Bronte Capital:

Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.

Le Citi Toujours Dormer…
Why oh why can’t we have a better press corps? Eric Dash and Julie Creswell write that:

Citigroup had poor risk controls.

As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.

They weren’t.
And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: “Huh?” How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don’t answer that question. They don’t even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said “wait a minute! this doesn’t add up!” is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.

I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage. It is simply about the question “do we trust them to repay their debts”. You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay. Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed. All estimates are a shot in the dark. In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout. It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either. So Citigroup was always a “trust us” thing and now we do not trust.

The long answer has to be a replay of the various themes of this blog. So lets do it in pieces.

1). The losses in the banking system in America are not unmanageably large. Anyone that tells you otherwise just hasn’t done the maths (and that is most people). I have written this idea uphere… and nobody yet has an adequate response though Mark Thoma has tried and even Kevin Drum on the Mother Jones blog has commented on it.

One offender not doing the maths is (very surprisingly) Paul Krugman – although his last post in which he blamed lack of capital for the crisis was March – so maybe he has done some maths since. Krugman usually does the maths and is spot-on in his analysis of Fannie and Freddie. I am usually an unabashed fan of the Shrill Professor – so his various diagonoses leave me perplexed.

2). The problem with the banking system is that it is structurally short of stable funding. America has a loan to deposit ratio that is collectively well above 100. So does the UK, Iceland, the Baltics and most of Eastern Europe, Australia and New Zealand. This means that collectively the banks need an awful lot of wholesale funding.

Japanese banks fizzle, they make no profit – but they do not collapse. Why? Because they are structurally long finance. Agricultural Bank of China (the notorious ABC) is deeply desperately insolvent – but it is still here. Why?

Because it is long funding. Generally it is banks in current account deficit countries that are vulnerable. The main German bank that collapsed (Hypo Realestate) had two large businesses with no deposit base. It was the bank in a current account surplus country that collapsed – the exception that proved the rule. [There is an issue with banks with life insurance subsidiaries in current account surplus countries. They are vulnerable but for completely different reasons – the subject of another blog post – a long time into the future...]

3). The crisis will end when people are convinced to roll the wholesale funding. Government policy that brings us closer to that point is probably effective. Government policy that does not bring us closer to that point is almost certainly ineffective. Policy that takes us further from that point is counter-productive. My case examples of counter-productive policies are the confiscation of the rights of the debt holders of Washington Mutual, and the pointed refusal to issue government guarantees even when it is utterly obvious that the government is on the line (as in Fannie Mae and Feddie Mac). The confiscation of Washington Mutual convinced bond holders that their positions would be compromised by government fiat and with little notice. As I have posted many times I thought that was reckless and that Sheila Bair should resign. The refusal to guarantee Fannie Mae and Freddie Mac at this point looks like sheer stubbornness but I think is driven as much as anything by government accounting concerns – a full guarantee means the assets and (more importantly) liabilities get bought onto the government balance sheet.

The cause of the crisis

This is a wholesale funding crisis and the cause of the crisis is plain. It is lies told by financial institutions. Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap. They sold it to people who provide wholesale funding.

Now they need to roll their own debt. The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs. They no longer believe. It is “fool me once, shame on me, fool me twice, shame on you”. As I have put it the lies that destroyed Bear Stearns were not told by short sellers. They were told by Bear Stearns.

Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him. In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold. The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them. When they tell the truth now, nobody will listen.

Robert Rubin racks his brain about how he would have done things differently. Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth. The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup. Even Robert Rubin. In a world where Berkshire credit default swaps are going skyward because people do not believe that Warren Buffett has no collateral requirement Robert Rubin’s reputation ain’t going to count for much.

Anyway given that the crisis is a wholesale funding crisis we need to do something to make the people who provide wholesale funds happy.

What of course would make the people who provide the funding happy is a plausible government guarantee. Iceland couldn’t provide one because its banking sector was ten times GDP. But the US probably could.

The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt. The problem of course is that is hugely risky for the taxpayer. My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside. That is full nationalisation. The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it. That is fine. Take the risk – make a profit – it’s the capitalist way. Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario. Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government. In a full nationalisation I see no reason for Sheila Bair to resign. (Her tenure in that position would not threaten the financial system.)

I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis. But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc). Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit. It would not be the first time – Norway made such a profit.

But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system. Indeed they are determined it seems not to control financial institutions. If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG.

A cost effective TARP

What however is required is something that convinces the funders that the banks are solvent at the least possible cost to the Treasury. Now my view is that if the treasury guarantees (and hence takes the risk) it should own. That is a view in favour of nationalisation, but as that is not on the table let’s do the next best thing. Suppose the Treasury takes the “fat tail only”. Then the banks are solvent. Imagine for instance if the treasury agreed to capture the losses at Citigroup above say $90billion. Why did I chose 90 billion – well – it is the stated capital of Citigroup.

As Citigroup has at least its net worth guaranteed then Citgroup is solvent. Funding should come back.

Note that excess of loss insurance policies are almost certainly the cheapest way in which to guarantee banks. The reason of course is that you take on only the losses you need to take on. However you leave the upside with the banks.

The Federal Government should logically charge for the excess of loss policy. There will be some banks with very big losses that will claim on it – and so there will be losses recognised even if the system is solvent. My rule – which is a little arbitrary – the government should take 20% of the equity of all institutions that want to buy an excess of loss policy. I figure in five years time selling the equity should pay most government losses.

