Time to Bury the Rotting Carcasses of Dead U.S. Banks

Beached whales tend to explode as they decompose, spreading a stinking mess all around unless swiftly disposed of. So too for dead banks. This week's relief rally on bank declarations of 'profitability' is a classic Dead Cat Bounce in the context of looming insolvency for several leading names, however lax the new Treasury stress tests prove. We face $1.6 trillion in ARM resets between now and end 2012; the $790bn outstanding in credit card debt is already experiencing 7.8% charge-off rates. Even with a soft-focus mark-to-market rule, banks face a Tsunami of write-offs across every credit segment that will rapidly overwhelm their current anemic capital base. Let's get some perspective. The financial collapse that has engulfed the world economy can seem overwhelmingly complex, but in essence it boils down to two interacting financial theories that were tested to destruction.

The first was that securitization, the slicing and dicing of individual asset risk at any given bank to be parceled up and sold on, would lead to a more stable financial system by limiting the balance sheet concentration and hence vulnerability to external shocks of each institution. Risk was to be scattered to the four winds.

That neat idea ignored the systemic risks that ensued if most institutions lent recklessly on the assumption that their individual credit downside had been 'outsourced' to a seemingly bottomless pool of anonymous global investors. In other words, an innovation meant to reduce specific risk ended up raising systemic risk. This was exacerbated by the emergence in the latter stages of the boom of a new generation of ludicrously complex and ultimately unsaleable derivatives such as a 'Collateralized Debt Obligation of Asset Backed Securities' or CDO of ABS. Most of the $450bn issuance of this grotesque financial mutant was simply shoved off-balance sheet (and offshore) into Enron style vehicles such as SIVs in 2006/7.

The second dangerous idea was that emerging markets could grow their economies far faster than their financial infrastructure and simply export excess savings to the more sophisticated developed world banking system. In the process, by raising credit availability and lowering interest rates in the US and elsewhere, they effectively subsidized demand for their exports, leading to ever larger surpluses to be sent back to consumer nations in a perpetual motion machine of capital flows moving at an ever more frenzied pace. Some of that recycled capital found its way back to emerging markets via Western bank loans to local corporates and oligarchs. Once US consumer balance sheets began deteriorating sharply from late 2006 as the real estate bubble burst, both theories began unraveling fast. Unfortunately, economics isn't an exact science subject to laboratory experiment.

Now, we face the mammoth task of delevering the US and other economies in as orderly a manner as possible, dealing with the huge destruction of bank capital, and restoring confidence and trust between actors in the financial system. The credit intermediation system is in tatters; private securitization was at the peak intermediating 50% of US household credit, and it has effectively imploded leaving the Fed to plug the credit gap.

US household net borrowing has collapsed and gone negative for the first time in 50 years; business borrowing looks set to follow. While the focus has been on ensuring the supply of credit, a bigger question going forward may be the demand for it. No substantial economic recovery can take hold without the restoration of a sustainable private sector credit system. So what needs to be done to achieve it?

To bury the insolvent money center banks, we need to pre-empt systemic risk. Bank senior debt holders cannot be immune from sharing the costs of the disastrous management of their investments and will have to accept a reduction in the par value of their securities as part of a comprehensive dismemberment of insolvent institutions, with the government aggregating unsaleable elements into a transparent new debt instrument.

1. Impose default/debt relief on all mortgage and credit agreements; void all derivative contracts without an underlying economic rationale eg CDS contracts not hedging underlying corporate or sovereign debt exposure but as pure bets on default. When the taxpayer is proving the chips, it's time to shut the Casino.
   
2. Bundle all the bad debts into a debt instrument, a Bad Bank Bond, akin to the Brady Bonds used in the Latin American debt crisis and have it underwritten by public tax receipts 30 years out with tenor of 30 (i.e. create a 60 year bond). This will ultimately be attractive to institutions with very long-term liabilities to hedge.
   
3. Force the weakest banks to swap their existing claims on debtors for claims on this new instrument and exclude them from writing new business ie put them into run-off, whether privately or publicly managed.
   
4. Make a wholesale market in the Bad Bank Bond to establish price discovery.
   
5. Keep printing money and maintain fiscal stimulus until a self-sustaining (albeit inevitably modest) cyclical recovery takes hold.
   
6. Allow the best managed banks, including the regionals and overseas players, to fill the market vacuum; the entire system of US housing finance needs to be transformed to a bank balance-sheet focus. At some point, the GSEs should be phased out of the day-to-day private credit infrastructure. Governments have a crucial role to play in aiding liquidity and price discovery when markets fail as they are currently, but not on an ongoing basis.
   

