Tier 1 Capital

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Break Up The Banks: Part 3 … Phew

I didn’t realize that when I first wrote about this issue I was plunging into so deep a pool. I knew that it was a hot topic, but the amount of time and space being devoted to it are, to say the least, extraordinary.

Today’s edition brings two major players into the game: Martin Wolf, my favorite writer at the Financial Times, and Ben Bernanke opining on the Fed’s view.

I disagree with both, so I owe an explanation as to why.

“There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.”

Let’s tackle Wolf first.

His opinion is presented in an op-ed piece in today’s FT. He starts by stating the obvious: big banks are a problem and that the problem is now much worse than before. It became worse because we didn’t do anything yet to fix it, while the big banks that survived the last crisis have now gobbled up weaker players and grown market shares. They are even bigger than before.

Wolf describes all of this, so I am fine up until the moment he backs off the inevitable and obvious solution. If some banks are too big, then we should make them smaller. Instead he offers up a rather lame defense of letting them stay large: we might find it difficult. Plus he muddles some rather easy facts around to create a better target to shoot at.

Allow me to straighten Martin out.

His straw man is the notion – one I agree with in principle – that we should re-instate the separation between regular, main street, banking, and what he calls ‘casino’ banking – I have used the word ‘gambling’ – which used to be the exclusive domain of the old investment banks. The reason for separation is clear, at least in theory: main street banking is boring stodgy and utility like. It includes dull stuff like managing checking accounts and making small business loans. There is very little sexiness in that business which is why all the real ‘high flyers’ flock towards investment banking. The ‘casino’ banks would include all the various activities we have come to know and hate: derivatives, securitized products trading, and the real bete-noir of the AIG collapse those infamous credit default swaps. In other words all the high stakes gambling stuff that any sensible main street bank would avoid like the plague.

Wolf argues that it would be very hard to separate the two activities. He uses a cheeky sleight of hand to support this contention: he says that “all the lending” would be left to the casino banks – including lending to households and small business. This is plainly false. The old commercial banks we had in the US – before the ill-fated abolition of Glass Steagall – were not just payment system operations the way Wolf suggests the new main street banks would be. They went much further: they were the primary providers of credit to small and medium sized businesses and to households. Why they wouldn’t continue in this role Wolf fails to explain. I think he is arguing that the new main street banks would have absolutely no credit risk at all. I don’t see why this should be. The system worked well for decades after the Depression era laws like the Glass-Steagall Act broke the banks up. Yes there were periodic bank losses, but they were never even remotely as catastrophic as last years implosion. All those periods of loss were associated with the economic cycle – banking lagged the cycle because profits dropped as customers suffered losses and defaulted on loans. Last year the banks were the cause of the problem: banking had become a leading factor instead of a lagging factor.

I give Wolf credit though, because he highlights a big issue that seems lost in the current discussion.

He suggests that the solution I just gave – re-creating the old commercial banks – implies that generating loans is good, but securitizing them is bad. He wonders why it is that we should think securitization is bad. Because it separates the bank from its customers. That’s why. He misses the point that the re-creation of the old commercial banks includes with it the reduction – if not the elimination – of securitization.

Why is this so important?

Securitization allows banks to package up and sell loans that they have made – those awful mortgage backed securities based upon packages of sub-prime mortgages are a classic case in point. This process frees up capital on the bank’s balance sheet, it generates fees, and it, in theory, reduces risk for the banks because the default of those loans is now someone else’s problem. All true so far. But: it also means that the lender has no enduring interest in the customer. This is great in good economic times, but when the seas get a little choppy it also means that customer’s have a much harder time getting forbearance or other types of help to allow them to weather the storm. The old fashioned customer-lender link is severed. The economic consequence of this is that there is no organization with an interest in acting as a brake on the deterioration of the asset: the new holders have no relationship to protect, so they are quick to ask for foreclosure on bad mortgages. The other damage that securitization brought us was also rooted in this customer-lender severance: the lender had no long term interest in the loan, but had a very high interest in the volume of loans – that’s where the fees are generated. It doesn’t take a rocket scientist – although the point eluded all the math wizards on Wall Street – to realize that this is a recipe for loose credit standards. If a bank doesn’t have to face the potential loss of a loan it makes it will be willing to lend to just about anyone. Sub-prime mortgages are a direct result of securitization for exactly this reason.

