How TARP Paybacks Expose Weakest Banks

The government has finally acknowledged something it wanted to keep secret six months ago: Which banks are in the worst financial health.

It’s now obvious that Citigroup (C), GMAC, Bank of America (BAC) and perhaps a dozen other large banks are in rough shape, but when the Troubled Assets Relief Program went into effect last October, the idea was to mask problems at sick banks by flooding the whole financial system with liquidity. President Bush’s Treasury Secretary, Henry Paulson, famously imposed TARP bailout funds on big banks like Goldman Sachs (GS) and JPMorgan Chase (JPM), which took the money even though they said they didn’t need it.

Paulson was trying to prevent a repeat of the runs on Bear Stearns and Lehman Brothers that occurred when big, institutional clients, worried that those banks could fail, decided to pull their money out. All at once. Pumping some healthy banks with money, Paulson reasoned, would distract attention from the sickest banks, and buy time until the risk of panic receded.

Without a doubt, the healthy banks enjoyed the government loans, which came at a lower rate than they'd have to pay in the capital markets. But the conditions—such as limits on executive pay and Congressional mob rule over certain business practices—have turned out to be too onerous.

So the banks that can pay back their TARP funds are doing so. The Treasury will recoup about $68 billion. Capitalism lives. Commence celebration.

The first set of big bailout repayers includes Goldman, JPMorgan, American Express (AXP) and seven others. Two dozen or so smaller banks will also pay back their TARP handouts. It’s obviously good news that these banks can stand on their own, the feds will get out of their business and taxpayers will get some of their money back.

But the TARP paybacks by the healthy banks are also a sign of confidence in the support structure for the sick banks. Last fall, with panic intensifying, it might have spelled the Lehmanization of Citigroup et. al. if the government had singled them out as unable to survive without government aid. Yet that’s what the government has now done. Letting the healthy banks pay back their loans makes it clear who the real Bailout Babies are: At least 10 large banks, and a couple hundred smaller ones, that aren’t yet planning to reimburse the taxpayers.

It’s notable that this is happening without any bank runs or other signs of distress. That’s partly because investors and institutional bank customers have had months to absorb bad news about big bailout recipients like Citi and BofA, and adjust. The government, for better or worse, has clearly signaled that it won’t let those banks fail.

The “stress tests” conducted by the Federal Reserve earlier this year provided greater clarity on the 19 biggest banks, which itself was reassuring, even if part of the data-dump was a signal of more trouble ahead. The markets prefer predictable bad news over uncertainty just about any day. So the de facto nationalization of Citigroup is a ho-hum event, [now that we know it doesn’t signal a contagion that will spread like swine flu through the whole sector.]

The optimal situation, of course, is for the government to completely get out of the business of funding banks. But it’s likely to be years before the most-troubled banks work through all their money-losing loans, declare their writeoffs and get off the government dole. Some won’t survive and will be sold or liquidated by the FDIC. But the first major TARP repayments are an important pivot point on the way back to a healthy financial sector. Now we can focus on the sick banks and let the rest solve their own problems.

Disclosure: no positions

Comments

[DannyBoy153:]

I don't understand why BAC is in a rough shape because it is not repaying TARP now. How is BAC, C, and GMAC similar? WFC isn't paying back TARP, is WFC in the same boat too? If that's the case, then how is "WFC," BAC, C, and GMAC similar?

Jun 09 02:29 PM

[bbro:]

Absurd article.....if economy is in recovery mode by end of year....will
Rick say he was wrong????

Jun 09 05:14 PM

[home econom...:]

I don't think the economy is in it's way to recovery. This is going to be a chronic failure because of the irresponsible people from way back before G.Bush is the president. It's been almost 20 years, maybe more than my calculations that the economy is not doing good.
The private business sector has lost it's benefit of giving a popular merit increases to employees or employee that worked hard and deserve a motivation factor to work harder - money.
In fact, back when it was clinton who's ruling, people started just to be thankful they have job - nevermind the merits.
So, until the job sector stabilizes, which is how is the question, everybody in in deep debt, then there might be a chance for the housing business to recover in a slooooow manner. People have to have steady job first, next is savings for downpayment, then next is kids education putting last for the housing.
People can easily be trained. They are like braindead, whatever they see and hear, they believe. They tend to not to use their own brain cells, that's according to my observations.

