The Great US Banking Crisis is entering Phase III. In Phase I, triggered by the collapse of Lehman and the botched rescue of AIG in September, most major banks faced a dramatic collapse of creditor confidence. The phase was ended partly by bank recapitalizations using government money on October 13, but largely by massive credit lines from the Federal Reserve. Any US bank with a household name became too big to fail.
Nevertheless, a Phase II broke out just before Thanksgiving, in which the equity price of Citigroup sank inexorably toward zero. Such an equity collapse is a silent killer of banks-just as deadly as a collapse of creditor confidence, because the view forms that a bank is not sound. This creates unattractive counterparties in the payments system (in which letters of credit and the willingness to take counterparty risk are essential) and will cause any uninsured depositors, such as corporates, to shift into Treasuries and other government-backed paper. Even insured depositors edge for the doors. Phase II was ended only by a large and very generous additional government infusion of Troubled Assets Relief Program (TARP) money on November 23, as well as a combined TARP-FDIC-Federal Reserve guarantee for $300 billion of Citigroup assets.
The fundamental problem is no longer a liquidity crisis centered on specific classes of assets (primarily mortgage-backed CDOs), but a solvency crisis that spans the entire range of bank assets.
Phase III is a repeat of Phase II, but now the market is worried about Bank of America as well as Citigroup. Citi's total value (market capitalization) on Wednesday was around $25 billion, despite a balance sheet that-properly measured-is at least $2.5 trillion. The additional support discussed in the press for Bank of America's purchase of Merrill Lynch is a further sign that the crisis is deep and hard to eradicate. These problems are appearing against a backdrop of a steep decline in global economic activity, suggesting that other major banks will run into similar problems. The fundamental problem is no longer a liquidity crisis centered on specific classes of assets (primarily mortgage-backed CDOs), but a solvency crisis that spans the entire range of bank assets. Even J.P. Morgan Chase (the third in the new "Big 3?) has seen its share price fall sharply since the start of the New Year, and concerns over the financial system further threaten credit markets and payments systems. We should anticipate that even the best-managed banks may not be able to weather this storm.
A broad, systemic solution for the banking problem, which specifies exactly what the US government will do-with the full support of Congress-would remove a major uncertainty hanging over the real economy and help clarify everyone's economic prospects. This is particularly important now since investors and businesses are not sure how the Obama administration and the newly elected Congress will change policies. The damage caused by unclear and volatile policy changes at the Treasury over the last several months needs to be put behind us. A broad, long-lasting, systemic solution will not necessarily or immediately start banks lending again, but at least it will remove a major roadblock to growth and provide the policy clarity that is necessary for businesses, investors, and households to plan.
The problem now is politics. The goodwill and confidence of Congress with regard to the outgoing Administration's efforts is basically nil. The new administration has not yet put its bank strategy cards on the table, presumably because they were hoping to have a bit more time for preparation (and the second round of TARP money is not yet available). But key banks are in trouble now, and a decisive program of action needs to be drafted and communicated within a week. What should the Obama administration do, and with how much money?
In economic terms, the following principles would make sense:
- We need a very large, aggressive recapitalization of banks that lays to rest any concern about their capital positions.
- For those assets where there is large uncertainty about pricing, we should ideally remove them from the balance sheets of banks. Since we are aiming to restore trust, we really need to "eliminate" as many areas of uncertainty that can lead to insolvency as possible. This almost certainly implies creating a Resolution Trust Corporation (RTC)-type framework.
- The program must protect creditors to banks, but it can either be tough or easy on bank equity owners. If it is tough, it needs to be mandatory in order to ensure complete participation and to keep banks from free riding-each bank has an incentive to claim few problems (witness the problems at Bank of America and even J.P. Morgan, which were previously thought to be safe). If the program is easy on equity holders, banks will come in quickly when the door opens, but there may be a political backlash.
- The program needs a fixed timeframe, preferably aiming for completion within three months.
- While we refer to "banks" here, the program should cover all regulated financial institutions, including major consumer lenders, insurance, and other large players (but not hedge funds).