So Wolf gets it totally wrong: securitization is bad when applied en masse to bank loans. The type of commercial bank I advocate as the future would be forced to hold their loans, or at least the majority.

It is one thing, and a very normal thing, for a bank to lose money when the economy goes into recession. It is quite another for banks to lose money because they willfully overlook basic underwriting techniques. Securitization is not the only cause of bad lending – unrealistic profit targeting is another obvious one – but is a major one.

Once Wolf dismisses breaking the banks up he is left to answer the ‘too-big-to-fail’ question in other ways. He resorts to the same arguments that Bernanke also uses. He suggests we impose huge capital requirements on riskier activities; that we introduce laws to make bankruptcy easier and more painless for financial institutions; that we abolish off balance sheet activities – yes banks have vast amounts of assets not recorded on their balance sheets and thus not protected by capital; that we require fancy and more rigorous loan loss provisioning – a loan loss provision is a ‘rainy day fund’ that banks create to offset loan losses, the idea being to set the fund up when the bank is profitable and then to draw it down in hard times; and that force banks to have better capital – more plain equity and more ‘contingent’ equity which is an exotic form of capital that is only converted into plain equity in emergencies.

At this point Wolf and Bernanke are making the same suggestions so I should conflate them for my response.

First: all of these novel ideas have been floating around for years. Why were they not adopted? because the banks lobby really well and managed to prevent them being put into force. Wold and Bernanke will have to be much more convincing to persuade me that the banks, who are now more powerful, will not be able to stop them again.

Second: imputing higher capital ratios is a great idea. I am all for it. The problem is that we have capital ratio requirements already. Banks have proven to be very adept in avoiding them. Regulators have been very lax in enforcing them too. There is no evidence I know that suggests that either the banks or the regulators will change. Indeed as soon as this crisis abates enough I would wager that laxity will pervade and a new crisis will form.

Third: those plans for easy bankruptcy are not that easy. These mega banks are arcane warrens of subsidiaries and murky tax-dodge off-shore vehicles. Unless the bankruptcy procedures include a regulation that clears away all that mess up front – forcing the banks to eliminate their tax dodges would help finance more adequately staffed regulatory bodies, which is an exquisite use of bank profits – the courts will inevitably foul up anything remotely hasty. The unwinding of Lehman still rumbles on with international squabbles over jurisdiction delaying the process. Somehow I doubt whether we could feasibly wind Citicorp up over a weekend even with the best bankruptcy laws in place. Besides the problem is not simply winding up a bankrupt bank, it extends deeply into allowing the markets to digest and value the bits of the bank being wound up. And a mega bank has, by definition, a huge share of the market, which begs the question: who would buy all that stuff? Would we have to resort, as we just did, to forcing a Merrill sized chunk down the throat of an unwilling Bank of America? If so, what have we gained?

There is nothing easy about a mega bank bankruptcy. No matter what the law; no matter what detail its ‘living will ‘ has; and no matter how well oiled the regulatory framework for the bankruptcy may be: at the end of the day we will have to have buyers for the assets. The most eligible buyers would be … the other mega banks. Who would then become super-mega banks and we would immediately compound our original problem. The other alternative would be for the government to own some of the assets itself, but we shied away from nationalization before and are unlikely to go that way in the future.A third course of action would be to break up the failed bank and sell it off as stand alone entities to private investors. But … ummm … both Bernanke and Wolf don’t think breaking up the banks is a good idea.

Unless, apparently, when the bank in question is bankrupt. In which case: I can think of a couple of large banks that fit that category last year. And what did we do? Nothing.

Which brings me back to breaking up the banks.