Jun 09 06:20 PM

[District Ba...:]

I agree with the main contention of this article - but anyone who didn't already know that BAC and C were two of (if not #1 and #2) weakest banks in the country? If you need the government to tell you which banks are (relatively) strong, and which are at risk of failure, you shouldnt be investing in the sector.

Jun 09 06:32 PM

[Mad Hedge F...:]

tThey will be the first takeover targets. The world’s largest hedge fund is taking profits on one of its biggest positions. I’m talking about the US Treasury allowing ten banks to repay $83 billion in TARP money. I guess the banks really want to get the government green eye shades out of their board rooms, who have been surreptitiously swiping the soap out of the executive washroom. This means paying back 5% money when it costs 6% to fund in the markets, and 10% of you want to raise equity. I guess it’s worth it if this enables you to revive your celebrity golf tournaments in California for “clients,” throw Caribbean parties for your top producers, and get the Gulfstream out of storage after it couldn’t be sold. Could bonus compensation also be an issue? Gee, do you think? I have to begrudgingly give the government credit for making a ton of money on this trade. Not only did they borrow from us at zero and lend at 5% in huge size. They also got, at the point of a shotgun, fistfuls of equity warrants that have tripled. And they did stop the bank runs that took Morgan Stanley (MS) down to a near death experience of $6, boosting it back up to a positively virile $32. Alas, if only I could play by their rules. I have a question, Mr. Geithner. Does the government have to pay taxes on those profits? Will it report them?

Jun 09 06:43 PM

[DannyBoy153:]

In asking my question, how is "WFC," BAC, C, and GMAC similar?, I was hoping someone would point out what makes these banks weak and what makes them strong. BAC and C are always in the same sentence but I've yet to find anyone to explain why BAC is as weak as as C. A lot of he say she say with no support.

Jun 09 07:12 PM

[Jasper M:]

Dannhyboy,
I'll take a stab at it.
1) BoA, like many of the troubled banks, has a lot of toxic assets on its books. Mark-to-Myth means they feel no particular reason to deal with them. "Everything's fine here, we value these at 80 cents, since we are holding them to maturity (wink, wink)"
2) BoA, like Citi and WFC, has the extra onus of having made some Veeeery bad acquisitions. Merrill was a stinker, *I* saw that coming a mile off, made 10/1 on BoA puts. Seriously, BoA shareholders should be demanding someone go to jail on that one. It is a huge negative on BoA's books.

If all these assets were marked to market, today, BoA (and Citi, and Many others) would disappear in a puff of market discipline. Everyone knows it. They are zombies, held up by various applications of government forbearance, and Nothing else.

And in the end, for most of these, that will not be enough. They Will fail, 'cause at some point, the people will lose faith in the government's policies, and the runs will begin. Banks tend to die on the deposit side, not the asset side.
But short-haters, spare me, as I will Not be riding Citi, or BoA, or Goldman, down to zero - I already made a killing on them last year, and I try not to short the same stock twice.

Jun 10 01:51 AM

[DannyBoy153:]

Jasper, thanks for your thoughts. In response;
1) Mark to Market is a good concept, but only when markets are efficient. Market efficiency is a widely debated topic so I will simply state my position: Markets are efficient BUT not all the time. Buffett and Munger are believers in this as well. When the market misprices an asset you believe is worth more, you buy it. When Buffett bought the Washington Post, he believed the true value was somewhere in the neighborhood of $400 million, but in the market, it was selling for $100 million; one of his best stock pick. Munger has said he got rich by having money laying around at low interest rates and buying when he sees opportunity; in other words, when assets got mispriced.

