Memo to Bernanke and Paulson: Confidence Is a Function of Capital, Not Liquidity

Includes: AIG, JPM, MER, WMIH
by: Christopher Whalen

Click here to download  the "Emergency Economic Stabilization Act of 2008" draft released on September 28, 2008 [PDF file].

Click here to download a section by section analysis of the draft legislation[PDF file].

During the presidential debates last Friday, Senator John McCain [R-AZ] said that we are "at the end of the beginning" of the economic recession that is affecting the US and the entire world. We completely agree.

So let us try to describe in financial terms why we believe that the legislation currently being finalized in Washington will be ineffective in achieving the stated goal of restoring liquidity to financial institutions and thereby make it possible for banks to begin to expand their balance sheets and lending books, both of which are currently contracting at an alarming and accelerating rate. In a soon to be published article by Alex Pollock and John Makin, both of American Enterprise Institute, "The RTC or the RFC: Taxpayers as Involuntary Equity Investors," the two respected financial observers write:

Do we need a 'new RTC' as the U.S. Treasury is proposing--or something else? We believe that an alternative framework is needed. Its key elements should be two: recognition of systemic risk embedded in the illiquidity of mortgage-backed securities and capture of the upside of a rescue for taxpayers, not for banks and (former) investment banks that created the bubble….

A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital.

Pollock and Makin point out that simply buying bad assets from banks does not solve the most basic problem, namely restoring confidence in one another among financial institutions by ending questions regarding solvency. In this regard, click here to see a proposal circulated by and among individual members of Professional Risk Managers International Association over the weekend.

The plan has two big virtues from our perspective: 1) it minimizes the outlays by the Treasury by keeping bad assets in private hands and 2) it provides a capital facility for solvent banks, a provision that is missing from the drafts we've seen of the assistance proposal now under consideration in Washington.

It is important for all Americans to understand that this financial crisis began more than a year ago with the collapse of liquidity in many types of mortgage assets, but the battle is quickly shifting to concerns about capital and solvency. The Federal Reserve System, Federal Home Loan Banks and the Treasury have already advanced huge amounts of liquidity in the form of debt to financial institutions in an attempt to help them stabilize their funding sources and slowly begin to re-liquefy. Click here to see a map of the balance sheet of the Federal Reserve Bank of New York maintained by our friends at Cumberland Advisers.

But unfortunately neither these existing sources of funding nor the proposal to provide even more debt-financed support gets to the core issue that is undermining in the financial system, namely worries about solvency. Consider two models for government assistance. The first is the Resolution Trust Corporation ("RTC") model of the 1980s, which was used to buy up bad assets following the S&L crisis of the 1980s. The older model comes from the 1930s and the Reconstruction Finance Corporation ("RFC"), the most authoritarian federal agency that has ever existed in the United States.

Directed by Jesse R. Jones, the RFC used its vast legal powers to test the solvency of banks and commercial companies and, when those institutions were proven solvent, they were allowed to re-open. Those financial institutions that were determined not to be solvent were closed by the FDIC and either sold whole or in pieces to other institutions.

Below are two very simplified numerical illustrations to highlight the failings of the current plan in Washington by way of a comparison between (1) the RTC/Paulson model and (2) the 1930s RFC model, which is conveniently illustrated by the purchase of WaMu (NYSE:WM) by JPMorgan Chase (NYSE:JPM). Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out -- a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future.

Significantly, the advances from the FHLBs and the covered bonds issued by WaMu's bank subsidiary were conveyed through the receivership and assumed by JPM. More on this in our next comment.

The RTC/Paulson Model supposes the Treasury's bailout fund purchases $1 billion dollars worth of illiquid assets from a participating bank at par. The bank receives $900 million of cash that was raised via deposits or other forms of debt and $100 million in its own capital, assuming a 10:1 leverage ratio. If the assets are sold below par, then the selling bank takes a capital loss and the other providers of liquidity, whether via deposits, debts or official sources of funding like the Federal Reserve System and Federal Home Loan Banks, are also taking an implicit if as yet unrealized loss.

In this first example, the overall solvency of the bank is actually hurt and the issues of confidence and safety and soundness are left unresolved or even worsened. This is why we believe the proposal being considered in Washington will be ineffective at best and may actually worsen the crisis of confidence in US banks.

The RTC/Paulson model does nothing to arrest the de-leveraging of the commercial banking system and may even worsen the crisis of confidence. In our view, Senator Dick Shelby [R-AL], the House Republicans and the members of either party who want to have political careers in two year's time are right to vote no on this proposal.

The RFC/WaMu Model In the second example, imagine that Treasury takes a $1 billion preferred equity position in a solvent but illiquid bank. Instead of only receiving 10% of the amount of the cash infusion from the Treasury as capital, the bank receives the full $1 billion as new capital to absorb losses and then serve as a basis to re-lever the bank's balance sheet and make new loans.

By putting capital into solvent but illiquid banks, the Treasury can help them to offset losses of existing assets and provide new capital to use to make new loans to support the real economy. Remember, when new capital is invested in a bank under the RFC model, all of those funds are available to support the bank's balance sheet, including deposits and bond holders.

If an insolvent bank is resolved by the FDIC, but its asset quality problems are too severe for a purchaser to assume the full burden of dealing with these assets (unlike the JPM/WaMu transaction), then the Treasury bailout fund could subsidize the transaction by purchasing preferred equity in the purchaser and providing a small but still significant option for the taxpayer to benefit from any recovery on the failed bank's assets.

This allows the FDIC to minimize the number of troubled institutions that it must operate as receiver and keeps the troubled assets in private hands, where the cost of resolution will be minimized in order to maximize profit. But as suggested by the proposal advanced by individual members of PRMIA, the first goal is to keep as many banks and assets as possible out of government hands.

The difference between the current, RTC type model and the 1930s RFC model can be summarized succinctly: The bailout proposal now before Congress does not deal sufficiently with the issue of solvency and ensures that the US banking system will continue to deflate and de-lever, meaning that less and less credit will be available to the private economy and the recession is likely to be far longer and deeper. It is not as bad as the 1930s, but if Ben Bernanke and Hank Paulson don't soon refocus their attention from liquidity to solvency, it could be much worse.

With the RFC model, on the other hand, by quickly moving to inject capital into solvent banks, we can actually reverse the process of deleveraging and deflation that is currently grinding the global banking system -- and the world economy -- into the ground. By using new leverage and private capital, we can not only re-liquefy the banking system but also decrease the length and severity of the now present recession.

As we've said before and will no doubt say again, the roadmap for how to achieve this positive end is in Jones' memoir, "Fifty Billion Dollars: My Thirteen Years at the RFC." We know for a fact that the Library of Congress has many copies of this excellent book as well as copies of the congressional hearings regarding the creation of the RFC and Jones' periodic reports to the Congress. But will anyone in Washington bother to read them?