I am all for all of Wolf’s suggestions. I think they’re dandy. We need to impose them on the newly broken up smaller banks. That way these new banks will have strong incentives not to get too big. That would be great wouldn’t it? A whole bunch of smaller, highly capitalized, safer, and competitive banks. More choice for consumers and businesses. More safety and soundness. A capitalist dream. Who doesn’t want that?

Well Bernanke.

The key insight into his position is when he argues that one reason we don’t want to break up the banks is so that we can preserve value for the financial sector. Wow. Our regulatory regime has to be cognizant of the shareholder value of the banks? It has to preserve that value? I think Bernanke has his proverbial knickers in a twist here. Tightly too. Silly me. I thought the object of the regulators was to preserve safety and soundness – the public part of the banking system. In technical economic parlance the safety and soundness of banking is a ‘public good’. That means it belongs to all of us since we benefit from it. That public good provides us with a motivation to preserve it. It has value to us. Hence our willingness to bail banks out and to regulate them. The ‘private good’ in banking – the profits that go to the shareholders – is of no consequence to us. That’s the private investor’s problem. That’s why they have Boards of Directors. The Board oversees the protection of the private goods. The regulators oversee the protection of only the public goods.

Duh.

Economics 101.

Obviously not at Princeton.

Actually Bernanke’s startling comment gives us an insight into why the Fed – and the Treasury – has been so soft so far in imposing an new regulatory regime – they think like Wall Street. They act tough: Paulson’s hard ball tactics late last year being an instance. But now that things have calmed down they are back to being obsequious. I find it astonishing, and dismaying, that Bernanke has anything but a tangental interest in bank values: capital yes, market value no.

When all is said and done I just don’t see a viable alternative to break up. Everything else can be worked around. Besides, as I mentioned above, all those other methods for controlling the banks are great additions to the break up process.

Let’s have both.

The banks proved to the world that they were a combustible mix of incompetence and venality. There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.

Break them up.

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Moral Hazard and Banking

What an odd day. Clearly all our statisticians are at the beach because there is no data release of any kind today. So we can all take a break from the stress of trying to figure out what the entrails mean and relax a little.

But wait.

The immediate danger of depression is behind us, and the recession is ending – it may already have ended – so now is a good time to begin the inquest and strategize over how to avoid a repeat of the ‘Great Recession’.

Let me begin by saying that I doubt we will avoid recessions. They are an inevitable part of the exuberance of capitalism. The Keynes/Minsky vision seems to be correct: confidence builds as growth is sustained; people inevitably become greedy and over-extend; eventually this over-extension leads to implosion and a cathartic cleansing of illusory wealth. Only for the cycle to begin again. This cyclicality matches up well with what Schumpeter saw as ‘gales of destruction’ being immanent within the capitalist system.

One of the illusions we have just had dispelled was that of academic economists. They thought their orthodox theory had developed such refinement that we could moderate and avoid severe cycles. And I know of very few mainstream economists who imagines otherwise: there was a general sense of self-satisfaction within the profession that we had the theories and tools to fend off major bumps in growth. The evidence of the past thirty years seemed to back that notion up. All that was needed, the orthodox argued, was to clean up the details.

Some details.

“The best way to contain the evils of moral hazard is to make it personal.”

It now turns out that Keynes and his followers were exactly correct: markets are inherently fallible. This fallibility stems from the natural, residual, uncertainty that is a permanent property of our world. There is nothing we can do to eliminate it. All we can hope for is to box it in and translate it into manageable risks.

And on the front lines of uncertainty we find the banks.

So as we set out to rebuild the dykes we must focus on the banking system.

Lost in all the hubbub over health care is the fact that we are facing a large scale overhaul of the way in which we regulate banking. In many ways this is the most important reform being discussed in Washington – failure to reform the banks will accelerate our momentum towards the next recession.

We all now know far too much about banking: the headlines of late 2008 were replete with bank failures and collapses, bail-outs and bonus scandals. A certain banking fatigue set in and it was with a sigh of relief that the big banks seemed to have survived and then passed the stress tests organized by the Treasury earlier this year.

Not so fast.

