Why the bank bailouts are doomed
It's tempting to believe that more money will fix the messes of American and other global financial institutions. But simple calculations tell us the system is insolvent, and the possible solutions are unpalatable.
By Jon Markman
January 29, 2009
In the past 12 months, U.S. and British taxpayers, sovereign wealth funds and private investors have sunk $1 trillion into failing U.S. and British financial institutions, while central banks have slashed their cost of funds to nothing and their collateral standards even lower. Yet major banks continue to collapse. Why?
It's tempting to suggest that fixes so far were too late, too small and too clumsily applied. Yet new evidence suggests a much more uncomfortable answer: Perhaps the hole at the bottom of bank vaults is simply too big to fill even by governments that can mass-produce money with the press of a button. And therefore the only cure may be the most precious commodity of all, and that is time.
The math is not complicated. Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles -- leveraged lending vehicles used by big banks to fatten their profits in boom times -- are being forced back to banks' balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. I know that we throw around words like "trillion" like they're nothing, but that is a lot of money. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.
Banking's leaky bucket
In aggregate, therefore, the entire system is simply insolvent, as liabilities are greater than assets. Governments aren't forcing banks to admit this, but investors are, and that is why big banks' shares have lost half of their value this year. Governments, meanwhile, are trying desperately to help banks plug the gap, but they're coming up short. When you add the $500 billion from sovereign wealth funds to the $500 billion from the first tranche of the Troubled Assets Relief Program, it's only $1 trillion. That's already been provided. So that leaves a gap of $500 billion to $1.5 trillion.
The easy way to fix this problem, of course, would be to change the rules: Tell the banks they don't need to keep 10% capital reserves. But that sort of glib solution only sounds good, and the reality is that in any normal business sense most of these businesses are ruined.
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Because the calculation is so easy -- and so devastating -- it kind of makes you wonder why the Bush administration created TARP in the first place. But the administration couldn't do nothing, as that would have been politically unpalatable, so $500 billion has basically bought more time for someone to come up with a better answer. Tick, tick, tick. Quite a few days have passed since October's TARP passage, and though bank shares enjoyed a brief end-of-year respite when hope emerged from its bunker, investors' patience has worn thin.
"People got bored with the credit crunch last year and assumed that it had gone away, and yet nothing has changed," said Satyajit Das, a credit expert who spoke to me from Johannesburg, South Africa. "The banking system simply has no capital. All the money that's been allocated so far has been like pouring water into a bucket with a hole in the bottom."
You can't very well have a bankrupt banking system, however, so the market has spent the first three weeks of the new year pricing in the inevitable next step: nationalization of most large banks. The reason is simple: If your owner can print money, you don't need to keep any reserves. Problem solved.
Ozzie-and-Harriet loans
Nationalization is a tame term for a concept that is paradoxically radical and boring. It's radical in that banks would have to issue equity to the government, a process that wiped out current shareholders. Yes, that would mean most bank stocks would go to zero. It's boring in that it would allow the banks to be run completely differently going forward in that they wouldn't have to answer to shareholders on a quarterly basis, they wouldn't be able to pay high salaries to executives and they would make loans that the government believed were in the public interest. Of course, the government would say the banks would be privatized eventually, but realistically it could be decades.
To be sure, the landscape of world business would change dramatically. Private owners have made a mess of things, but you can bet government bureaucrats would be worse. They probably would take fewer smart risks, such as lending money to the next Michael Dell or Bill Gates, and more dumb ones, like giving mortgages to low-income families with meagre means of repayment.
They would almost certainly not support lending to hedge funds or providing money for leveraged buyouts, or do much merger-and-acquisition financing at all. You can pretty much count on the U.S. government knocking the financial system back to the Stone Age, or at least the 1950s -- a situation in which banks accepted passbook savings accounts from Mr. and Mrs. Smith and then made plain-vanilla loans to Mr. and Mrs. Jones.
If this is to be the case, then perhaps the new U.S. Treasury secretary should stop the charade with the second tranche of TARP money and certainly not contemplate TARP II and TARP III, as has been discussed in Washington. Just nationalize the banks and get on with the next phase rather than pour more money down a hole.
It's not like there aren't already nationalized businesses in the United States. There's Amtrak, the U.S. government-run rail system. Mortgage lenders Fannie Mae (FNM.N) and Freddie Mac (FRE.N) are under federal control. There's even the post office, which could easily be a private business if it weren't determined to be a U.S. taxpayer-supported public utility by America's forefathers.
The high price of life support
Personally, I loathe this neo-statism, which is a less objectionable term for socialism. The best course of action, which would have been the most painful in the short term but beneficial in the long term, would have been to force banks to open all their books to regulators and investors, allowing us to see which were solvent and which were not. Then the U.S. Federal Deposit Insurance Corp., which is sort of a mini-nationalizer, could have closed the bad banks and merged their assets into strong banks, and we would be halfway through the crisis by now.
Instead, the previous U.S. Treasury secretary, Henry Paulson, decided on this disastrous course of putting insolvent banks on life support at the expense of U.S. taxpayers, which has only led to a massive waste of money and time.
Now time is running out, because the next phase of the credit crisis is at the door: the part where we see a normal rise of loan defaults during a recession, further crushing banks' earnings. At the moment, defaults are running at 2.5%, but history shows they will hit 10%-plus over the next year or two as commercial real estate and business loans sour. This is why fixing the U.S. banking system will not end America's recession; it will help only to smooth the path of a turbulent descent.
Get out your parachutes -- it's going to be a rough landing.
At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.
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