnings, I might add — is supposed to respond in this environment?
There are excellent reasons to not borrow and excellent reasons to not lend in our present economy, and the data from the last 20 years, dot-com bubble excluded, demonstrates those reasons are possibly structural. This whole “bad bank” plan is simply a terrible distraction and a canard used to offload losses. I’d much rather re-examine why lending and investment went so astray before blindly believing just one more rescue will do the trick.
February 3rd, 2009 at 2:02 am PST
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the czechs tried voucher privatisation of their banking system in the 1990s. the results were not not inspiring. a lot of scam artists went around buying up shares cheaply from members of the public who did not want them but were not good at valuing them. there were also big corporate governance problems – without any large interested shareholders, banks’ management were left free to make bad / politically motivated lending decisions. most of the banks ended up being nationalised again and then resold, this time to western strategic buyers.
February 3rd, 2009 at 9:11 am PST
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Steve,
The solution needs a little more of a historic perspective.
ndk mentioned it is a debt-crisis.
I postulate it is a “debt-money” crisis.
It is a crisis that has at its genesis a flawed debt-money system that does NOT create the interest with which to make debt service payments.
Except as more debt-money, which is equivalent to more interest required.
Which is also never created.
The Volcker group identifies this as a debt-service crisis.
Please have a quick read of HOW Debt Money Goes Broke”.
http://www.financialsense.com/fsu/editorials/2005/1212b.html
by financial linguist Steven Lachance.
As he concludes, it is not possible to create new debt money fast enough to continue making “debt-service-payments” on the debt money already out there.
Insolvency.
Two solutions available:
A new money system.
Let the market decide.
I am, of course, for a new money system.
Thanks.
February 3rd, 2009 at 11:38 am PST
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Another historic perspective: let’s start to talk about “lemon banking”. You know what a lemon is in economic terms… I will not use the trade name lemon bank as this appears to be a real bank name in Brazil…
Lemon banking is TARP and any bad bank solution. That’s the wrong bank model: if you have lemon banks there is no point in insuring them or try to buy or price their assets with taxpayers money and guarantees (no cash for trash). The Market for Lemons, Quality Uncertainty and the Market Mechanism, applies. Therefore Lemon banking laws should also be enacted.
Gresham’s law also applies: “Bad money drives out good.” Bad banks and good banks cannot exist together. That’s why the only solution is the good bank model. Let the bad banks fail in peace…
February 3rd, 2009 at 11:50 am PST
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oh man. we are really screwed when we have to cite henry blodget as a competent source. mike milken is trying to be annointed a saint in the meantime…so in ten years, i wonder what bernie madoff is going to be the authoritative source for…
February 3rd, 2009 at 2:33 pm PST
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ndk, that’s interesting data. i wish i understood what some of the categories meant — what exactly constitutes ‘investment’ etc.
the conclusion you could draw from this is that the current debt load is not sustainable given the productivity of the underlier. in aggregate therefore there should not be new loans made although there are certainly cases where it makes as much sense as ever.
challenge therefore is how to make sure that the economy and financial sector don’t collapse. on one hand there is the real possibility of a debt-deflationary cycle driven simply by the fact that the notional of the debt is high and money is not available. on another hand there is the possible of dominoes in the financial sector driven by forced sale and liquidation — kind of a mass Lehman value-destroying scenario — again very bad for debt holders. and on yet another hand there is the probability where a lot of potential innovation, growth, and human potential is lost because funds required for investment aren’t available. then there are the inflation scenarios, none of which i believe for now.
February 3rd, 2009 at 9:15 pm PST
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Obama is receiving bad advice from “experts” who are cognitively (and financially) captured by the plutocracy. He needs to fire up his Sectera (Blackberry version NSA) ASAP and go outside of the DC bubble. Better still, take a weekend at Camp David with Krugman, Rogoff, Roubini, Stiglitz and others that are outside the DC circle; no one else, very hush hush and run an exercise of compare and contrast their advice versus his “experts”. I’m sure our President would be in for a rude, but salutary awakening. That is for the short term.
Long term, one person, one vote. Only public money for campaigns, Buckley’s decision be damned. Yes, I know it “can’t” be done blablabla. But it can: Alas, it depends on us to make it so. And we will make it happen only when the economic pain becomes unbearable and everyone realized that our government in its present form is not functioning anymore.
Only then will we accept the simple fact that you get what you pay for. By that, I mean that at the present time, Americans refuse to pay for elections. Weeeell! Guess what? Politicians obey to those who foot the bill. And we don’t; thus politicians don’t obey us.
“Common sense, the least common of the senses.”
–Winston Churchill
February 4th, 2009 at 3:06 am PST
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Steve – Deposit liabilites are only about 40% of JPM and Citi’s balance sheet. Take the 60% debt, whack it in two … issuing 50% debt, 50% equity … give that to the bondholders. 10 minutes to recapitalization.
February 5th, 2009 at 1:42 pm PST
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“House of Cards,” the definitive look at the origins of the economic crisis, premieres on Thurs., Feb 12 at 8pm ET on CNBC. See the inside accounts from key players, tracing the calamity from Main Street to Wall Street to Washington. CNBC even reveals how one savvy investor even profited – by 600% – as the house of cards fell. Watch preview and see web extras at http://houseofcards.cnbc.com.
This is the definitive record of today’s unprecedented economic crisis.
February 10th, 2009 at 12:32 pm PST
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We are not all Swedes. Being italian, I pull out from the chorus for nationalization and say that nationalization is not necessary nor inevitable. GOOD BANKS are inevitable!. Actually there might be no need to nationalize banks…
February 15th, 2009 at 6:51 am PST
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I recommend an alternative approach I call forced nationalization. The way this works is a whisper campaign of pulling money from the largest banks and depositing funds instead in regional banks. In a short period of time, this would clearly force the government’s hand and require nationalization.
February 17th, 2009 at 4:25 am PST
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Anyone who’s seen enough George Romero movies knows how to deal with zombies. Direct shots to the head! 12-gauge!
February 17th, 2009 at 11:36 am PST
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Umm… – where are the bondholders and uninsured depositors in this discussion? They too like the current shareholders should pay the price before public funds or guarantees (which are likely to be called upon) are put at risk. They took risks and it didn’t work out for them. Why should they be indemnified at taxpayer expense?
February 17th, 2009 at 6:47 pm PST
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