Those self-same banks are right back at it. Even a cursory look at recent bank activities suggests that their behavior is little changed. Yes leverage [the ration of total assets to capital] is way down from the ridiculous and unsustainable levels that brought about the implosion, but there is absolutely no evidence that they would not pump themselves back up once the economy gets under way.

The biggest obstacle to getting a sound banking system is moral hazard. This is the idea that someone – a bank in this case – can undertake an otherwise excessively risky course of action because they are aware, a priori, that they will be saved from the consequences of that action.

Banking is rife with moral hazard. In fact it is the poster child for the concept.

As long as regulators, the government, and ultimately the taxpayer are viewed as a credible back-stop to the reckless speculation, gambling, trading of the big banks they have no incentive to rein in the yahoos who inhabit their trading desks.

And the problem is that these folks are really clever yahoos.

They have figured out that they can undertake inordinate risks without compunction because they will never have to face the consequences. The individual traders have every reason to go beyond the limits of reason because their bonus structure pays them on short term profits not long term profits. So a gain of $1 million today produces a nice bonus which is not subject to reduction when that gain turns into a $100 million loss a year from now. The traders and bankers keep their bonuses whatever the future reversal of fortune may be.

This is why the crisis did not produce many bankruptcies amongst the banker elite: their cash was already stashed away when the bottom fell out of their scams trades.

You and I were not so fortunate.

Nor are the shareholders driven to avoid the same risks. Stock prices are intensely related to short term profits. So a shareholder can sell a holding once the stock has run up in price, no matter how illusory the profits are upon which that price is based.

Then, when the collapse comes, the shareholders simply turn to the taxpayer and expect to be bailed out – after all bank ‘A’ is simply too big to fail.

So moral hazard has the perverse effect of turning the yahoo, French cuff crowd on Wall Street, that epicenter of capitalist cheerleading, into a bunch of socialists.

They loot the banks for private gain and then leave the corpse for us to revive. More to the point: they have the gall to expect to be allowed to do this. They get all hissy when someone points out their utter incompetence and they counter by claiming we don’t understand banking – filled as it is with jargon and abstract modeling nowadays.

My position is that any industry that loses as much as banking did, and destroys as much wealth along with it, and then requires life support from the public, has little room for hubris.

Bankers are the ones, based upon their demonstrated performance, who don’t understand banking. Unless, that is, your definition of banking is a scheme to bilk the public of a fortune before retiring to the Hamptons/Connecticut/Park Avenue.

These people are the world’s richest socialists. Even the hey day of the Politburo failed to match this crowd for the looting and personal aggrandizement rife on Wall Street.

So, as we turn our attention to bank reform we need to engineer a way to remove these guys from our payroll. They cost too much. Next time they gamble it has to be with their own money. And if they need our cash for help some of them have to go bankrupt before we pay up.

Eliminating moral hazard is easier said than done however. Banks are central to the economy. That’s why they get away with the games they do.

So to attack them we need to target carefully. We may not be able to eliminate moral hazard but we can make it really painful for these dangerous people to rob us again.

We can make them put up more capital. Perhaps a part of the capital base has to be contributed by the trader/managers of the bank. Perhaps the top paid folks only get capital shares and not cash. Irredeemable shares for some period – say ten years. Force them to have skin in the game sufficient to make them think twice about risk. We need to send Goldman Sachs back to the days of real partnership, not this faux, quasi socialist, partnership that they revel in today. Partners should lose every cent – yes even the Hamptons cottage – they own before the taxpayer puts up a dime.

Then we can also penalize banks that get too big: force them to double the capital set aside for all assets over a certain size. Heck triple it. Do something to stop these behemoths swamping us.

Next: they should write ‘living wills’. One of the big problems today is the web of hiding places that banks syphon off their money into so they can avoid taxes. Their corporate structures are impenetrable. This was one of the main reasons no one wanted AIG to go belly up: no one had a clue where all the money was and what the consequences would be. A corporate living will would remedy this: it is a blueprint for bankruptcy. Once in place living wills vastly reduce the risks of a bank failure. As such they reduce the ability of a bank to force us to pay for its folly.

