Bank Liabilities: Why the Discussion Isn't Explicit

By James Kwak

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

The story goes something like this. Let’s say that Citigroup (C) were restructured - via bankruptcy, or via government conservatorship - in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG (AIG) had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again. Or almost: it is possible that the Federal Reserve’s massive efforts to provide liquidity to the banking system will be enough to keep banks functioning. But who wants to take that risk?

This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.

So what changed this week?

Simon’s theory is that the semi-forced conversion of Citigroup preferred into common shares was taken as a sign that the government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt, and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. Now, Tim Geithner could come out and say, “Yes, we forced a conversion of preferred into common, but we’re going to stop there and not do the same to creditors.” But no, actually, he can’t say that, because that would constitute an explicit guarantee of all bank liabilities. So the market is left wondering, and we know by now that markets don’t like uncertainty.

Another possibility is simply that more and more people are thinking that the government may end up restructuring debt. Martin Wolf and Willem Buiter, both very serious people, both have raised the question of whether the government should be protecting creditors. Wolf, I believe, doesn’t answer the question (although he discusses the issue very well); Buiter says no.

Each time the lines on that chart above have spiked upward, the government has taken some action to imply that creditors will be protected, without making any promises. Chances are we’ll see another action along those lines. At some point, though, the government may lose credibility.

As an aside, one of the steps in Sweden’s sometimes-heralded bank rescue program was an explicit government guarantee on all bank liabilities. If any country could guarantee its banks, you would think it would be the U.S. But the real barrier to taking such a step is probably political more than anything else.

Comments

[paul1307:]

Actuarial versus accrual; interesting point. The problem is in encouraging the banks to value depreciating assets as though they were appreciating, which they're not. The assumption is that housing will go up; the question is, when? My point about a 50% decline requiring a 100% appreciation to get back to even is that we may be two years yet from a bottom. How long then - after a further 50% or more depreciation - will it be until housing goes up 400% (if it quarters, it needs to quadruple). In an orderly market, those toxic assets would have been sold when they caved, but kiddie bankers with no concept of depreciating housing prices held them rather than dump them, and that's why FAS 157 was enacted in 2007, nearly two years ago, to provide a method for valuing depreciated assets they never should have held in the first place.

It's not "banks," but "bankers" and they're trying to save their jobs - at any cost (except to themselves, of course). When TARP started under Paulson, the plan was to buy the toxic assets; the banks wouldn't sell them at a discount (ala RTC and the S&L crisis). Rent them out? By all means, but first you'd have to find renters with proven credit histories, and folks who've been served liens and eviction notices aren't good risks. Trouble is that the glut of houses are in areas suffering the worst economic problems, meaning the potential pool of renters is poor. The bankers played as fast and loose as anyone on Wall St.

I wish there was a simple solution, like "ditch mark-to-market" but the trouble lies not in the accounting procedures but the depreciation of the underlying assets, no matter how you "account" for them. They'll mildew into the ground before the banks can dump them, unfortunately. What's really needed is a surgical separation of the assets from the banks, a forced auction or some such where when the banks go FDIC, FDIC auctions them off to the highest bidder. Then you'll know what they're really and truly worth.

It's at the point now where the banks aren't listing vast numbers of the houses they've set liens on, and they refuse to foreclose which would put a value on the houses, or sell, which would put a market value on the defaulted mortgages. I've seen FL houses where the "owners" didn't like eviction; many thousands in damages. "As bad is this is, we haven't even seen ugly yet; but we will." To those waiting for the laws of chemistry to be rescinded, you're not looking very closely at the situation, and by the time YOU notice anything, it will be way beyond "too late." That's why there's always that 10% who "didn't get the memo" if you know what I mean. When they're finally impacted directly, they're "shocked!" to think it could have crept up on them without their noticing it. Hello, this is your wake-up call, ugly is about to happen.

