The Great Bank Rush of 2008: What's the Money For?

So many in the media seem to have swallowed the Kool-Aid that this bailout is necessary (or that the economy will self-destruct in mere days), but is it really?

IndyMac (IDMC.PK), Countrywide (CFC), Washington Mutual (WM), Merrill Lynch (MER), Lehman (LEH), AIG (AIG), Bear Stearns (BSC), Fannie (FNM) and Freddie (FRE) have all bitten the bullet, and the economy is still (sort of ... mostly) standing. JPMorgan (JPM) and Bank of America (BAC) seem to have developed voracious new appetites for new subsidiary operations, and Goldman Sachs' (GS) and Morgan Stanley's (MS) (simultaneous) announcements that they are converting to bank holding companies seems to imply that they too have their stomach juices churning for new goodies.

So who's left? Who's hurting? Where is this great self-immolation going to come from? The fact is that it isn't.

A week ago we learned that we had to cough up $700 billion in a few days with no strings attached, when just a week earlier no one knew a thing about this lurking monster. Now, a week later, the world still hasn't ended and, well ..., maybe a third up front, and they won't pay their execs so much, and maybe a little equity stake for the taxpayers, and yeah, we all can watch things real close too. Hmmm. Maybe we'll even get some mortgage renegotiations tossed in? That would be nice.

Stop right there. No way on that last point. No mortgage renegotiations. The banks say it mustn't be done, and that tells us something very important. Since mortgage renegotiations are hands down the best way to put REAL value back into this troubled paper (and would be the most palatable solution for the public), the only reason there is for the banks insisting that this not be in the bailout is that the banks don't want these properties returned to their owners, and they don't want to keep them either. That means that the banks simply want to raise cash quickly. But for what? What's the money for?

Two weeks back on Black Monday, the market jumped off a cliff and Bank of America swallowed Merrill Lynch whole. It was such a big news day with so many stories that a little tiny item, but for a single sentence buried nine paragraphs down in a Financial Times article, went entirely overlooked. The sentence read, "The Fed also suspended rules that prohibit banks from using deposits to fund their investment banking subsidiaries." THAT should have been the day's headline, and everything that has happened since can be explained by that sentence.

The sentence of course refers to our FDIC-insured deposits. The Gramm-Leach-Bliley Act of 1999 ended the strict separation of these deposits from unregulated investment banks, but even after that, only 30% of a bank's deposits could be used to back it's investment subsidiaries, and only 10% could back any individual subsidiary. Any more than that, even in the heydays of deregulation fever, was considered too risky to be backed by FDIC insurance.

All that went out the window on Black Monday. Merrill Lynch needed to be bought quickly and Bank of America was interested, but there was a problem. JPMorgan had gotten billions to back Bear Stearns' bad paper during that takeover, and Bank of America needed a similar deal. Trouble was that back during the Morgan-Bear deal, the government had $900 billion sloshing around in its accounts, but by Black Monday there was only $100 billion left that had not already been promised, and that couldn't be spared. In other words, the Fed had run out of money. That's when the deal was struck. Bank of America could use ALL of its FDIC-insured accounts as backing for Merrill's bad paper. The sale was made. Bank of America had its prize.

Of course, the Treasury couldn't just do this rule change for Bank of America; they had to do it for everyone, and all of a sudden, the entire landscape of banking had changed. Every bank that had FDIC-insured deposits was now worth a lot more money because its insured assets could now be effectively collateralized and used to back investment banking operations. Within days, Goldman Sachs and Morgan Stanley, seeking to stake their claims to the vein of gold that Bank of America had mined, converted from investment banks to bank holding companies. The Great Bank Rush of 2008 had begun.

Within days, JPMorgan, still digesting Bear Stearns, was next to score a prize when Washington Mutual (WM) was seized. It was a good deal all around. JPMorgan took only the $188 billion in FDIC-insured accounts, but in return for sticking us with the garbage, they agreed to cover all of these deposits without any money from FDIC funds. A real prize for JPMorgan, and it was nothing down for us; only time payments.

From here on out however, the pickings are likely to get smaller. There are (depending upon how you measure) 30 to 50 regional banks that will now be prime candidates for takeover by these four mega-banks, and of course perhaps thousands of lesser banks floating around. The question then becomes how to pay for all these little banks. International markets are really fed up with American financial institutions, and are not liable to loan on favorable terms, and the Fed and Treasury are simply tapped out. That leaves you, me, and a $700 billion bailout plan. And THAT'S why all of a sudden, they need the bailout. They want to buy little banks.

Two questions remain. First, will this work; will it save the system? Perhaps. Maybe if these folks can suddenly learn to be VERY conservative bankers. Fine, except that these people did not get to where they are because conservatism was an arrow in their quivers. Which leads to the second question: What happens if it doesn't?