The best solution will be that which can garner the strongest support on Capitol Hill for large-scale action-otherwise the market will not believe in the sustainability of government funding and the entire effort will be self-defeating. Congress is moving closer to a decision on details for the second round of the TARP, and we suggest the conversation next move in the following direction:
- Create an RTC-type vehicle to buy assets with large uncertainty over value from banks. The RTC will be financed by the issue of new Treasuries-i.e., the government is issuing debt and using this to buy assets. The price the RTC pays needs to follow transparent guidelines. Independent valuation experts could be hired to value assets at market prices, and the RTC could offer to pay that price for the asset. If banks have marked the asset at a higher price on their books, the RTC could offer to inject new equity into the banks to make up the difference, so the bank's capital is not impinged, and in return receive five year warrants on common equity equal to the value of this injection. The RTC could also require the banks to give a certain value of warrants as a fee for the service. The warrants should be convertible to common equity once the RTC sells them.
- The RTC, at the time it buys assets, could also make additional direct capital injections into banks. The bank regulator would determine whether the bank needed capital, assuming a deep recession over the next few years, to ensure banks are very well capitalized under any scenario. Ideally, all banks should be required to increase capital within a specified time period (three months) and they can obtain this capital from the RTC, at market prices, if they cannot raise it privately.
- The RTC will end up having warrants controlling over 50 percent of voting shares of some banks when the warrants are converted. The RTC should aim to sell those warrants within a specified time frame. During the interim, the RTC should appoint independent directors to monitor the banks' activities, to ensure the banks' actions are consistent with maximizing the sale price of the warrants. There should be no political influence over the allocation of credit.
- The RTC should aim to raise US bank capitalization by at least $1 trillion from its current level-this could be financed through capitalizing the RTC with the $350 billion second round of TARP funds, and then giving the RTC access to the Federal Reserve window for borrowing. This is substantially higher than current estimates of what is needed and is necessary in order to give confidence that banks are well capitalized even if there are very bad economic outcomes. Since the RTC has much lower financing costs than banks, it will have an inherent advantage over banks. The potential losses for the RTC will depend on how hard the program is on banks but will be substantially less than $1 trillion, and probably less than $250 billion, if the pricing is done near to reasonable market values. If the economy recovers more quickly than anticipated, the RTC could be profitable, but this is not a goal nor is it likely.
- The program should be offered for a limited timeframe and then stopped altogether. After that date banks that have problems should fail through the usual FDIC mechanisms as before, with complete loss of equity value. This will give banks incentives to clear up their problems at once.
- The RTC should aim to hold troubled assets to maturity or until there is much greater clarity on pricing. It should aim to sell warrants where it has large voting stakes as soon as feasible. It could hold voting stakes on smaller positions for longer periods. The sales should occur in a transparent system with minimal restructuring of banks in advance. It is likely that some of these will be highly attractive, and private equity groups and funds will form to buy them. They should be given enough time to understand the opportunity, and to raise funds, prior to selling these stakes in order to maximize receipts for taxpayers. It may be worthwhile to temporarily change regulations on ownership concentration in deposit-taking institutions in order to encourage greater investor interest and rapid restructuring of banks by concentrated investors.
- If the program is tough on bank equity holders, it needs to be mandatory and cover most banks. It cannot selectively hit banks over time depending on their apparent capital positions since this would cause major disruptions in markets. A program that is tough on banks will cause bank share prices to fall sharply, but it may benefit the rest of the economy since it removes a major uncertainty in the system. If the program is not tough on banks it should clearly help markets and would not need to be mandatory (although all should be highly encouraged to participate). This is a political decision. We recommend a mandatory system that aims to get a "fair" value for tax payers. It can still provide pricing to banks which is near or even somewhat above current market valuations, since the low cost of RTC financing gives it an advantage, but there is no question that banks will resist this approach.
Last fall we saw the massive disruption that can occur when the market as a whole loses confidence in the financial sector. The repeat of such a scenario would easily outweigh all of the benefits that will be gained from the upcoming fiscal stimulus package. It is time to stop pretending that the actions taken to date have been sufficient to ensure the stability of the financial system and solve the problem once and for all.