I would go further and break up the big banks, but that isn’t too popular. No one nowadays has the fortitude of Teddy Roosevelt we are all too beholden to corporate America. Oh well.

Lastly: the banks who get embroiled in the Byzantine labyrinths of derivative trades, cross-trades, swaps, swaps of swap, trades of cross swapped trades and so on, all of which has now been shown to add to rather than subtract from risk, should be penalized via extra capital requirements. make them pay for playing these games. The entire derivatives market needs a good dose of reality: hedging makes a ton of sense for a mid-west farmer trying to organize his/her cash flow. But the rest of the entire market is useless: it merely is a way to generate fees for lawyers, bankers, and accountants, none of whom, apparently, have a clue about the consequences of their actions.

Need I remind you of my bete noir: credit default swaps on US bonds? The insanity inherent in that transaction beggars belief.

So make them pay.

They should put up extra capital against derivatives. And the traders should have their pay linked directly to the successful unwinding of the deals. If the deal goes bad, the trader goes bankrupt. Simple. Clean. Effective.

The best way to contain the evils of moral hazard is to make it personal.

And until we drain the banking system of moral hazard we can be assured we are headed back into another bubble and thence into another recession.

That’s why bank reform is important.

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The Citibank Fudge

This is why you should not believe a word a banker tells you. Alternatively, bankers seem all to aspire to careers as illusionists. Today we are told that Citibank has reached an agreement with the government to convert most of the preferred stock the government acquired when it saved the bank fro collapse. The conversion is into equity. As a result Citibank has $58 billion of shiny new equity sitting on its balance sheet and we, the taxpayers, are now proud owners of about 36% of the bank.

I feel richer, don’t you? And Citi is now powering itself out of trouble. No?

“Sleight of hand accounting tricks do nothing to clear the air, improve the bank’s position, or resolve the policy issues surrounding our need for sources of credit to help sustain an economic recovery.”

Vikram Pandit the failed CEO of the bank blathers on in his press release about how the deal instantly makes Citi one of the world’s best capitalized banks.

Ummm.

Let’s take a breath here and try to ignore the obfuscation. Just how much new capital was infused into the bank via this deal?

None. That’s how much.

This was a switch of book entries. Preferred stock was eliminated and equity took it’s place. Here’s the magic: equity sits at the bottom of the balance sheet, while preferred stock sits a little bit higher up. Both count in the regulator’s calculation of ‘Tier 1’ capital. But, and this is the trick, only equity falls into the bucket known as ‘Tangible Common Equity’ [‘TCE’]. So if your standard for a bank’s capital strength focuses on TCE, Citi appears suddenly to be a whole lot stronger. Hence Pandit’s silly comment. But if you look at broader measures of capitalization, at Tier 1 capital for instance, not much has changed.

There is no new cash. No new capital. This is an accounting change not an economic one. It is trickery. The kind of balance sheet shiftiness that helped cause the economic crisis in the first place. As long as banks lie about the substance of their balance sheets with such abandon and apparent earnest nothing will be done to produce an actual fix of the mess they are in.

In order for the trick to work you need a compliant audience willing to go along. We have that too: our regulators have shifted their attention, right on cue, to TCE. Tier 1 is so yesterday. That they all huffed over it for the best part of two decades is neither here nor there. TCE is ‘in’. The shift in emphasis means we don’t have to annoy the poor banks any more. And we don’t have to do nasty things like pressure them into bolstering Tier 1 capital ratios. Apparently TCE is ‘better’ quality capital, untainted by things like the terms and conditions usually attached to preferred stock. Quite right. I agree with that. Which is why I wondered about the original capital infusion. Why didn’t we taxpayers take an equity stake right up front.