Mar 08 12:21 AM

[paul1307:]

By the way, using a five or 10 year price average takes you back to a time - at least here in N. VA - where houses went from $50,000 in 1995 to $500,000 in 2005. There is no simple solution, and that's the rub. Even if you split the difference to $250,000 or so, the mortgages are still closer to $500K than $250K. That's what happened in FL. Folks bought houses for delivery in one year. If you needed immediate occupancy you paid flippers prices for available houses which were appreciating at 3% per month. That's not only how we got here but also why selling them has become the problem. What's next? I'm waiting for the radio air heads to start telling "their people" that if they don't like the way their neighbors are being bailed out while they still have to pay their mortgages, just stop making your mortgage payments. I can already hear them saying it now: "What's your mortgage company going to do, kick you out? Foreclose? They aren't foreclosing now! So just stop making payments and tell them you want your principal reduced." I think that may be coming sooner than later, and that's when the real anarchy of this situation begins, when the rule of law no longer works, contracts are not enforceable and average citizens think they have a right to "get even." Like I said, it hasn't really gotten ugly yet.

Mar 08 12:32 AM

[Fitz919:]

No one wants the troubled assets, that's why they can't be priced. Also their value fluctuates daily in a downward direction, therefore no one would want to hold them. It's only a rumor spread by banks that these assets will be worth more in the future. Why did banks get stuck with so much of this stuff? The pipeline which created it, continued to deliver it, right up to the moment the market for it collapsed. The banks got caught holding the bag...which then blew up in their faces...along with their customers.

The solution isn't what Obama is doing. His plan is for mortgages which reset in 5 years. All the resetting Subprime, Alt A, and Option Arms triggered this mess in the first place. 4% Fixed Mortgages for everyone who wants them is the solution. Each repaired mortgage which had it's origin within Mortgage Backed Securities must stay inside that security, and the reduced dollar amounts in the form of mortgage payments will flow to the holders of those securities. That will increase the value of the troubled assets...and that will reverse the course of this recession.

No one in Government will do this because it's hard to do. We have lots of qualified people who are now unemployed who could do the work.

Our real problem is that we have people in Government who want to take over our financial system, and then use it to empower themselves. Obama's mortgage reset plan proves it.


On Mar 07 05:16 PM john s. gordon wrote:

> a solution: transfer title to the problem properties (don't call
> them assets) to a 'Resolution Trust Corporation' (renamed). a quasi-governmental
> agency, who will package the properties & auction the packages
> to people or entities with deep pockets. seidman rides to the rescue.
>
>
> gets the 'troubled assets' off the balance sheets of the sick banks
> so that we can proceed with normal banking functions (receive deposits,
> make loans, etc).
>
> over time the holders of the packages will make profits.
>
> remember, in the 1930's the agents of the rockefellers went all over
> the country buying up distressed assets @ 3c on the dollar. after
> 1945 they made money. who can do that for us now?
>
> let's avoid the japanese model of 'lost decade'.

Mar 08 01:02 AM

[Vox Rationalis:]

User 366653 wrote:
> First, I think "the market" is missing something: Trust preferreds
> have seniority over straight preferreds. Therefore, it would be hard
> to imagine that C or anyone else would orphan the trust preferreds
> by eliminating the dividend without offering the option of conversion
> to common as a way out.

Of course, Ford did just this last week - at the same time it offered a conversion of debt to common, it deferred payments to the trust preferreds. Different situation, of course, since I don't believe Ford has any straight preferreds, but relevant.

Mar 08 01:45 AM

[Leftfield:]

I appreciate the article and comments; it's been very informative. Trouble is, our system seems unsustainable to me. Misallocation has been propped up by unprecedented leverage and we're being asked in many of these comments to be realistic and bail out the worst offenders.

I'm self employed and I've had a difficult life keeping up with ridiculous taxes, healthcare and countless other costs inflated by a system which rewards the most overpaid in too many cases. Which seem to be those in the systems that are most inefficient and overpriced because they can write the rules or profit from increasingly artificial rules.


There are many regional and smaller banks getting hurt in many ways by the present situation who are well managed and are being ignored.

I don't see why saving the big players is absolutely necessary. Toyota was once small but did most everything right, GM the opposite. My kids and I are supposed to save GM now.

Large banks, hand in glove with DC politicians have been the biggest instigators of unsustainable costs everywhere. Promises have been made everywhere that can't be kept without inflating the dollar into worthlessness. Now it takes countless unaccountable $trillions to keep it going, the perpetrators say. No guarantees.

I'm not convinced that among the ultimately hard choices we're stuck with, propping up the worst offenders makes much sense at all.

Mar 08 08:56 AM

[User 366653:]

To your first comment - who cares what my name is? In what way is it relevant?

