taxpayers

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The Banks and the Economy … What’s New? Nothing.

The spate of recent bank earnings releases continues unabated this morning with Bank of America telling us that its first quarter net income was $4.25 billion. Along with the results last week from Wells Fargo, Goldman Sachs, and Citibank this B. of A. performance paints a picture of recovering health in banking.

Not so fast.

As I warned last week with the others, B. of A. earnings report has a distinctly thin and probably unsustainable tone to it because, amongst other things, it includes various ‘one time’ benefits from asset revaluations, increased gains from trading income, and some accounting trickery relating to debt it inherited from Merrill Lynch. Take these away and basic banking profits look pretty anemic.

This was the same story we saw at the others. In particular the big banks appear to have benefitted from strong trading profits and a variety of imaginative accounting changes. Core lending was not the source of increased income for any of them. So the outburst of relief we are seeing and hearing around Wall Street is entirely ephemeral.

In fact B. of A.’s shares sank in value quickly as analysts realized the tenuous nature of the bank’s performance. It seems as if the markets are learning at long last to be as skeptical as I am!

These income reports are all appearing as the government ponders its next move in the ongoing bank crisis. I remain extremely concerned as to the willingness and ability of the Treasury Department to take decisive action. I know you all must be jaded by the banking woes we have seemed to suffer for ever by now, but let me repeat: without healthy banks there will be no lasting recovery in the overall economy. It’s that simple. So getting the bank bailout right is the central economic issue we are facing.

Here’s a sobering statistic to underline that point: according to this report, US Treasury: Monthly Lending Survey loans from the twenty-one largest banks in the country, most of whom have received government bailout money, fell by a median average of 2% in February. So credit is now tighter than it was before the taxpayers pumped all that money into the banking sector.

And the credit outlook is fairly grim.

Deep in B. of A.’s report is the news that it sees a tide of consumer and real estate losses rising. This accords with the data we have been seeing from the government and is reinforced by the news of rising bankruptcies in commercial real estate firms. The next step in the recession will soon be upon us, and will bring additional loan losses for the banks just as they are trying to rebuild capital.

From an individual bank’s point of view making new loans during such an uncertain economic period is highly risky even when the bank is well capitalized to withstand losses. With all our major banks propped up by government bailout cash, with capital at less than anemic levels, and with traditional sources of capital such as the issuance of new shares blocked off by investor uncertainty, I can understand why the banking sector is not generating new loans. The problem is that the economy needs more credit just at the moment banks are unwilling to provide it.

So that is the central conundrum Geithner and his merry band are trying to resolve. It is fairly typical of severe economic crises: a conflict between the best interests of private investors, i.e. the banks, and the best interests of the public at large.

There is no easy way to resolve this conflict. Various ideas have been floated most of which end up being a giveaway of taxpayer money to the private investors so as to induce them to act in our collective interest. The current Geithner plan is simply one of the more egregious examples of such subsidies. This, of course, assumes that we lack the courage to take over the banks in some form of nationalization or state sponsored reorganization. The goal remains the same: we need to get bank capital up to acceptable levels so that the upcoming wave of losses do not impinge on the bank’s lending capability. Unfortunately none of the proposed plans I have seen comes anywhere near addressing this issue, they simply are aimed at much more modest targets like getting toxic assets priced correctly so that a market can open up for them. So my fear continues: we will splash more taxpayer cash into the banks and still not get them sufficiently healthy that they then perform their role as engines of growth.

Our lack of political will to deal with the banks is an extraordinary disappointment. It isn’t as if the issue is unknown. Yet all the signs are that the administration feels that it has to kluge together some inevitably suboptimal program in order to avoid feeling the wrath of congress.

Why?

Is the issue not urgent enough? I think it is. Are the consequences of botching the policy response not large enough? I think they are.

I realize that Congress has demonstrated a remarkably poor grasp of the economics now needed – it still seems in the grip of fervent pro-market ‘Reaganite’ advocacy, and seems equally unwilling to fathom the extent of the failure of those ideas we have just witnessed. Remember: this crisis was not the result of maladroit implementation of free market theories and policies. It was the result of a precise, clever, and faithful implementation. The men and women who wrought this disaster were genuinely motivated and driven by the principles central to laissez faire dogma. Remember ‘trickle down’? Remember ‘a rising tide floats all boats’? These were not merely politically motivated phrases, they also reflected deeply held beliefs. There was a certainty to them in the minds of their advocates.