Oh wait. I know why. The amount of cash we handed over would have meant we nationalized the bank: Citi’s stock price was so terrible at the time that the same pile of cash would have bought practically the whole lot, rather than the paltry 36% we now get. So part of the trick turns out to be that the regulators had to be willing to get less in return. They had to bide their time and convert our preferred into equity only after it was clear we wouldn’t … well you know … own the bank. We don’t want to do that. So we provide capital in the form of preferred which sits in Tier 1. That makes the bank stronger in reality since it has more cash. the market loves that. It drives the stock price back from oblivion and up to about $3 a share. Now at $3 a share our cash only buys 36% not 100%. Blushes and embarrassments are saved all around. the only remaining trickery is to make it look like the conversion is a major step along the road to rehabilitation of Citi. that’s where Pandit’s stupid comments come in.

Voila! The administration avoids nationalization by accepting less for its investment. And Pandit looks heroic for adding ‘quality’ capital.

Oh, the wonders of bookkeeping.

Other banks have raised real capital recently. They got cash. That’s a real economic improvement. At least they are being more honest about resolving the disaster they wrought on us.

But this news from Citi demonstrates just how far we are from having transparent and honest discussions when it comes to the truly weak banks. We, and by this I mean the administration, the regulators, the media, and the bank managers, just do not seem able or willing to acknowledge that some of our largest banks are still in dire condition. Sleight of hand accounting tricks do nothing to clear the air, improve the bank’s position, or resolve the policy issues surrounding our need for sources of credit to help sustain an economic recovery.

We cannot heal ourselves if the players in the game keep bending the rules so they don’t have to take tough decisions.

Or do simple things: like telling us taxpayers the truth.

The next thing you know they’ll be paying us back the TARP cash with our own money. I wouldn’t put it past them.

Addendum, 3:45 p.m. June 10:

Hidden in the weeds of today’s Citigroup announcement is a ‘poison pill’ clause. This seems to be an explicit acknowledgement that the bank could be a take over target, or maybe subject to fun and games speculating by hedge funds. The clause allows shareholders to double their holdings at half market price if someone who owns over 5% of the outstanding stock adds to that holding. The idea being to stop anyone new accumulating over 5% and stopping those currently with over 5% from adding more. They would be stopped because their efforts to accumulate would trigger a flood of new shares being issued and hence diluting all existing holdings – the effort would be be pointless.

This is an odd poison pill though because the real cause for concern appears to be the tax law. The IRS will prevent a company with highly concentrated ownership from fully using tax loss carry forwards. Since Citi has managed to lose a pot load of money is would want to avoid falling prey to that IRS ruling. It wants to use its tax losses to generate after tax income and thereby augment capital. Hence the stop on accumulation. The IRS defines concentration as a company where over 50% of all the shares are owned by people with more than 5% each. The Citi clause, which went into effect today, doesn’t include the government.

That’s good because we may need to give them more cash sometime and it would be awkward if an internal clause stopped us.

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The Results Are In!

And the winner is? Well that depends on your point of view. The early winners seem to be Goldman Sachs and JP Morgan Chase who flew through the tests with flying colors. The losers include Bank of America and Wells Fargo, the latter of whom must be particularly peeved having been lauded by no less an authority than Warren Buffet just a few days ago. Following up the rear is GMAC who seems to be the only tested bank who pulled the equivalent of an ‘F’.

So. Now what?

The banks that have been told to get capital have until June 8th to present a plan showing how they intend to do so. They then have until November 9th to raise the cash.

What if they don’t? We’ll see about that later.

Now that the whole charade is over and the dust settles what have we learned?

The tests indicate that the Treasury Department expects this group of banks to suffer a further $600 billion in loan losses through the rest of this credit cycle. Those losses are expected to stem from such things as the effects of rising unemployment and the ‘normal’ cycle in commercial real estate. This estimate is on the low side. Other organizations, most notably the IMF have forecast losses much worse than this.

In part the difference between the IMF and the Treasury may flow from the fact that the Treasury allowed the banks to do the predicting by using the banks own risk assessment models. This involvement of the banks would naturally skew the expected losses down. After all these are the same risk models that helped create the mess in the first place.

As you know I have been highly critical and skeptical of the entire testing process. I find it odd that the banks were involved so deeply in the process – it sounds more like a self-assessment than a rigorous audit. And the fact that they were negotiating the results seems just absurd. These two factors fed my naturally cynical nature, and resulted in my conclusion that the tests were run as a ‘misdirection’ play to make it seem as if we were facing the banking crisis rather than actually doing anything about it.