Second - yes, I remember Nat City and Wamu, but they were fleas compared to C and BAC. You haven't addressed my question: how will the FDIC cover the overwhelming losses associated with the mega banks. And seriously - how many years would it take to find buyers for what is left?

Third - great idea - have the state insurance commissioners, who usually have a staff of a dozen or so examiners, manage all the insurance companies. That ought to work really well!

Fourth - Photosynthesis is, to the best of my knowledge, not related to economic conditions (I learned that in Botany 101). What did end, however, was the last shred of confidence in our financial system. You may choose to believe that people will be happy observing the growth of a weed in the gutter after they lose their job, their house, and their retirement plan - I'd rather keep my job and let you study the weed.


On Mar 07 10:24 PM Jimmy Lathrop wrote:

> user 366533 or whatever number you are hiding behind:
>
> Remember National City? They got bought by PNC.
>
> Wamu? Absorbed by Chase
>
> The insurers? They'll be taken over by the state insurance commissioners
>
>
> Did photosynthesis end when Lehman Brothers declared bankruptcy?
>
> I remember eating a salad with dinner, maybe it was hoarded.
>
> The bottom line is that the politicians can't be in office forever
> and they will want jobs in the industry. You want to help them have
> a soft landing, knock yourself out.

Mar 08 12:02 PM

[User 366653:]

You may be right - our system may be unsustainable. We have two choices - try to sustain it, or give up.

I'd rather try to keep our financial system intact. I'm still waiting for someone to walk us through the scenario where you nationalize all the major banks and insurance companies, or simply let them fail, and everything just magically works out. Can't someone just explain how that process would play out?


On Mar 08 08:56 AM Leftfield wrote:

> I appreciate the article and comments; it's been very informative.
> Trouble is, our system seems unsustainable to me. Misallocation has
> been propped up by unprecedented leverage and we're being asked in
> many of these comments to be realistic and bail out the worst offenders.
>
>
> I'm self employed and I've had a difficult life keeping up with ridiculous
> taxes, healthcare and countless other costs inflated by a system
> which rewards the most overpaid in too many cases. Which seem to
> be those in the systems that are most inefficient and overpriced
> because they can write the rules or profit from increasingly artificial
> rules.
>
>
> There are many regional and smaller banks getting hurt in many ways
> by the present situation who are well managed and are being ignored.
>
>
> I don't see why saving the big players is absolutely necessary. Toyota
> was once small but did most everything right, GM the opposite. My
> kids and I are supposed to save GM now.
>
> Large banks, hand in glove with DC politicians have been the biggest
> instigators of unsustainable costs everywhere. Promises have been
> made everywhere that can't be kept without inflating the dollar into
> worthlessness. Now it takes countless unaccountable $trillions to
> keep it going, the perpetrators say. No guarantees.
>
> I'm not convinced that among the ultimately hard choices we're stuck
> with, propping up the worst offenders makes much sense at all.

Mar 08 12:16 PM

[Glitch:]

On Mar 06 10:28 PM Fitz919 wrote:

> The layer, upon layer, upon layer, of Credit Default Swaps within
> the 500 trillion dollar Derivatives world cannot be saved.


This is a vastly misleading value. These CDS/derivatives are all based on the same assets. The $500-trillion amount is the aggrigate of all outstanding contracts, but a large majority of those contracts are derivatives of derivatives - there may be a total of $100 in derivative contracts built onto a single $1 risk of loss; when that loss materializes, its still only a $1 loss to the system (the other $99 worth of contracts cancel themselves out). The aggrigate $500-trillion amount is NOT the potential risk to the banking system, it is impossible for anywhere close to that amount to actually be lost.

Yes someone does get stuck holding the bag along the way (or a bunch of someones get stuck holding a small fraction of the bag). But a $100 derivative contract may only be exposing the holder to potential loss of pennies.

Mar 08 03:22 PM

[Fitz919:]

Would a banker pay for a $100 policy to insure an asset worth 1$? If he did he would expect his $100 payoff if he lost his $1. Your premise holds no water.


On Mar 08 03:22 PM Glitch wrote:

>
> On Mar 06 10:28 PM Fitz919 wrote:

Mar 08 08:26 PM

[Glitch:]

No, you arent understanding the premise.