To be precise the excess of loss policies should not be for 100% of losses beyond an attachment. In reality the government should guarantee only 90% of the losses beyond the attachment. The reason for that is when the attachment point is hit you want the bank in question to have an incentive (be it 10% of recoveries) to actively mitigate the losses. A better incentive is also to have the losses covered by the government – but with the government receiving equity in the institution dollar for dollar for the losses covered. This will still mean that institutions are nationalised – precisely those with the biggest losses. [The equity grant to the government for covering the losses will punish institutions that have to claim and will help mitigate government losses from the scheme…]

Mr Paulson seems however to be wanting to give government money inefficiently to financial way too cheap. The bailout of Citigroup is a case in point. They gave a capital injection (subordinated debt) for which they charged the princely sum of 8 percent. Hey – that was what bank preferred stock yielded in 2006 – and way below the fair value of such money now. Then they just guarantee 300 billion of assets – admittedly subject to an excess of loss rule (above 40 billion). This excess of loss threshhold is way too low. It could be 80 billion and Citigroup would remain solvent. Then the government also did not take anything like a large enough equity stake in Citigroup even though Citigroup would have willingly handed one over. Why not? Because they play fast-and-loose with taxpayer resources.

That said – the excess of loss policy is the right idea and for that (and for once) I applaud Mr Paulson. This is the first bailout I have seen with a decent design.

Now as for Sheila Bair. Her takeover of Washington Mutual and the subsequent collapse in Wachovia is perhaps the most glaring example of abusing the bank intermediate creditors this cycle. She should resign for it – and the intermediate creditors will not be comfortable until she takes the fall. But, and you will sense me relenting a little here, if the deal is that the government writes excess of loss policies on a grand scale her continued tenure in the job doesn’t actually threaten the financial system. But until then she is the symbol of the risks faced by the providers of intermediate finance. Absent a comprehensive solution as outlined here she should resign. With a comprehensive solution her position is neutered – and she can stay in it without risk. If she is driver for a comprehensive solution then I will forgive her staying around – but at the moment she seems far more concerned with modifying mortgage terms – that is about first loss. An efficient comprehensive solution is about excess of loss – and she isn’t playing that ballgame.

John Hempton

Category: Blog Spotlight, BP Cafe

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “How to Design a Bailout That Works”

  1. DavidB says:

    Here is an idea that I have been hashing out in my head. Let’s see if I can get it out clearly enough to get a few marbles rolling on the board:

    What the government should do is allow the banks and homeowners to write down the amount of the mortgages that makes the borrowers solvent again and able to pay the loans. There are a few incentives in this so bear with me.

    How this would work is the government would guarantee the difference between the current cost of the loan and the amount the bank and the borrower agrees to write the loan down. The amount of the writedown will be decided between the bank and the homeowner. They will basically do a redo of the application to make sure the person can actually pay their mortgage this time.


    1. In order to make sure the bank does not try to write down a larger chunk of money than normal, they can only write down the difference as a loss on their books that they can carry forward on future taxes. This will give them the incentive to write down as little as possible in order to get as much of a monthly payment as possible from the borrower.

    2. The borrower will not be able to sell the house and collect more than the new loan is worth with one exception. This is the difficult part so I hope this comes through clearly. In order to get the borrower to hold on to the house and rebuild equity every dollar that the house is sold for above the new loan value goes back to paying off the difference that the government has guaranteed. Only if the value goes above the original loan cost can the borrower earn those dollars. This will make sure the person holds onto the house in order to build equity in it. Now here is an example:

    -Lets say the original loan value is 100K

    -The borrower and the bank come to an agreement to write the value of the loan down to 80K based on the borrowers ability to pay

    -The Feds guarantee the 20K difference and the bank writes down the 20K difference as a loss against their taxes never to be recovered

    -In a short time, the value of the house rises to 90K and the borrower having built 5K of equity payments into it decides to sell

    -The borrower is allowed to pocket the 80K which is the original cost of the new loan. They make the 5K equity difference that they built in between 75K and 80K. The Feds pocket the difference between 90K and 80K or 10K and they end up with a 10K loss on the original difference they guaranteed.

    -This gives the borrower the incentive not to sell the house because the government pockets the difference and they are no further ahead

    - Let’s assume that the house instead goes to 110K in value and the borrower decides to sell. What happens? The borrower gets their 80K. The government gets paid back the 20K that they guaranteed and the borrower gets the extra 10K that the house gained in value on top of the original value of the 100K loan. This provides an incentive for the homeowner to sell when the market recovers and ensures that the feds get the full value of their guarantee back minus inflation. It keeps the borrower in the house and making payments and it minimizes the amount the Feds need to guarantee. It saves the bank a ton of money in foreclosure and gets their cash flowing again

  2. dwkunkel says:

    DavidB – Your suggestion makes so much sense that’s it almost guaranteed to never be considered by the bailout mavens.

  3. Simon says:

    Davidb – Gets my vote to.

  4. Ed Sanders says:

    I would not for one moment claim to understand the banking system better than Mr. Hempton. I do however understand language, and I think if he read his own excellent analysis he might see his one fundamental error.

    This statement:

    In reality all that is needed is more trust.

    is precisely and 100 percent incorrect. It is not trust that is needed, but trustworthiness. That is what is missing from the current situation, and it is laid out as plain as day by Mr. Hempton:

    … nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either.

    I spent enough years in the newspaper business to know that when someone can’t provide a reasonable explanation of how something works, they don’t know. You can’t buy a meal from a chef who can’t tell you what’s in your dinner and you can’t buy securities from a guy who can’t tell you where the money is coming from.