Citibank; Volcker and The Banks

It seems like an age since I was filling this space with my opinions about the pros and cons of nationalization. In terms of bank earnings it has been an age: the big banks have all done extremely well this past year. Not that they could have fouled up in such a featherbed environment, rigged as it is to their advantage.

Interest rates remain extraordinarily low; the yield curve is tilted sharply upward; liquidity is sloshing about as never before; the government maintains its safety net; competition is severely reduced by the loss of some key players; and efforts to re-regulate the industry look to be tinkering around the edges rather than striking at the heart of what the industry does.

Yes, life is good for the gamblers bankers of America.

Which is why there has been a torrent of repayments of that infamous TARP money. Goldman got the ball rolling and now every one of the big banks who were saved from themselves by our collective generosity have either paid the TARP cash back, or have announced plans to do so imminently.

As taxpayers that’s a good thing: we get our money back. But if you’re a bank shareholder I wonder whether this rush to repay the public is such a good thing.

Take a look at Citibank.

They are paying back their TARP money. This isn’t because they have suddenly become rock solid. Far from it. It is because they want to get out from underneath those annoying rules the government imposed regarding bonuses.

So paying back TARP cash is a jolly good thing if you’re a Citi banker. Not so much if you are a shareholder.

Why?

Because the handing back TARP leaves a hole in the bank’s capital account and thus makes it much less secure. Naturally even the thick headed folks running the bank notice this and have planned to raise capital to offset the TARP cash. This has two effects, neither good.

First, it dilutes the ownership of the existing shareholders. The new shares may fall into the hands of people who currently have no Citi stock. The managers may like this extension of the ownership base, but the existing shareholders will now have to share future profits with a whole bunch of newbie owners: they’ll get less of a share. Having stood by the bank during its dark hours last year and early this, they may find this dilution a less than generous reward.

Second, the TARP money was relatively cheap. The annual cost of capital was low compared with the cost likely to attach to newly issued equity. So the bank’s management has raised its cost of capital, and thus reduced its ability to make the same level of profit from its lending activity as it had with TARP cash. In other words management has deliberately lowered its profit run rate.

So the net effect of the payback seems to be that the bank is no better off in terms of capital. If anything it may be weaker: it could have raised new equity and kept hold of the TARP money for a longer period. The new equity would then have bolstered capital rather than filling the hole left by the TARP repayment. Plus the bank’s future earnings could be depressed slightly by that higher cost of capital.

Capital no better and earning potentially weaker. This doesn’t sound like a good plan.

Except if you are an executive eyeing that big bonus you would have been denied while TARP still cluttered your balance sheet. Then the scheme makes perfect sense.

Then of course is the public indictment that would have followed from Citi being the only bank not to pay TARP back. That would not have looked good. It would have inevitably drawn our attention to what has been unstated all year long: Citi is still in bad shape. Even though it is earning a profit it is stumbling about without a certain hope of survival. It’s recovery will take many years, and one blow from the economy – commercial real estate perhaps – could be enough to finish it off.

There is a line of thinking that says the TARP repayment is sensible from the public’s point of view: we got our cash back. But what happens when Citi trips up again. Its current management doesn’t inspire confidence and its business model is a convoluted mess. The words ‘Citibank’ and ‘decisiveness’ sit uneasily together. This is a bank being propped up by those extremely favorable conditions I mentioned at the outset. One storm is all it will take to reveal the rot that still remains.

Then what happens?

Presumably Citi comes running back for a new bail out.

This is should not get. Instead it should be nationalized, broken up and sold off in pieces. And its current managers should all be fired.

Interestingly the idea of breaking up the banks is gathering support. Paul Volcker had been, up until recently, a lone voice arguing the case for this idea. Alan Greenspan had joined in, but elsewhere the notion had been consigned to fringe status. Now, however, Volcker’s idea is beginning to attract more support, some of it in Congress. There is hope yet. I have been a big proponent of smaller banks from the beginning of the crisis: they are easier to push through bankruptcy; they are less ‘systemically’ dangerous; they are more agile and responsive to customers; they are less able to rig prices and markets for profit; and the fact that there would be more of them implies greater competition and thus lower prices. All these things are in the public interest. I have yet to see a convincing counter argument presented.