Company A buys a derivative secured by a mortgage (or whatever). They then sell a new derivative to Comapny B, that is secured by the derivative Company A owns (The insurance allows them to get a higher sale price from Company B). And of course, Company B can then sell a derivative to Company C, C to D, D to A, A to E, and E to B. So now there are 6 $1 derivatives based on that single $1 mortgage.

So the derivative market is now $6. But if that underlying $1 mortgage defaults, it doesnt lead to $6 in losses throught the system. Company A may loose its $1 investment, but it also doesnt have to pay out on the derivative sold to Company B, so for Company A its a wash - no loss. Same for Company B, C, etc, etc. And when insurance is involved, once the first claim for $1 is paid, there is no more loss further along the chain - everyone else gets exactly what they paid for, per their particular derivative's contract.

What makes it all so complex is that each derivative is not sold on a 1:1 basis - each one is comprised of a sliver of many different assets. So as each default occurs, the loss gets dissected and passed along the chain until it has been fully absorbed (or paid for by insurance). But the total loss doesnt exceed that $1 amount; even if 2000 investors take a loss due to that $1 default, their cumulative net loss will still be limited to $1.

If I'm wrong, then explain. But dont just say it "holds no water".


On Mar 08 08:26 PM Fitz919 wrote:

> Would a banker pay for a $100 policy to insure an asset worth 1$?
> If he did he would expect his $100 payoff if he lost his $1. Your
> premise holds no water.

Mar 08 09:23 PM

[Fitz919:]

You have forgotten that bankers are smart, and are using other people's money, so here is what they do:
When a banker insures his asset, he buys a policy so big that it will not only cover the asset, but also reimburse him for all his premiums and give him a substantial profit to boot. For the banker, taking a loss on his original asset, is now profitable.

Since each layer in the derivatives world had this goal in mind, of turning potential losses into profits, the values in these policies have gotten so large that their isn't enough money or assets on the planet to settle the losses. It's like mutually assured destruction. That's why their is such great concern over a potential cascade effect when a large bank or insurer fails.

AIG has recently paid out $50 billion to settle some of it's claims. It didn't have the money, so it used our money...bailout money. Assets which used to be considered liquid...no longer are, so the claims could only be settled with cash.

The $500 Trillion derivatives world is built on promises made which cannot be kept. That's why it's dangerously unstable, and must be dissassembled before it collapses.

You seem to think that the payouts on claims can pass through the layers without disturbing the house of cards, but it wasn't built that way. It was built on the "too big to fail premise", and believe me they knew what they were building.

Each layer requires a bigger and bigger payout, to cover the original (asset + premiums + profit) that's why your premise doesn't hold water.


On Mar 08 09:23 PM Glitch wrote:

> No, you arent understanding the premise.
>
> Company A buys a derivative secured by a mortgage (or whatever).
> They then sell a new derivative to Comapny B, that is secured by
> the derivative Company A owns (The insurance allows them to get a
> higher sale price from Company B). And of course, Company B can then
> sell a derivative to Company C, C to D, D to A, A to E, and E to
> B. So now there are 6 $1 derivatives based on that single $1 mortgage.
>
>
> So the derivative market is now $6. But if that underlying $1 mortgage
> defaults, it doesnt lead to $6 in losses throught the system. Company
> A may loose its $1 investment, but it also doesnt have to pay out
> on the derivative sold to Company B, so for Company A its a wash
> - no loss. Same for Company B, C, etc, etc. And when insurance is
> involved, once the first claim for $1 is paid, there is no more loss
> further along the chain - everyone else gets exactly what they paid
> for, per their particular derivative's contract.
>
> What makes it all so complex is that each derivative is not sold
> on a 1:1 basis - each one is comprised of a sliver of many different
> assets. So as each default occurs, the loss gets dissected and passed
> along the chain until it has been fully absorbed (or paid for by
> insurance). But the total loss doesnt exceed that $1 amount; even
> if 2000 investors take a loss due to that $1 default, their cumulative
> net loss will still be limited to $1.
>
> If I'm wrong, then explain. But dont just say it "holds no water".
>

Mar 09 12:33 PM

[Glitch:]

I agree completely, with one exception.

When "Layer 1" defaults, the insurance pays out (likely for the inflated value you mention).

