Ken Lewis Finally Gets It Right: 3 More Banking Myths to Add to His 6

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by: Tom Brown

That headline is no typo. Ken Lewis’s op-ed in Monday’s Wall Street Journal was spot on. In particular, he notes six widely held myths about the banking business that are flat-out wrong. Lewis is right on all six:

Myth 1: The banks aren’t lending. Yes, they are.

Myth 2: The banks are insolvent. Not according to GAAP. The vast majority of banks will come through the crisis in great shape.

Myth 3: The Troubled Asset Relief Program (TARP) hasn’t worked. When the TARP was enacted in October, the financial system was on the brink. Since then, spreads have narrowed, debt issuance has resumed, and loan volumes have grown.

Myth 4: Taxpayers have given the banks billions and won’t get their money back. Bull! The TARP investments consist of preferred stock paying dividends of 5% to 8%. The program is not charity!

Myth 5: The banks that caused this mess must be held accountable. Hello! Take a look at all the CEOs who’ve lost their jobs and the massive losses suffered by shareholders. Banks and their owners have paid dearly.

Myth 6: The only way to fix the banks is to nationalize them. If nationalization means 100% ownership of selected banks for brief periods of time--well, the government does that all the time when the FDIC seizes insolvent institutions. But if the nationalize-‘em-now crowd wants 100% government ownership of all the country’s 8,000 or so banks, it’s asking for economic disaster and a logistical nightmare. A nationalized banking system makes no sense in a free-market economy.

As I say, Ken Lewis did a fine job. Policymakers looking for solutions to the credit crunch would do us all a favor if they recognized the myths above for what they are, and craft their proposals accordingly. But misperceptions about what’s going on in the banking business these days don’t just stop with Ken Lewis’s list. A number of additional myths about the banks are lately floating around that are just as wrong as Lewis’s six—and just as pernicious:

1. The system is full of “zombie banks.” You can’t read an analysis of the banking business these days without sooner or later coming across a dire warning that the system is shot through “zombies” that need to be put down. What, exactly, a zombie bank is is never quite defined. Presumably, it’s an institution so loaded down with bad assets it has no hope for survival. But in that case, regulators are already pretty good at coping. Typically, they’ll take a failing—sorry, “zombie”—bank and slap it with a cease-and-desist order. That in turn limits the damage the bank can do to the system by, say, cutting off brokered deposits and limiting the bank’s ability to make new loans. A difficult problem this is not.

Or maybe zombie banks are the ones not making any new loans. If that’s the case, I just don’t see it. As noted, bank lending is one of the few areas of the financial system that’s working more or less normally lately. Zombies seem thin on the ground.

More likely, though, the zombie-phobes are referring to big banks that haven’t yet bitten the bullet and written down the bad assets on their balance sheets as aggressively as they should. This I don’t buy. If there’s anything the big banks have gotten good at over the past two years, it’s marking down assets. By now (as Gary Townsend noted here last week) the gaps between banks’ “fair-value” marks and their corresponding cash-flow marks are huge—with the fair-value marks typically being much, much lower. Our work on Wells Fargo (a favorite suspected zombie) shows that the company has aggressively taken required marks, especially the dodgiest paper from Wachovia. In his chat with CNBC this week, Warren Buffett himself all but said FAS 157 has forced banks to be overly aggressive in taking marks.

So the “zombie bank” is a myth--the industry’s equivalent of Sasquatch. If anything, most big banks are reverse zombies.

2. Banks’ toxic assets need to be purged from their balance sheets. A number of typically thoughtful, well-informed people (such as Alan Blinder, in Sunday’s New York Times), as well as some not-so-well-informed people, seem to think banks need to get rid of their toxic assets altogether and start fresh. They’re wrong. First, most of the assets these people are so worried about have already been written down over the past 18 month to below the net present value of the cash they’ll actually generate (thank you, mark-to-market accounting). So the assets aren’t so toxic anymore. If the banks get rid of them, they’ll likely be foregoing future value—and for what?

Might additional marks against these same assets happen in the future? Of course! In fact, it’s quite likely banks will have to take additional marks against their CMBS holdings in the first quarter. But if the banks intend to hold that paper to maturity and believe it will generate cash flows whose NPV is higher than the current marked price, why should they be concerned?

Others argue banks need to get rid of their toxic assets so that they’ll resume lending. But, as noted, banks are already lending. If they’re not lending even more, it’s not because of any underwater securities they own, it’s because the recession has stunted loan demand. A number of studies (most notably from Sandler O’Neill and Sanford Bernstein) have shown that bank loan growth typically turns negative in a recession. In this one, however, growth has actually stayed positive.

Finally, some analysts argue Citigroup in particular needs to get rid of its toxic assets, as a way to avoid expensive additional capital infusions by the government. I don’t buy it. At this point, no entity knows those assets better than Citi does, or could manage them more efficiently. Certainly no institution has a greater incentive to maximize their value. And outside investors with an interest in acquiring them would require an incredibly high rate of return (read: would only be willing to pay a lowball price) to take the assets off Citi’s hands. What good would that do?

3. The banking industry is insolvent. This little gem has been repeated so often lately it’s taken on an air of received wisdom. Only it’s bogus. As it happens, the federal government isn’t the only one stress-testing banks lately; we’ve run some aggressive bank-by-bank tests of our own. In particular, we’ve assumed loan losses as a percentage of loans rise to twice the peak rate of the last cycle, and to the level experienced in 1934, when FDIC data first became available. Even under those scenarios, under GAAP the vast majority of the country’s 8,000 banks would remain solvent.

No, it’s not hard to come up with doomsday scenarios in an industry typically levered 10 to 1. It’s particularly not hard if you suddenly decide (as some have done) to throw GAAP out the window and replace it with new accounting schemes selected to put bank finances in the worst possible light. But that would be nuts. GAAP isn’t a set of random accounting rules that have been put together with no rationale. You might quibble with this rule or that, but you can’t deny that there’s a logical framework to it all. Besides, bank managers manage to GAAP; regulators regulate to it. To simply decide to ignore GAAP now is insane. It’s especially insane if your alternative (and this is the insolventists’ favorite) is a liquidation-accounting regime that arrives at asset values by assuming that every asset in the banking industry gets sold every day. I am a Cubs fan, and have followed the team’s sale process with some interest over the past year. It has been arduous. But if Sam Zell had to value the Cubs under the same liquidate-it-right-now-or-else assumptions the accounting revisionists insist on, the team would be next to worthless. But the Cubs aren’t worthless. Similarly, the liquidation assumptions that many analysts have made unreasonably devalue the banking system’s assets, and falsely make the system appear insolvent. It’s not.

There’s an awful lot of misinformation about the banking system lately, and even a lot of misinterpretation of facts that are generally agreed upon. That’s too bad. Until the financial crisis ends, the economy won’t likely recover. And once the economy does recover, regulation of the financial industry could use a substantial overhaul. It would be helpful if everyone agreed on the facts (and problems) are, before we start looking for solutions.

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