We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector:
- The plight of equity-holders should be ignored;
- Long-standing rules governing bank ownership shouldn't be compromised in a panic; and
- Bank balance sheets won't heal unless deep pain is felt, and preferably as quickly as possible.
Bank Equity Holders: Out of Luck
Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae (FNM) and Freddie Mac (FRE) - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders. This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out.
GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it's payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. Those risks have been borne out. And you are busted.
Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things can and do happen. It's high time that equity investors understood this. And I'm not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:
The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.
Exactly.
Don't Play Games With the BHCA
The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, the long-standing Bank Holding Company Act rules make a lot of sense to me. Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?
We have the example of TPG/WaMu, which, I'm afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees.
The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I'd be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I'd have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.
Good Bank/Bad Bank as a Way to Move Forward
The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.
What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments).
The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital.
This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now - in order to lay a strong foundation for future growth.
Note to Bank Managements: Take the Medicine - Now
Bank managements' steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books.
As it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don't address the issues of transparency. Mr. Paulson should devote more calories to this issue and less to bailing out the GSE's and protecting their common stockholders. Yes, the GSEs are hugely important, don't get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.
Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool's game. Get to it.
This article has 26 comments:
The government can bail out bad mortgage holders but the CEO's of banks and brokerages are getting away with murder. All the profits and bonuses that have been paid out under this system of unregulated greed infested system only line the pockets of a few at the top. The rest lose their jobs, their homes ,their life savings etc.
How do you lose BILLIONS of dollars, then get a bonus to leave the company.??? New CEO's come in to FIX the problem while thousands of hard working employees are laid off for short term savings.? How does this system work any better? Wipe out the common holders (AND TAKE AWAY THESE GOLDEN PARACHUTES) and start over
On Jul 27 08:16 AM User 182544 wrote:
> Well Mr. Ehrenberg......if you really don't want the Feds to spend
> your tax dollars......then stop voting for Democrates!
Talk about naivety. A corrupt financial system knows no political party.
Economics, financial sanity and morality are out in the elections years. I wonder if there are coming back after.
Now I still owe money to those to whom I borrowed money. And it's too bad for them too, since I can't pay them. So, they lose too, and perhaps they will make the next person who wants to use their money to make loans to others go through a much more stringent examination of how they plan to make loans.
So, those people who took out loans they couldn't afford, whether it be individuals or banks, and for those who loaned out money, whether it be the banks and the stockholders of the banks, or the government, it's just too bad for them. They should feel the pain of irresponsibility. And since the government is you and me, then we need to make our representatives know how we feel about this. I write mine a lot about many issues. I don't know if it does any good or not, but I try. My district just got through kicking out one of the bums 2 years ago. And we'll do it again if needed.
Should not, but do anyway. They managed to squeeze out a ride-along amendment to the housing bill, so they get to share in future appreciation. Do you suppose they'll now leave their seat at the table?
In the good/bad bank scenario we can relieve the current management of those " banks " and let them run the bad bank. Why ? They've already done a magnificent job of it already. Then fire them en masse when the job is complete.
morgages.By definition morgage is a loan guaranteed by the value of a real estate property. It is inconceibable that the bulk of the the financial ins titutions of our beloved country were so inept that threw the country tn recession more likely is a scheme to transfer wealth from trusting ordinari people to the favored.
One needs to understand that the sub-prime mortgages were originated with the unreasonable expectation that prices would continue to rise. This expectation is no different than the expectation of rising prices of commercial real estate prices in the eighties which brought down the S&Ls.
The culprit is the Federal Reserve which unreasonably increased the money supply. It's real simple, when money is plentiful, lenders fall over each other trying to make loans. As long as the underlying security continues to appreciate, the risk seems to be mitigated. When prices stop rising, it doesn't take rocket science to understand the resulting problem. It can be likened to a Ponzi scheme.
These loan originators, mortgage companies, investment banks and rating agencies should all be investigated for fraud and malfeasance.
I'm not real confident that the politicians are willing to go after the fat cats that made a ton of money in these schemes and who regularly contribute to their campaign coffers.
If banks can convince everyone that only the foreclosures are bad and everything else is ok, then everyone will be willing to accept the market declines are not as bad as thought and maybe I should buy. The new paper will replace the bad paper, securitize it and sell it and business as usual. Oh yes, since tax revenue has declined we (Fed/States) will need to raise taxes to replace the lost tax income
but probably only temporarily (right). please name one government program that is not a ponzi scheme.
due to a one time writeof which is not really a write of Just changing the location of the cash from one account to another account for the incase arguement. The incase argument says that if we have to write of the bad loans we can do it without having to spend any money to write off the loans. Which again means we can juggle the accounts. Which means we'll be able to foreclose and turn the forclosed property to our sell dept which will sell it at a profit/loss and recover most of our money through the sale and later show big profits since the whole thing was written off earlier and now the new money is all profits. Okay what does all mean. It means that soon they will run out of bad loans to foreclose on and
the people who stayed with the stock all 85%(institutions) will end up laughing all the way to the bank(WM) to deposit their big huge profits. While the cry babies will cry all the way to sleep. The shorts whether naked or dressed will recover some of their capitol but not all since there isn't enough shares to buy back out there.
Of course the shorts writing for Seeking Alpha will be thrilled.
Congress needs to be blugeoned into action. The only way I see that happening is if an immediate investigation into soft money donations by Countrywide, Fannie, Freddie et al. to members of Congress commences.
Funny how the first high-profile executive to call a recession last year was none other than Angelo Mozilla after he realized the party had ended. He knows who was ON THE TAKE.
While everyone got all hot and bothered by solar activity affecting a planet named earth no one bothered to notice the housekeepers and landscapers making off with six figure refi cash outs.
If we could only SHORT SELL CONGRESS...