Policy must force existing asset owners (including bank bond and preferred stock holders) to accept capital destruction as a fact, so that needed restructuring can take place in which debt is discharged and ownership changes hands. Bank management cannot be allowed, in collusion with timid regulators, to delay the natural cyclical healing process in this recession, essentially Schumpeter's process of 'creative destruction'. Citigroup (C) has liabilities of $1.8 trillion; the deposits that the FDIC has some responsibility for (up to $250,000 per depositor) add up to $241 billion. So the system for winding down troubled banks can't cope with a 'too big to fail' giant like Citi, covering only a fraction of the overall operation...that has to change before these huge banks can be dismembered and we see a transition of their assets to new owners. Some may be from outside the current banking industry; it may well be that Wal-Mart (WMT) will end up being among the biggest retail banks in the US in a decade.

Ultimately, emerging from this mess will require the US to gradually build a solid and nationally-integrated private banking infrastructure, funded mainly through retail deposits, in order to make bank balance-sheets as the principal repository of housing finance in the US rather than politically manipulated GSEs. The fast rising US savings rate (likely to be 8% plus by year-end) and consequent deposit growth is an important step in that direction. To clear the way for a rational and sustainable financial system, it's time to bury the rotting carcasses of America's dead banks.

Comments

[jasonjim:]

Just what we need in this crisis, more negativity, nothing positive from this author called Sean. There is a way out of all difficulties and this author touched on none of them. He was expert though in confusing the issue even more than it is at the present time.

Mar 15 11:11 AM

[Mortgage Ma...:]

We face $1.6 trillion in ARM resets between now and end 2012; Yes, we do, but just take a look at the amazingly low rate these ARM's will re-set into and this is nowhere near the calamity it once was. If ARM mortgage holders are paying there way now (as a huge % are) then resetting these ARM's will be good for the overall economy not bad.

Mar 15 11:27 AM

[philipmax:]

I like your analysis but strongly disagree with your solutions.
Yes, there is a systemic failure, but it is of the entire global banking community. This is why conventional solutions are irrelevant. It is a worldwide banking pandemic.
It's not just the shifting of money from producer to consumer that caused this problem. IT WAS IRRESPONSIBLE LENDING that was marketed as triple A investments to the developing nations who put their faith and TRUST in our regulatory system that failed. We failed them, and now, they refuse to deal with us and we can't find other suckers to play with. The result is a freeze-up of the banking system and trade between nations that compounds the problem by involving the whole world economy.
No amount of punishment that we meet out to the stockholders will fix this mess. The stockholders are not the culprits. As long as banks continue to be run by the same criminal element that caused this mess, we are spinning around in hopelessness. We have to change managements and ethics in the entire banking industry or nothing will be achieved. Intervention and debasement of stockholders interests is not a solution.
Take this message to Washington!!

Mar 15 12:08 PM

[morph366:]

With respect to your conclusion
To clear the way for a rational and sustainable financial system, it's time to bury the rotting carcasses of America's dead banks.

Leaving aside the last bit which one has to admit is certainly powerful imagery, it may be too much to hope for a financial system which is both rational and sustainable.... If human beings are involved it's unlikely to be rational but no matter I'd happily settle for a system that's just sustainable.

Mar 15 12:16 PM

[MattZN:]

For rotting carcasses the money center banks seem to be operating just fine from where I stand. Sure, Citi isn't a happy camper, but even Citi is still originating mortgages. BofA and Wells are doing gangbuster business, including mortgage origination. Why would anyone want to bury them?

Did the author even bother to do ANY research before posting such drivel?

-Matt

Mar 15 12:55 PM

[icandoitdon:]

there you have it. a rational analysis that gets to the heart of the issue and the steps that must be taken to constructively solve it, notwithstanding the anger expressed by disgruntled "investors" who've made bad bets on zombie banks.

the federal reserve and treasury are bent on perpetuating a failed financial system built on excess leverage, underpriced risk, securitized lending, no effective federal regulation and opaque accounting rules that permit financial institutions to take huge off balance sheet risks. that model has failed and anyone who doesn't understand that doesn't understand economics, capital formation or investing.