Be that as it may.

The tests are now done and we must all face the new reality.

So the discussion now shifts to the next few months and the consequences of the testing process.

Are the banks safer?

Well not yet. Some like Goldman and JP Morgan Chase are already chaffing at the bit to repay TARP money so that they can get on with their business without government interference. I don’t blame them. We should all recall that the banking landscape has been re-written over the past few months. There are far fewer major players and some of those left standing are ineffective players at the moment. I can imagine the guys at the healthy banks want to get stuck into the game: they will make hay over the near tern while their weak competitors do lazy eights as they raise capital. Expect profits to rise sharply among the healthy. Not only is the competitive landscape ripe for profit making, but loan spreads are high, the yield curve has been twisted in favor of lenders, and cheap government bailout money is lowering the cost of doing business. In short if you are a ‘healthy’ bank things are truly looking up. The government is doing all it can to give those banks a leg up.

Meanwhile: the weak banks will wallow around. Their spreads and so on will also improve. So their profits will be better. Loan losses will cripple any efforts to expand lending, but that has become secondary. Public policy, which at the start of this crisis was focused on getting lending going again, is now more focused on keeping the weak banks alive long enough that they can thrive on their own. The second objective is to keep the out of pocket cost to taxpayers as low as possible.

An interesting problem may emerge later in the year when, and if, one of the weak banks fails to raise the capital the government has ordered it to. Right now the Treasury Department is indicating that it will forcibly inject more capital at that point. I doubt it. One of the administration’s goals in the test process was to punt the problem forward. By November with banking conditions slightly improved and the economy gradually rising from recession, both of which are certainly possible, the politically smart move would be to punt again. Since the administration seems to have been driven by politics rather than economics so far I would bet on another punt.

Plus I expect lost of discussion to surround that part of a bank’s capital called Tangible Common Equity [‘TCE’]. As I have said here many times that ratio can be fixed more easily than broader measures of capital such as Tier 1 Capital. Geithner has been hugely successful in switching our attention to TCE so there is no reason to change now.

One of my yardsticks for the testing process would have been the level of howls from the industry. Normally a strict audit will elicit predictions of dire consequences and imminent disaster. So far the reaction has been more one of confusion. The stock market has bid up then bid down the stocks of the weak banks, largely due to the flood of rumors we have suffered through. Now that the facts are before us the market should settle down. I would expect banks that are deemed healthy to attract investors, while those who are weak will have a harder time raising private funds: who would want to invest in an organization that the government has on life support? So an outcome of the testing is that the weaker banks, who need to find capital, may find it harder to do just that. The best avenue for capital growth will then be from the sale of subsidiaries and lines of business. Look for hedge funds and private equity funds as well as the healthy banks to attempt to bulk up by acquiring bits of their weaker competitors.

This really is a case of the rich getting richer and the poor getting poorer.

In the end I am glad the process is over. I am sure you are too, given all my venting over it.

But the concerns remain. We should be leery of declarations of success. The second wave of losses is coming, and the structure of banking remains the same. If anything there are some too big to fail banks that will now be much bigger.

Saving banks is one thing. Fixing them so they can’t screw us all up again is another.

So I will leave you with this:

My concern has always been with the structure of the industry: it needs to be reined in so that we are not exposed to its excesses again. As I watched the administration deal with the immediate issue of saving the weaker banks I used it as an acid test of their ability or desire to take what I perceive to be tough action to downsize or limit the power of the industry. The stress test process leaves me highly skeptical. The government seems to be unable or unwilling to face the banks down. Whether that results from hard nosed political calculation or from simple cowardice I don’t care. The result remains the same. Until the banking industry is severely restricted and its major players reduced so that they can fail without destroying everything around them our economy remains at risk: from the undue influence of financiers and from the very high prospect of another asset bubble resulting from easy credit.

So my confidence is high that the banks will be saved. And it is low that they will be fixed.

Too bad.