Of course there are variations in the way in which we would break up the banks. Would we break them up along product lines as in the old Glass-Steagall Depression era legislation? Or would we simply break them apart geographically? These details need to be worked out, but one thing we cannot avoid is that the banks have now grown to the point that the phrase ‘too big to fail’ hangs all too easily on the public’s lips. As Volcker has said: too big to fail means too big to exist.

Actually in reality too big to fail implies too big to bail out as well. We cannot afford the banks any longer. They have outgrown our economy’s ability to absorb their losses. By vectoring off into the alternative universe of purely paper transaction making – securitization, derivatives of derivatives etc – the banks have inflated themselves so much that they dwarf the real economy. But it is on the cash flows within that real economy that they rely for the guarantees that keep them afloat. Remove those guarantees and the entire edifice has to shrink rapidly down to be accommodated within the real world.

Let’s keep this simple: the social value of banking is its ability absorb time based risk – ‘intermediation’ – and in its superior ability to allocate capital. The profit motive should provide sufficient discipline to ensure that the banks provide these benefits without destroying their shareholder’s value and thus coming to us for a bail out..

That discipline broke down when the banks realized that they had become too big to fail. This realization led them to take excessive risk for the personal gain of their employees, safe in the knowledge that they had a public safety net to fall into. In other words the moral hazard economists bemoan so much had become a reality.

Since we do not want to remove that safety net: it exists to protect our money when a bank fails we run the risk of fostering ongoing moral hazard, and thus the likelihood of further financial crises. The managers of the banks have little incentive to act in a socially responsible way. At the risk of boring you: bank managers have become poster children for the concept of ‘rent seeking’ behavior.

All you need to know about rent seeking is that is a bad thing. Wherever someone can rent seek the relevant market is subject to imminent failure because the essential dynamics of capitalism have been twisted for personal gain.

So it remains with banking: case in point Citi’s repayment of TARP cash in order to free it up to pay out big bonuses.

The only serious way to keep those safety nets to protect our deposits when a bank fails, and yet get rid of the rent seeking enabled by moral hazard, is to make the banks small enough that we can allow them to fail. In other words we re-introduce a dose of capitalism. Competition is the central mechanism that makes capitalism work. The big banks have grown so large that they can blunt the impact of competition. They have become ‘oligarch’ like. They can distort the rules. In fact some of them – Goldman in particular – won’t play in a market that it cannot distort to its own advantage.

Moral hazard breeds rent seeking, which leads to anti-social behavior. The only disinfectant sure to work is heightened competition and the withdrawal of the too big to fail feature of the current system.

That means breaking up the banks.

Get it done and the economy will benefit enormously.

Meanwhile: if you own Citibank stock, watch it like a hawk. That bank is still very unsteady.

Addendum:

I forgot to mention that I think the rush to pay back TARP by all the other banks is a combination of a domino ‘fairness’ effect – once one was allowed the rest had also to be allowed – and politics. The government can present the repayments as a ‘win’ for its handling of the crisis.

What it cannot do is claim to be reducing the Federal deficit: TARP was never accounted for at its full cost. Rather it was accounted for on a ‘net’ basis. This means that only the money the government estimated would never be paid back made it onto the books as a cost. The rest was accounted for as a loan … which is what it was. This is an oddity in that the government doesn’t usually account for assets and liabilities, it uses a variant of cash accounting and has no balance sheet to speak of. Sometimes it simply doesn’t report things at all – see the Iraq war costs under Bush. This messy accounting has always been a pet peeve of mine, which is why I bring it up!

Update:

Now we read that the Treasury Department is having second thoughts about disentangling itself from Citi. The reason is that the equity issuance – Citi raised about $20 billion in what is the largest single equity issuance ever – needed to refill the hole left by paying back the TARP cash went badly. The money was raised but the market was not impressed. Citi even now finds itself being sued by Abu Dhabi whose investment authority is claiming that it Citi misrepresented its financial condition. The net result of this latest mess is yet another black eye for Citi’s management and a setback for the administration. The former wanted to get out from under close government supervision; and the latter wanted not to be embroiled in a protracted relationship with what could be a dying bank.

The story continues …