So the question is, was the market efficient enough to price the assets on the bank’s books. In my opinion it was not. Fear was high, trade volume on those assets were low to nil, there was a huge gap between the price of a willing buyer and a willing seller, etc.

Buffett is a believer in Mark to Market because he believes people might put false figures on the balance sheet. He would rather have the balance sheet at Mark to Market and have management explain what they think those assets are worth. But guess what, many don’t read management’s discussion filed in their 10k’s so Mark to Market, when markets are inefficient, has problems of its own that can possibly lead to more distress. In my opinion, what banks have on their books is more reliable than what the market is currently pricing it at.

2) Merrill was a good acquisition. Good in that it added to earnings in the first quarter and will add more in the future. Not GREAT because it was bought expensively and used common stock.

Good short call on BAC. But I would argue that you were right on the market being fearful and inefficient rather than right on BAC being a bad bank.

Jun 10 10:37 AM

[Jasper M:]

Danny,
1) The demands of Mark to market are notable, But the abuses of mark to Myth are open ended.
As for market efficiency, I hold that market's are efficient, IF you are honest about WHAT they are efficiently pricing, which is sentiment. Which changes with the wind.
Mark to market allows those few who Choose to perform due diligence (in the face of market psychology) to not be defrauded.

As for your assertion that the market was not efficient enough to price the bank's assets, the markets correctly priced the Fact that the decades long credit inflation that built recent valuations had gone into reverse, meaning that aggregate real estate prices (the basis of the portfolio) would Never get back to where they were when the deals were done. That is a singular success for the markets, which few others have managed.

2) Which brings me to Merrill. In the words of John McEnroe, "are you Kidding Me?!"
I remind you that they sold themselves because they had destroyed their own capacity to survive independently.
Merrill Lynch used to be the Microsoft of retail brokerage. They pretty much owned that space - and they gave it up. I used to do business with them, and watched them go from platinum to linoleum, in about 15 years, chasing a very Bad business model.

One of the things that makes a bank "bad" is taking the sort of risks that render it insolvent in fearful times. You'll notice I am not bragging about making $ off of shorting, say, Bank Mellon? They are a relatively conservative outfit, not likely to get caught out by market gyrations.

Jun 10 04:38 PM

[DannyBoy153:]

Jasper,
I won't comment any more on market efficiency, but I would like to point out that saying "aggregate real estate prices would Never get back to where they were" is kind of over stating it. Never is a long time and with inflation at...say 4%...and no thought to appreciation, current prices will double in 19 years, triple in 29, quadruple in 37, quintuple in 42, sextuple in 47, septuple in 51, octuple in 54...need I go on?

Merrill contributed more than $3 Billion to net income in the first quarter and it will contribute more in the future. I guess what's trash to you is gold to me...and $3 billion buys a lot of gold.

Jun 11 10:21 AM

[Jasper M:]

Danny,
1) Excuse me, perhaps I should have specified "adjusted for inflation". Price increase due to inflation is not profitable.
Also, a base Austrian model would seem to imply severe deflation for the next few years. Illiquid assets tend to suffer disproportionately in such environments.
(from mid 20's, to '32, real estate lost 90% in this country)
So, to restate, "Adjusted for inflation, these CMO packages will not be profitable In Your Lifetime."
Good enough?

2) Re Merrill, compare what was paid for it, at a time when capital was very dear, and the losses it imposed in BoA's sheets before Q1. Further, recognize that much of its Q1 is phoney, as the company is still sitting on losses it has not yet recognized.

Which takes us all the way back to mark-to Market: Companies can choose to ignore losses, in effect defrauding their stockholders.

Jun 11 01:37 PM

[DannyBoy153:]

Jasper,
1) Time will tell if the real estate prices will get back to what it is on the books and I'm betting it will. Over time, demand for real estate will only increase.