How wrong they were.

But how strongly lingers the antipathy to a proper alternative. Look at the resistance to deficit spending. Those silly ‘simulated ‘tea parties’ last week were a joke, but they could only exist if a core of people thought the populace at large could be stirred into opposition.

And the leaders of the opposition seem to have raised sufficient ruckus that Obama hesitates even as the bank crisis lingers.

If only we could untangle the banks from the economy somehow. Which of course we can’t. Oh well. At least we aren’t in the mess that Ireland is. They truly have fallen into a Depression era hole. The nationalization debate is raging there too, but the stakes are so much higher. Their economy is in free fall, the latest data shows it may shrink 10% from the peak, and the bailout needed for their banking system is gargantuan in proportion to their economy. If their problems were scaled up to our economy we would be discussing a $30 trillion bailout and stimulus. So bad is the Irish situation that their government is now being forced into restrictive economic policies to assuage the fears of the bond market. So they are having to crunch down on the economy to save their banking system from total melt down.

At least we’re not there. Yet.

But our banks are nowhere near healthy. Which means we aren’t either.

Plus ca change.

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That Geithner Plan Again

Joe Stiglitz has an excellent and simple description of the economics of Geithner’s toxic assets buy out plan in today’s New York Times: Op-Ed Contributor – Obama’s Ersatz Capitalism

As you know I remain opposed to the plan. It has two flaws both of which are fatal from my point of view:

First: As Stiglitz demonstrates the plan fails its own test. It is supposedly designed to surface market prices for toxic assets so that they can be traded at ‘fair value’. The problem up until now has been that the market has failed to price these assets reliably and so they cannot be moved off of bank balance sheets and housed in more appropriate places like private equity funds where both capital and risk appetites are abundant. So getting the price right is seen as crucial to freeing up the market.

But Geithner’s plan doesn’t actually achieve this.

Instead is allows the market to determine prices for the implicit option attaching to the asset. This is very different. Because the government is insuring the private investors in the plan from most of the downside loss, those investors will focus primarily on the value of the gain they can achieve. Once the downside is virtually eliminated from the calculation the price an investor is willing to pay will be much higher than a price that takes into account a potential loss.

As a result the prices that Geithner’s plan will elicit from the bids by investors is necessarily skewed upward. The ‘true’ value of the toxic assets will still not be revealed.

So who benefits from this?

The banks. They will be able to take advantage of the skewed prices and dump toxic assets at prices well above true value. The investors. They will be able to bid aggressively knowing that the gains and losses will accrue from their bids will be heavily asymmetrically weighted towards gains.

So who loses from the plan?

You and me. The taxpayers. We stand to make gains on some of the assets, but our return on equity pales in comparison to that achieved by the private investors. And when the toxic assets turn out to be toxic we lose big time.

So the plan fails in its stated goal: it does not price toxic assets, it only prices the implicit option on those assets. And it amounts to a heavy subsidy of both the investors and the banks.

This subsidy is augmented further by the ‘adverse selection’ problem Stiglitz mentions. Adverse selection is a situation when the selection process has a bias towards a negative result. In this case the bias is negative because the banks will be able to select the worst assets for sale. They will be able to keep any assets that they feel have a chance of coming good. Since the market knows this the investors will be inclined to bid lower in order to cover their own losses [they still have the potential to lose their equity stake] but the selection bias almost certainly condemns the taxpayers to losing money – there will be far fewer ‘good’ toxic assets sold so the upside is severely limited.

The second flaw in Geithner’s plan is far more important. It simply doesn’t address the continuing undercapitalization of the major banks. This lack of capital is the reason that lending will take a while to pick up speed. Until the banks are flush with capital they will have to avoid making new loans that might go bad. Since we in a deep recession that means pretty much all loans. Hence, at the moment, a wise bank makes no loans. Especially if its capital is limited.

So.

The Geithner plan has all the hallmarks of something put together by people who have limited imagination, little courage, and limited resources.

It sets us on course for a Japanese style economy for years to come.

And that’s what annoys me most.