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It’s Stress Test Eve … Oh Fun

I can hardly wait. After what seems like months of talk, leaks, and rumor we have finally arrived at what should have been a decisive moment in our economic crisis. Tomorrow is the day that the administration is going to release the results of its now infamous stress tests on our major banks. I say ‘should have been’ because there doesn’t appear to be much mystery left, and the leaks and rumors have taken the sting from any news the Treasury Department will convey to us.

As you know I think all those leaks were designed exactly to distract us. They were a series of trial balloons floated by the administration to determine what the stock market thought was a reasonable outcome. Too much of a shortfall for the weak banks and a panicked sell-off may have been triggered. Too little and the market would simply have laughed at the evidently rigged results.

The problem the government had, and still has, is that the tests have no real credibility. Since we all knew that they couldn’t afford to go back to Congress for more money the tests had to end up with only small amounts of capital being required. On the other hand the test had to look as if they were serious, so there had to be some relative ‘failures’. Then again those failures could not be so big that the test results precipitated a run on the banks in question, something that would have then meant the government had to step in actively.

So, having committed to doing the tests, which it did to demonstrate its determination to solve the banking crisis, the government had to ensure they were useless.

Which it has done admirably.

Such is the effectiveness of the confusion spread throughout the market and the media by the incessant leaking of tidbits of information that no one is quite sure what to make of the real news when it arrives tomorrow.

All we know is that there are no failures in these tests.

Which is shocking given the awful state that some of the banks are in.

The entire administration strategy has been constructed around the belief that if the banks are given enough time they will heal themselves without the need for any serious intervention from the government. By intervention I mean forced re-organization in the way the FDIC has already cured the problems of thirty-six small banks across the country so far in 2009.

The effort the administration has made to protect the banks from the results of their own mistakes is enormous. They have shifted the regulatory emphasis from Tier 1 capital ratios to Tangible Common Equity [‘TCE’], which all the leaks refer to as the ‘better’ gauge of bank strength despite years of official focus on Tier 1. Why the shift of focus? Because you can fix TCE simply by converting preferred stock, which doesn’t count as TCE, into common equity, which does. So by changing the regulatory focus the government made it much easier to fix any problems it may then have identified in the tests. And, just by chance no doubt, the most troubled banks are those with tons of government preferred stock sitting just waiting to be converted.

How convenient.

The hope is that as the economy recovers later this year and with the yield curvesharply sloping upward[the difference between short term and long term rates is called the ‘yield curve’], thanks to the aggressive activity of the Federal Reserve Board, bank earnings will grow sufficiently to restore capital to decent levels.

Presumably this assumes that the banks will not be lending too much since that would have the effect of using the capital to support growth rather than to re-establish acceptable ratios against the old book of business.

Larry Summers keeps beating the drum that all the banks need is time. The stress tests were set up to distract us from the real ailments of the banks, and to consume time. They have succeeded brilliantly.

But our banking problems remain.

Just to demonstrate my point here are a couple of articles, both of which tow the party line.

First the Financial Times. Here’s the giveaway statement:

  • “People close to the situation expect Citi to have to raise less than $10bn in extra capital, and possibly as little as $6bn, through the expansion of its planned conversion of preferred shares.”

This comes after the initial paragraph lets us know that Citi is deemed to be $50 billion short – a figure that looks about right given the mess its in. So a $50 billion shortfall becomes an easily manageable $10 billion. How? the conversion sleight of hand and the new focus on TCE. Were we still in the old days of Tier 1, e.g. as recently as January, then that $50 billion would still be $50 billion and Citi would be sucking wind.

The second comes from this article in today’s New York Times. In reference to Bank of America’s expected $33.9 billion shortfall the article says this:

  • “It could satisfy regulators‰Ûª demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock.”

Cased closed.

Both papers commit the error of thinking that conversions of preferred stock into common equity fix capital problems.

Obviously the government has won the propaganda war. It has no intention of dealing with our weak banks, other than to try to buy them time.

This does not bode well for a strong recovery.

But, hey: it’s Stress Test Eve! Have fun everyone.

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