2) MER was taken over 1/1/09. Before that it was not on BAC's balance sheet. Purchase account requires that MER be written down to market when acquired so to say Q1 profits are phony and the company is still sitting on losses is...shall I say wrong?

So back to mark to market: When companies mark their assets up to market, their profits are fake. When companies mark their assets down to market, their losses are real. Seems to me that your argument for mark to market is a little bias.

Jun 11 05:37 PM

[Jasper M:]

Danny,
We Have to stop meeting like this.
1) Re real estate demand, we have Years of inventory - At Current Prices. Normally, this would not be a problem, as prices would drop, and the market would clear. But the government is actively trying to artificially hold up prices, just like in the last depression. So that inventory will hang around. Indefinitely (= the roofs cave in).
And since the demand of recent times (the times of the origination of the assets in question) was the product of a nigh unprecedented, and utterly unsustainable, credit inflation, which has begun its inevitable, inexorable collapse, the sort of speculation fed demand you saw during said origination period will not be back.
And I won't even add "In your lifetime" here, as, like most developed countries, the US birth rate is fading a bit. So there will be no long term demographic bailout, either. Unless we get WAY friendlier with the Mexicans than we have been recently.

2) Re Merrill,
> Purchase account requires that MER be written down to market
> when acquired
?!? Dude, in case you haven't heard, Merrill's statement of accounts for that merger were INFamously fraudulent. Hearings going on before Congress on the matter Right This Minute. Thain's con job was so egregious, and so obvious, that the US Secretary of the Treasurery had to strong arm Ken Lewis, Personally, to get the deal to go through. (this last courtesy of the NY AG Coumo)

How do you not know this??

> So back to mark to market: When companies mark their assets up to market, their profits are fake.

I never said that. The market price is The price. Merrill's assorted trash, I promise you, has Never been marked there, as they were cooking away well before the recent accounting changes (like so many others).

[Perhaps you could start an Instablog, so we could discuss this without disturbing the others?]

Jun 12 12:33 AM

[DannyBoy153:]

Jasper,
1) Not years of inventory, try "only" 9 months worth of inventory at currents rates at the end of April 2009. 10.1 months of supply if seasonally adjusted. In January 2009, it peaked at 14.3 months of supply, 12.4 seasonally adjusted. Highest level since 1973-1974. If construction continues to slow, this rate will continue to get lower. The law of supply and demand was in effect when prices fell and it will be in effect when prices rise.

2) Again wrong. The issue in court right not is not over if the Merrill deal was a good purchase, if losses where fake or real, or what's on Merrill's books... The issue is did the government over stepped its boundaries, why didn't Ken use the MAC clause since he had a fiduciary responsibility to do so, etc.

You gotta pick up an accounting book...or google the term "purchase account". I'm not going to assume this or that, I trust our accounting system. If you see something fraudulent that's back by facts and no "he say she say", then maybe I'm missing something.

I'll give you the last comment and I think we can just agree to disagree.

Jun 12 09:48 AM

[Jasper M:]

Danny,
10 Re inventory, you clearly haven't seen the reset numbers. There is a credit Suisse graph making the rounds, recently been updated from the 2007 version.
The inability of the Fed to materially depress mortgage rates means almost all of these resets will end up in foreclosure, = inventory. The resets waves don't stop until early 2012. Add a year for admin delays, that's 2013 until extra inventory keeps raining on the market.

2) Not court, congress.
Ken Lewis would not have had excuse to use the MAC clause if he had not noticed the mess Thain had made of Merrill. I remind you that your original posit on this matter was that Merrill was a good acquisition. I assume you are holding that Merrill's body blow to BoA's bottom line had nothing to do with the 100+ b-b-b-BILlion dollar losses of BoA since then?
And why did Lewis feel the need to fire Thain almost immediately afterwards?

You trust the accounting, I'll trust the Grand Jury testimony, and the verdicts of the market.

Jun 12 01:55 PM