But that also means, because of the insurance payout, that "Layer 2" gets paid as per the contract - so even if it is also insured, regardless of the amount, that contract is never violated and thus no insurance payout is triggered.



On Mar 09 12:33 PM Fitz919 wrote:

> You seem to think that the payouts on claims can pass through the
> layers without disturbing the house of cards, but it wasn't built
> that way. It was built on the "too big to fail premise", and believe
> me they knew what they were building.
>
> Each layer requires a bigger and bigger payout, to cover the original
> (asset + premiums + profit) that's why your premise doesn't hold
> water.

Mar 09 04:04 PM

[PDT:]

Tesa, you're right - the Federal government can print money until they run out of ink and paper. However, that has a real effect on the value of our currency, and in turn, our standard of living. Do you really want to turn the dollar into the US peso?

Beyond inflation, printing up more dollars does something else - it upsets China and Japan, the best customers we have for buying our debt. Now, I don't like the way we have been issuing treasuries any more than the next guy, but if we are going to make them far less attractive to those who would lend us the money. That in turn will increase our borrowing costs, and could even potentially lead to a downgrade in our sovereign debt rating.

Unfortunately, there aren't any easy solutions.


On Mar 07 11:08 AM Tesa wrote:

> You have got it crossed to justify your rants, There is not enough
> "private" capital to save it. US government will not run out of
> cash . It can always print money and that is why the banks rely
> on it to hold their bags after swindling the public.

Mar 09 04:51 PM

[PDT:]

Thanks, Gold! Nicely explained and your conclusion is spot on. People need to come to grips with the fact that the illusion of prosperity isn't the same as real prosperity.


On Mar 07 12:38 PM Gold is Good wrote:

> I've addressed FASB 157 numerous times but I'm going to give it one
> more go.
>
> First, it is important to define what fair value is. Under 157 it
> is "The price that would be received to sell an asset or paid to
> transfer a liability in an orderly transaction between market participants
> at the measurement date."
>
> This definition alone should alleviate those who claim that "lack
> of a market buyer" or "liquidity" are creating the problem. If this
> is the case, banks may use other methodologies to value their assets.
>
>
> Second, it is important to understand the various classification
> of assets under FASB. These include Level I, II or III assets.
> Definitions as follows:
>
> Level I - Highly liquid asset with quotable market prices (eg stock,
> bond)
> Level II - Illiquid assets which are unique but similar to other
> market assets (eg RMBS, CMBS, CDO paper)
> Level III - Illiquid asset with unobservable inputs (eg PE investment,
> private company ownership)
>
> Next, after we understand how FASB 157 is classifying assets, it
> is important to understand how it was impacted the banks balance
> sheets. Over the last 18 months, assets have moved from the Level
> I bucket into the Level II bucket and from the Level II bucket into
> the Level III bucket. This allows the "mark-to-model" accounting
> that many believe is responsible for the lack of trust in the system.
>
>
> Finally, think of it this way: If you were making an investment in
> a bank, would you prefer (a) an investment yielding 5% in a bank
> with all Level I assets or (b) an investment yielding 10% in a bank
> that classified all its investment at Level III, allowing it to dictate
> what the value of these investment are? I personally would choose
> "a" and believe that if we want to restore trust in the system, making
> asset valuation more opaque is not the answer.
>
> In closing, I would argue that the losses at the banks are real and
> not a function of mark to market accounting. If a bank wrote an
> 80% LTV mortgage in a market that has lost 40% of its value, the
> loan has already lost 25% of its value before taking into account
> back taxes, upkeep, servicing and sales cost that will likely eat
> an additional 10-15% of the value of the home. These losses are
> real and the sooner we start believing that the better.

Mar 09 05:02 PM

[Fitz919:]

It's more like dominoes of ever increasing size. When the first one (the original asset) falls, the first layer of insurance...the policy he bought pays out. This is the second domino. This second domino insured his risk with the bigger domino...domino three, and since domino two had to pay out, so will three, and four, and five etc. Each insurer, and each policy is larger, and yes they do have to pay out. How they pay out may be negotiable, that's up to the parties involved.

Since the derivatives world is so secretive, we'll never know how many dominoes are involved. But we do know that since Bear Stearns was absorbed by JP Morgan, the cost of the premiums to insure assets, and reinsure assets in the derivatives world has increased dramatically. So we can tell that the risk inherent in these instruments is constantly being reassessed, but I take no confort in knowing that.