Mar 15 01:24 PM

[samwise:]

BofA and Wells are doing gangbuster business? And Aunt Fannie and Uncle Freddie have been "nationalized" because they're all cute and cuddly! Far from drivel this is an excellent analytic from someone not afraid to point out the obvious. Clearly the respondents have never done anything in their investment life but throw good money after bad and believe when it's done by Uncle Sam, well, just slap the word "national interest" and that makes it all PEACHES AND CREAM, BABY. I especially like the use of BOLD PRINT by the way, because the downside risk of what's going on right now can't be stated strongly enough. RECKLESS is the word I would use. As to the particulars: there's a little bit of a stickler with #6--the "phasing out of the GSE's." And so should Social Security--but methinks you've got a problem with that, too. But thankfully we've had wise men running this country--and we have a "Federal Reserve." Needless to say there is a problem with the "Reserve" part right now! (Think Napoleon at Waterloo--when "even HE had to call up his reserves. Hint hint for all you non-history types--the battle was already lost by then.) Before getting into "what is to be done" you need to understand "what is." Here is a simple primer: what is nothing when it is nothing? Let me give you a simple answer: it's not an "exploding whale" (although that certainly can happen--we are EXPANDING our role in Afghanistan, aren't we!!!) No, simply put--it's "nothing." Now we all know thanks to our "weekend at Bernie's" that "nothing" can indeed me "a LOT of something" even though IT'S ALWAYS BEEN A LOT OF NOTHING. That says to all you angry dwarfs out there--STOP INVESTING IN THE INSURANCE BUSINESS RIGHT NOW. Now on to your very DISPOSITIVE analysis: what about "the banks" or as you term them "whales about to explode." First off, obviously, THEY'RE DEAD ALREADY, AREN'T THEY? In other words, the fact that "SOMETHING DIED" did not end the problem. No, we had to call in, let's call him "Tractor Trailer Ben." His job? Cart the Dead Whales off the beach. This is no small feat. TALK ABOUT STINKY. Second: HE'S BEING PAID THE GOVERNMENT RATE. We can sum that one up in word, can't we? EXPENSIVE. Third--we don't know if he carted the whale off the beach BECAUSE THERE'S BEEN NO OVERSIGHT. In other words, after leaving it to "dead whale mover" Ben and spending A FORTUNE to do it--come to find (shall we call the person saying this a "constituent"--no, probably a "whistleblower") MY GOSH, THE WHALE IS STILL THERE STINKIN' UP THE JOINT. Now there is a solution, one this adminstration may be doing whether it even wants to or not. When everyone is claiming to do things they aren't but are still taking the money I call it the "in case of EMERGENCY HIT THIS" approach which it seems so clear to me our fearless leaders are IN FACT now doing. To continue on your "dead whale" analogy I call it the "AIR STRIKE" option. This not only solves the existence of the "dead whale" problem--but may even have the added value of destroying "all those complainers out there." Now this can be something of a problem when dealing with "Wall Street." Lot of nice "buildings" down there. Just remember, no matter what happens, WE ALREADY HAVE A BANK and it's called THE FEDERAL RESERVE. Defending that is Ben Bernanke's job--I HIGHLY doubt he won't try. And should "faith and credit" be replaced with "STRENGTH AND HONOR" not only is that not necessarily a bad thing IT'S PROBABLY THE BEST NEWS THIS COUNTRY HAS HAD SINCE THE COLLAPSE OF THE NASDAQ and may be the best news SINCE THE CREATION OF THIS NATION IN THE FIRST PLACE.

Mar 15 04:39 PM

[InnocentsAb...:]

Monkeys have a hard time typing, because they don't have opposing thumbs.


On Mar 15 10:26 AM starwonder wrote:

> What is this idiotic Web site?
> Is any monkey with a computer allowed to post on it?
> What a joke!!

Mar 15 05:46 PM

[petyaczar:]

InnocentsAbroad, LOL

Nor do monkeys have opposing views.
Don't let Congress know, some of them, like Barney Frank and Pelosi may sense a corollation and earmark funds to study the relationship between lack of opposing thumbs AND lack of opposing views in monkeys.

$1,0000000000000000000...

or so should do for starters.

Mar 15 06:41 PM

[kuppyus:]

The biggest part of the root of the problem has been the GREED on the part of the primary lenders and organizers of this mess - the major banks.

Until the mindset is changed and the banks are run by people with solely a vested interest in reform and prudent operations, the system will remain a disaster.

Face the reality and tackle it head-on. The largest banks should be downsized by forced disposition of troubled mortgages to regional or local banks on a basis where the mortgages are transferred with contingency values in hope that regional and local banks can do better at managing risk with troubled mortgages since they know the local markets better than the global institutions. Allow the major banks to amortize the losses over a period of a few years to provide less harm than a full Mark to Market scenario would require.

Most importantly there needs to be a level of trust in the banks, which cannot be achieved from current management. The announcements this week as to "profitability" by C and BAC are indicative of the harm that continues to be done. I doubt any reasonable person believes these banks made real profits since there is so much uncertainty in the ongoing values of their receivables for credit cards, commercial mortgages, etc. The worst is far from over and the reporting of profits by those that really do not know the value of their assets is just more garbage that will need to be recanted in the future.

