My View on the Bailout de Jour

I appeared on Business News Network November 24,2008 to talk about how the U.S. tax payer got shafted by the deal to save Citigroup.

While there is no doubt that federal intervention was necessary, the terms of the deal were terrible for the government. The real cost is not just this deal but the precedent it sets.

View the clip

The shroud of Citigroup

It wasn't that long ago that Citigroup was considered a "good" bank.

Remember October 1, 2008? Citigroup announced it was acquiring Wachovia with the help of the FDIC. You had to be strong to do a favor to the government like that.

Citi was also a recipient of $25 billion in the first tranche of the $125 billion TARP money.

However, we know now Citi was not healthy. On Friday, Citi stock closed at $3.77 implying an approximate market cap of $19 billion  -- just a few weeks after the Treasury had injected $25 billion in capital.

This implied that the government was throwing $25 billion at something that was worth -$6 billion! It is the classic throw of good money at bad.

I am fully aware that some type of intervention was necessary. Citi falling would have created even worse chaos in markets.

But the recent injection of a further $20 billion and huge government guarantees on troubled assets is a spectacularly bad deal for the American taxpayer.

A waste of TARP

Bank of America is making a $7 billion dollar cash investment into China Construction Bank.

Bank of America received $15 billion directly from TARP and will get another $10 billion (when they close the Merrill Lynch acquisition at year end).

"Bank of America isn’t funding the purchase with proceeds from the government’s Troubled Asset Relief Program, or TARP," spokesman Scott Silvestri told Bloomberg.

It’s the old "in one pocket and out the other" trick.

Children in the candy store

The bad news keeps piling in:

• $150 billion commitment to a non-bank, AIG
• GE Capital (which is not a bank) gets FDIC Insurance backup for $139 billion
• American Express and CIT Group are now banks – I guess everyone is a bank
• Wachovia shareholders being urged to reject the Wells Fargo deal so Wachovia could apply for Treasury dough
• Hartford Financial agrees to buy Florida bank for $10 million to get access to $3.4 billion in TARP funds (now there’s a return on an investment)
• Autos looking for some loot too

It is like children in the candy store – ironically, as our economy accelerates its downward spiral.

Hurdles the new President faces

President-elect Obama wants to avoid the Herbert Hoover scenario. In this scenario, many economic initiatives are tried but fail to bring the U.S. out of recession. The high expectations are not met. The result: a single term.

Of course, there are differences. Herbert Hoover was inaugurated in March 1929. The stock market crashed in the last week of October 1929 and the economy fell into recession and depression shortly thereafter.

It is clear that the initial economic damage precedes President-elect Obama. Even though he inherits this mess, the American public fully expects a recovery during his administration. If the recovery does not happen, the Obama administration will be viewed in the same way as Hoover’s – a failure.

Who deserves to be bailed out?

I appeared on Business News Network to discuss: the missteps in implementing TARP, who should be bailed out, alternative plans to regenerate credit and the implications for the real economy.

View the clip

Bank earnings are impossible to interpret

It is earnings season and many banks will be reporting their earnings. What are we to make of these earnings? In usual circumstances, it is hard to decode earnings. Today, it is next to impossible.

By the way, why did Goldman Sachs and Morgan Stanley change their status to bank holding companies? One major factor was the flexibility they got to report their earnings.

The key to a basic understanding is FASB 115:

Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity.

This became effective on December 15, 1993.

Equity injection is not enough to get us out of this mess

The government doled out $125b of equity injection to 9 banks yesterday. It is a dramatic change from the original TARP proposal (to pay a premium price for toxic assets). I have advocated for weeks an equity injection (along with other measures).

However, there are serious problems with the government’s implementation.

1. There is no guarantee that this money gets into the credit system. Indeed, some institutions, like Morgan Stanley, might use this to reduce their risk rather than increase their lending.

2. What about the other 8,000 financial institutions? If they are healthy, they will not apply for the government equity. If they apply, people will assume they are troubled. There is a stigma effect. Hence, the government money will go to the most troubled institutions — exactly the institutions that are unlikely to use these funds to increase loans. So the multiplier effect (capital injection leads to loan creation that is a multiple of the initial injection) is muted when capital goes to troubled institutions – or borderline institutions that just want to reduce their risk.

The risk we face: AIG nationalization and other thoughts

The extraordinary risk will not be resolved by the nationalization of AIG or steps to make it easier to borrow from the Federal Reserve. We face the specter of the ‘night of the living dead scenario’ where there are hundreds if not a thousand financial institutions are operating today – but are dead if mark to market accounting was applied to their assets.

The Fed’s #1 priority right now is to reduce the probability of bank runs. If we see just one bank run, it could be contagious leading to runs on many banks. This is the nightmare scenario everyone wants to avoid.

The reason gold shot up by $90 is simple. It is flight to quality. In usual circumstances, flight to quality means that investors pile into U.S. Treasuries. Today, it is not so obvious that the U.S. Treasury bonds are risk-free.

There are two types of risk we are facing. First, there is the systemic risk of a complete breakdown of our financial structure leading to a very negative economic shock that impacts both business and consumers. Second, there is uncertainty. With this type of risk, people are unable to estimate the probability of the systemic risk – maybe its 1% probable or 50% probable – you can’t tell. With extreme uncertainty, business grinds to a halt until some of the uncertainty is resolved.

Night of the living dead

We face the specter of the ‘night of the living dead scenario’ where there are hundreds if not a thousand financial institutions are operating today – but are dead if mark to market accounting was applied to their assets.

In years to come, the real story will not be the subprime crisis or some housing bubble, it will be the spectacular failure of risk management systems in our, so-called, leading financial institutions.

Once bitten by LTCM in 1998, twice bitten by the recent crisis. How many bites does it take for firms to fix their risk management systems? You are supposed to plan for events (even if they seem remote) like the current one and have systems in place to survive – not to blow up.

The uncertainty is not just driven by Lehman or Merrill or even AIG or Washington Mutual.  People reasonably wonder about hundreds of other financial institutions and whether they are solvent.