I would assume that with lending as tight as it is, derivatives contracts may be negotiated downward in size, in a way deleveraging over time. But the total derivatives market is still growing at a rate of about 10% in the last year. (450T to about 500T).


On Mar 09 04:04 PM Glitch wrote:

> I agree completely, with one exception.
>
> When "Layer 1" defaults, the insurance pays out (likely for the inflated
> value you mention).
>
> But that also means, because of the insurance payout, that "Layer
> 2" gets paid as per the contract - so even if it is also insured,
> regardless of the amount, that contract is never violated and thus
> no insurance payout is triggered.
>

Mar 09 05:28 PM

[Sonia:]

I'd never heard of this - thank you for the education!


On Mar 07 11:26 AM Hari Seldon wrote:

> The banks were playing what organized crime would call a Bust Out
> Scheme.
>
> During the process, the perpetrator builds up a history of good behavior
> with timely payments and low utilization. Over time, they obtain
> additional lines of credit and request higher credit limits. Eventually,
> the account holder uses all available credit and stops making payments.
> Overpayments with bad checks are often included in the final stage,
> temporarily inflating the credit limit and resulting in losses higher
> than the account credit limit.
>
> AIG would be a classic example of this. All other large banks are
> guilty as well. Small local banks are victims in the scheme.

Mar 29 01:59 PM

[xxxx:]

There is a massive fraud going on at the highest levels of government that involves making sure you don't know that OUR banks are insolvent. (NOT ALL BUT THE ONES WITH POLITICAL CONNECTIONS). The second aspect of the fraud is how to get money to those banks without you "knowing it".

We are correct that massive hurt is comming, but what about when there is a whole network with governnemt support designed to hide it. Who is to say what will happen.

As for why it is happening I leave that for you to decide. My own personal view is that it is to drain as much taxpayer money as the banks can before going under and that makes management the most money. Second thought is they actually think sweeping it under the rug will work. Third if you buy enough time things will heal
Based upon prior bank actions I am going to go with greed,political connections, and payoffs.

If you have any other idea I am happy to entertain them, but I hate to say if this was a trial there is easily enough circumstantial evidence to decide guilt.

On Mar 08 12:21 AM paul1307 wrote:

> Actuarial versus accrual; interesting point. The problem is in encouraging
> the banks to value depreciating assets as though they were appreciating,
> which they're not. The assumption is that housing will go up; the
> question is, when? My point about a 50% decline requiring a 100%
> appreciation to get back to even is that we may be two years yet
> from a bottom. How long then - after a further 50% or more depreciation
> - will it be until housing goes up 400% (if it quarters, it needs
> to quadruple). In an orderly market, those toxic assets would have
> been sold when they caved, but kiddie bankers with no concept of
> depreciating housing prices held them rather than dump them, and
> that's why FAS 157 was enacted in 2007, nearly two years ago, to
> provide a method for valuing depreciated assets they never should
> have held in the first place.
>
> It's not "banks," but "bankers" and they're trying to save their
> jobs - at any cost (except to themselves, of course). When TARP started
> under Paulson, the plan was to buy the toxic assets; the banks wouldn't
> sell them at a discount (ala RTC and the S&L crisis). Rent them
> out? By all means, but first you'd have to find renters with proven
> credit histories, and folks who've been served liens and eviction
> notices aren't good risks. Trouble is that the glut of houses are
> in areas suffering the worst economic problems, meaning the potential
> pool of renters is poor. The bankers played as fast and loose as
> anyone on Wall St.
>
> I wish there was a simple solution, like "ditch mark-to-market" but
> the trouble lies not in the accounting procedures but the depreciation
> of the underlying assets, no matter how you "account" for them. They'll
> mildew into the ground before the banks can dump them, unfortunately.
> What's really needed is a surgical separation of the assets from
> the banks, a forced auction or some such where when the banks go
> FDIC, FDIC auctions them off to the highest bidder. Then you'll know
> what they're really and truly worth.
>
> It's at the point now where the banks aren't listing vast numbers
> of the houses they've set liens on, and they refuse to foreclose
> which would put a value on the houses, or sell, which would put a
> market value on the defaulted mortgages. I've seen FL houses where
> the "owners" didn't like eviction; many thousands in damages. "As
> bad is this is, we haven't even seen ugly yet; but we will." To those
> waiting for the laws of chemistry to be rescinded, you're not looking
> very closely at the situation, and by the time YOU notice anything,
> it will be way beyond "too late." That's why there's always that
> 10% who "didn't get the memo" if you know what I mean. When they're
> finally impacted directly, they're "shocked!" to think it could have
> crept up on them without their noticing it. Hello, this is your wake-up
> call, ugly is about to happen.