Mar 15 06:50 PM

[donzelion:]

Vibrant imagery like this should not be disposed of lightly:
------
Beached whales tend to explode as they decompose, spreading a stinking mess all around unless swiftly disposed of. So too for dead banks.
------
Perhaps, but what if those beached whales might be carrying a contagious pandemic virus? Keeping the corpses intact suddenly takes on wholly novel significance.

Ideally, one preempts systemic risk, but we're decades late for that. Problem is, true systemic risk carries massive, unknowable consequences:

For the Long Depression comes in the 1870s following global real estate bubbles and financial collapses, the Europeans sent their "huddling masses" to the U.S., and ultimately helped transform us into the global superpower we became in the next century.

For the Great Depression, the U.S. closed its doors, and most of the world put their masses into uniforms; one particular set of countries opted to blame one particular minority for causing everything, and the subsequent explosions reached a magnitude never before imagined.

"Creative destruction" is all well and good when its somebody else being creatively destroyed. But for the rest of us, it's prudent to try to put a firewall on the breadth of the destruction as best we can, before the bloodletting takes place.

Mar 16 03:59 AM

[Poor Dude:]

Well said, donzelion. Well said.

And it's truly unfortunate that there are those amongst us who only know that they can tweak a tad more profit out of driving Citigroup to zero, instead of only to $1.00.

But those people exist.

I guess the question is really this:

"What should we do with them?"

I vote that we cut off their heads and place them on spikes ... as an example to others.


On Mar 16 03:59 AM donzelion wrote:

> Vibrant imagery like this should not be disposed of lightly:
> ------
> Beached whales tend to explode as they decompose, spreading a stinking
> mess all around unless swiftly disposed of. So too for dead banks.
>
> ------
> Perhaps, but what if those beached whales might be carrying a contagious
> pandemic virus? Keeping the corpses intact suddenly takes on wholly
> novel significance.
>
> Ideally, one preempts systemic risk, but we're decades late for that.
> Problem is, true systemic risk carries massive, unknowable consequences:
>
>
> For the Long Depression comes in the 1870s following global real
> estate bubbles and financial collapses, the Europeans sent their
> "huddling masses" to the U.S., and ultimately helped transform us
> into the global superpower we became in the next century.
>
> For the Great Depression, the U.S. closed its doors, and most of
> the world put their masses into uniforms; one particular set of countries
> opted to blame one particular minority for causing everything, and
> the subsequent explosions reached a magnitude never before imagined.
>
>
> "Creative destruction" is all well and good when its somebody else
> being creatively destroyed. But for the rest of us, it's prudent
> to try to put a firewall on the breadth of the destruction as best
> we can, before the bloodletting takes place.

Mar 16 05:43 AM

[Poor Dude:]

And then we can have a lottery, to see who gets their Rolex, their Beemer, and their house in the Hamptons ....


;)

Mar 16 05:53 AM

[PeteK:]

Still the same words:
"Too Big To Fail."

Mar 16 06:00 AM

[TaurusTrader:]

No ... No ... No. It is NOT the time to bury ... it is the time to resurrect banks and make them functional! In my opinion we have untimely buried some and paying for it.

TaurusTrader

www.taurustrader.wordp...

Mar 16 12:55 PM

[CorradoCam:]

Sorry you guys, fact is:

The US has lived on credit for over 20 years.

Its citizen have lived on credit for over 20 years.

The rest of the world has financed that credit.

No longer.

When creditors no longer believe that the borrower can repay their debt, they stop lending.

The Fed can manufacture money out of thin air to become a creditor of last resort, but that is a short-term illusion that will end as soon as the money spills over into the market.

Start saving instead, as the rest of us have done these last few decades.

Bye.

Mar 16 05:29 PM

[misiosnechacz:]

I hope I won't see You in Obamas rescue team.

Mar 16 07:26 PM

[klarsolo:]

Sean, your profile says you are a CFA associate. May I ask what that is? Are you a CFA charterholder or a candidate? As far as I know there are no associates.

Mar 16 09:29 PM

[munkydotorg:]

maybe in the interested of controlling everything, the government should impose regulation to keep idiots like this from posting stuff.

this man is delusional and out of touch with reality. i'm not even going to bother pointing out the reasons, because by the end of 2009 he will be posting under a name other than Sean Maher (in fact, he may already be doing so). Not worth my time, because time will prove him wrong.

Mar 16 11:01 PM

[Fabien Hug:]

As a matter of fact they have opposing thumbs. Even their feet work this way. That's how they can eat a banana whilst they type.


On Mar 15 05:46 PM InnocentsAbroad wrote:

> Monkeys have a hard time typing, because they don't have opposing
> thumbs.

Mar 16 11:36 PM