In 1931 John Maynard Keynes famously wrote:
A “sound” banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.
In the past decade banks have been more free of government regulation than any time since before the Great Depression. Once again our “sound” bankers have developed procedures that became “conventional and orthodox” and have been ruined en masse by them.
Critics of the current methods of financial institution bailouts point out many benefits of simply temporally nationalizing insolvent banks and then reselling them when market conditions have improved.
Nationalization has multiple clear benefits. First, it gives U.S. taxpayers an upside on the billions required of them to salvage the banking system. Second, it need not reward the bank shareholders who elected the grossly reckless managers who oversaw their charges’ demise. Third, it is a relatively simple process with fewer opportunities to dole out favors to the politically-connected financial institutions that make sure there is a lavishly well-paid revolving door between financial regulators and the financial industry (ask Phil Gramm or Robert Rubin about this).
Nonetheless, bank nationalization, even if temporary, is vulnerable to demagoguery, and perhaps rightly so. While the current recession is a major embarrassment for capitalism, outright government ownership of traditionally private functions like banking also has a poor record.
Instead I believe the best solution to the problem of insolvent banks is what might be called informally liability cramdowns via a second coming of the Resolution Trust Corporation (“RTC II”). But first a word about the FDIC: the current banking crisis is so extreme that the FDIC can’t do its job: managing bank failures and protecting their insured depositors. So far only a few dozen random insolvent banks have actually been shut down, and not necessarily the worst. But for every bank that has been closed, another 20 or more operate as “zombie banks.”
This term gets used quite a bit, so here is a precise definition: zombie banks are banks that are too weak to make substantial new loans, are still overpaying their incompetent incumbent managers, can’t raise any capital in either private debt or equity markets because they are so clearly insolvent, are completely reliant on continuing opaque and ad hoc giveaways from the U.S. government and only meet minimum capital regulations by using aggressive and unrealistic “hold to maturity” accounting models to (over)value their toxic assets. The list of such zombie banks includes giants like Citibank (NYSE:C), JPMorgan Chase (NYSE:JPM), and Bank of America (NYSE:BAC), regional banks such as Huntington Bancshares (NASDAQ:HBAN) in Ohio and FirstFed (FED) in California, and small local banks like First Mariner (FMAR) in Maryland. None of these institutions are even close to solvent, and in normal times they would have been shut down long before they deteriorated to their present shape.
Not a single one of these hundreds of banks will survive without substantial government action. Yet right now the FDIC is simply too small and too limited in its funding source to manage the shutdown of every insolvent zombie bank, or even one tenth of them. Indeed, the FDIC does not even have sufficient funds to pay the claims of the insured depositors at these zombie banks, putting bank regulators in the impossible position where if they actually follow the law they will bankrupt the FDIC and absent further actually cause a bank panic.
I propose instead the following:
First, the FDIC needs to be bailed out by giving it $100 billion to start and indicating more will be available if needed. There will likely be no financial upside to this, but it will greatly increase confidence in the soundness of the banking system among depositors. These funds will only be used to protect insured deposits. Further, the attempts at expanding the FDIC’s mission to include backing paper issued by the likes of JPMorgan Chase, Goldman, and GE Capital should stop.
Second, banking regulators need to require regulated financial institutions account for certain classes of assets at current market prices and support such a market by disposing of at least 10% of such assets within a specified period. These suspect and largely toxic asset classes include all forms of collateralized private debt, credit default swaps, large commercial development loans, foreclosed real estate, and loans backing private equity leveraged buyouts. Right now these assets are dishonestly mis-valued by resorting to some combination of highly unrealistic “models,” pricing assumptions that bear little relation to market prices, or cherry-picking small transactions in the generally low-volume market for these assets.
By forcing an honest accounting of bank assets, this law would cause the timely death of the zombie banks as they are now structured, because they would be forced to report they do not have the required equity to debt ratios. The FDIC, now able to fulfill its mission of protecting depositors, will ensure the process is orderly.
Third, Congress should create a temporary new agency to recapitalize the newly failed banks according to a objective, speedy, and uniform procedures. The old Resolution Trust Corporation is a precedent for such a temporary agency. I suggest that the procedure be that the government fund 35% of the difference between the bank’s actual equity as determined by the new market pricing requirement and a ratio above the required well capitalized threshold in return for 35% of a new class of common shares. The remaining 65% of the gap would be funded by writing down the face value of the unsecured and uninsured liabilities of the failed bank (which in practice already trade for less than face value).* The holders of the unsecured debt would then receive the remaining 65% of the new common shares of the recapitalized bank.
Finally the old common shareholders would receive exchange-traded perpetual warrants to purchase the new class of common stock at a price that would fully compensate U.S. taxpayers and the unsecured creditors of the bank. (To be fair, the strike price of the warrants could be reduced by the dividends paid to new common shareholders.) In most cases, these warrants would be worthless or nearly so, but then so is the common stock of zombie banks these shareholders own now. Zombie bank common shares are frequently analogized as bets on the bank’s limited chance of again becoming solvent. This would make this apt call option analogy literally true.
This proposal has all of the benefits of nationalization, as well as a few others. First, there is an upside for taxpayers, who while not owning outright the new banks would still have a large and valuable investment, which could pay them dividends and could gradually be sold off in the transparent and liquid markets of our country’s stock exchanges.
Second, it would allow the easy removal of the bank’s incumbent managers. The old shareholders would lose all of their votes on the company’s board of directors, who would instead be named by the bank’s unsecured creditors (65%) and the U.S. Government (35%).
Third, the objective procedures would restore order to the current chaotic and outrage-ridden TARP program.
It might seem as if the unsecured and uninsured zombie bank creditors get the raw end of this proposal. I disagree. While selected creditors may no longer receive the almost random windfalls that occur when TARP overpays for bank equity or assets (for example the recent overpayment in the preferred to common equity Citibank share exchange) in general they would be better off by going from having a lot of loans to a shaky zombie bank to having somewhat less in loans to a strong and fully solvent bank with the remainder made up by stock in the now solvent recapitalized bank.
The benefits to the U.S. economy would be immediate and substantial as hundreds of zombie banks, now unable to lend money except to pristine borrowers at high rates, would immediately have ample funds to loan because they would be overcapitalized using honest and realistic mark-to-market accounting standards. The old management that ran the banks into the ground also could be easily uprooted by the entirely new shareholders in the bank. The proposal would preserve the valuable branch networks, non-management employees, brand names, and deposit base of the old banks. Finally the accounting requirement that certain toxic classes of bank assets be partially sold with the remainder marked to market will create a more liquid market for these assets.
*For an example of how the unsecured debt of zombie banks trades for far less than face value, FirstFed, mentioned above as a prime example of a zombie bank, recently has begun purchasing its unsecured debt for one third of its face value. GMAC (NYSE:GKM) did the same with moderate success in order to become a bank holding company.
Disclosure: The author currently owns JPM puts and recently closed short positions in FED and C.