Apr 06 01:40 PM

[Carousel:]

The San Francisco Chronicle had an article on Sunday about the lack of prosecutions and an assertion that this credit crisis is not real. The writer said that it's a deep recession from too much debt and too much debt-financed consumption but that the idea that it's because consumers and businesses can't borrow more is a lie devised by the banks to justify handing them a lot of money that they aren't going to lend to consumers and businesses anyway.

Check it out: www.sfgate.com/cgi-bin...

Apr 06 02:38 PM

[gu econ:]

James, you state that Mssrs. Wolf and Buiter raise the "question of whether the government should be protecting creditors".

Aren't depositors creditors of the banks? (Yes.) And while senior in the food chain to common and preferred equitiy, wouldn't they be junior in any bankruptcy to senior and secured debt? (Would seem to be.)

Let's assume the typical deposit base is of a financial institution is 20% to 30% of total liabilities. That's a cushion that has to be 100% wiped out before senior/secured debt loses one dime. So why would senior debt agree to restructure? They've got equity and the depository base (as well as any other trade creditors) to burn through before they take a hit.

Of course, depositors will be made whole by the US government (taxpayers).

It would be interesting to have a banruptcy lawyer weigh in on this.

Apr 06 06:44 PM

[HipHoption:]

Fitz919 - I'm really not sure where you get the notion that each subsequent trade is larger than the last. I have traded credit default swaps (CDS) before and most uses involve the buyer of protection purchasing the same notional amount as the underlying exposure. For example, if you own $10mln face amount of corporate bonds, you will buy $10mln of CDS to protect it. Likewise, the bankers that purchased protection on residual loan exposures they had from underwriting and syndication would have only purchased enough protection to cover their exisiting loan exposure. Remember, if you buy protection, you are paying (in most cases) an annual premium (paid quarterly). In other words, this protection costs money. If you purchased more protection than you needed, you would have negative carry (assuming the CDS premium was equal to the return on the loan) and therefore you would chronically lose money. This makes no sense and in fact didn't happen.

Glitch - you seem to get the mechanics of it.

Fitz919 - your comments seemed to be derived mainly from academic conjecture rather than real life examples.

One last point, and I'm sure this isn't the last place I'll make it. No doubt there were greedy bankers looking out for number one. But let's not forget that every year Bank A had 10% earnings growth and Bank B had a more conservative and stable 4%, there was moaning and gnashing of teeth by Bank B's investors (not just hedge funds, but endowments and, yes, your very own pension funds). This forced Bank B's executives to look for riskier businesses to keep earnings growth in line with the others. So while everyone rallies against the 'evil bankers' why don't we think a bit about who holds the most bank shares through our pensions - that would be you and me. I guess we're not so blameless after all...


On Mar 09 05:28 PM Fitz919 wrote:

> It's more like dominoes of ever increasing size. When the first one
> (the original asset) falls, the first layer of insurance...the policy
> he bought pays out. This is the second domino. This second domino
> insured his risk with the bigger domino...domino three, and since
> domino two had to pay out, so will three, and four, and five etc.
> Each insurer, and each policy is larger, and yes they do have to
> pay out. How they pay out may be negotiable, that's up to the parties
> involved.
>
> Since the derivatives world is so secretive, we'll never know how
> many dominoes are involved. But we do know that since Bear Stearns
> was absorbed by JP Morgan, the cost of the premiums to insure assets,
> and reinsure assets in the derivatives world has increased dramatically.
> So we can tell that the risk inherent in these instruments is constantly
> being reassessed, but I take no confort in knowing that.
>
> I would assume that with lending as tight as it is, derivatives contracts
> may be negotiated downward in size, in a way deleveraging over time.
> But the total derivatives market is still growing at a rate of about
> 10% in the last year. (450T to about 500T).

Apr 06 11:09 PM