It is important to understand what a massive gamble is being made with this. This rule change, allowing 100% of FDIC-insured deposits to be used to back investment banking transactions, effectively extends the coverage of FDIC insurance to all of these transactions, AND DOES SO WITHOUT REQUIRING ANY ADDITIONAL PREMIUMS TO BE PAID into the FDIC reserve fund. These investment transactions will now be covered by government insurance FOR FREE. We'd better not have too many of them fail.

Imagine this scenario. You have $80,000 in Bank of America when it collapses. (This is just a what-if; I'm not predicting this bank's failure.) You go in to get your money. After all, it is covered by FDIC insurance, isn't it? Sure enough, the clerk is about to hand you your $80,000 when a man steps up and grabs it from the clerk, claiming it is his. You protest, showing him your account. He's says he doesn't care; he's got an investment transaction at the bank and that makes him the first lien holder on the money that used to be in your account.

Obviously, this is a characterization. This scene would never occur. The net result, however, would be the same if any of these new mega-banks were to fail. Oh, you would get your money, but a hell of a lot more of it would have to be printed, and your money would be worth a hell of a lot less by the time you got it.

This is the risk that Paulson has taken; a risk taken without Congressional review, comment, or consent. Like the gambler he came to the Treasury as, he has bet all of your insured deposits that he can pull off a rescue of the American financial system. Maybe he can. Gamblers get lucky sometimes. Just ask them.

Disclosure: none

Comments

[Midas1:]

Face it, we're on a financial Titanic. For the greed of a few, there goes the country. Mr. Bush, is there anything else you'd like to ruin before you get your sorry behind out of office?

2008 Sep 29 10:46 AM

[dlaw:]

Wow is there are good observations here - really important stuff.

I don't agree with all the author's conclusions but so what?

He raises questions important enough that we should all be re-thinking our conclusions.

2008 Sep 29 10:54 AM

[MichaelZZ:]

FINANCIAL “CRISIS”

One cannot resolve a problem unless one understands the problem.

PROBLEM: Financial institutions have reduced their lending.
The problem results from the impaired equity portion of the balance sheets of these institutions, with the impairment caused by write-downs of their assets (loans).

Due to the losses they have taken, these institutions, by law, have had their maximum potential lending amounts reduced.
The amount they are able to lend is contingent upon the amount of their equity capital (EC), e.g., if an institution has an equity capital of one billion dollars and is able to lend up to 20 times its equity capital, it could lend up to 20 billion dollars.
After taking loan write-downs (losses) of two hundred million dollars, its EC would now be 800 million dollars, thus it would have its maximum lending authority limited to 16 billion dollars, i.e., a constriction of its legal authorization to lend.
This is the crux of the problem.

The institutions have funds, i.e., liquidity. But, without the legal authority to increase lending, they are sitting in stagnant water.
Those who say that one going to one’s ATM for a withdrawal may find a closed sign are, absolutely, lying or ignorant.
If one is a Representative or Senator and is lying, he or she should be Impeached and removed from Office.
Likewise, if that Representative or Senator is ignorant, he or she, apparently, is not, adequately, accepting his or her fiduciary responsibility of understanding a subject prior to advocating or voting for it, thus he or she should also be Impeached and removed from Office.

PAULSON PLAN: Purchase impaired mortgages from financial institutions with taxpayer funds.

Indeed, this would positively affect an institution’s EC, because the impairment (loss) would have been transferred to the taxpayers. This reversal of loss would be achieved by paying face price rather than market price, since if the market price were paid, there would be no effect upon EC.
This contemplated action is anti-capitalistic, immoral, and a method of stealing from taxpayers.
The taxpayers did not cause the capital impairment (this IS the problem, i.e., “It’s the balance sheet, stupid”).

Anyone involved with designing this scheme and voting for it should be incarcerated as co-conspirators to steal from the citizenry.
The scheme’s authors and those who advocate for it would be precipitating an admission that capitalism doesn't work, which is a lie.
Capitalism is the best economic tool ever devised, but as with any tool, it can be and has been abused.
Congress should accept most of the responsibility for creating the economic atmospheric conditions that enabled the abuse.
Further, any resolution of this financial phenomenon will not abate the underlying problems of the economy.
It is not the lack of lending that has damaged the economy. It is the economy, affected by greed, that has damaged the lending, but, of course, if appropriate corrective actions are not taken in regards to this financial phenomenon, our weak economics will be adversely affected.

If the Paulson plan were adopted, it would be the most massive SPE by multiples, the dollar would weaken, interest rates would go up, thus the decline in home prices would be exacerbated, and the EC would require further resuscitations.


BEST PLAN:
1) Allow some institutions to go the route of Countrywide, Bear Stearns, IndyMac, and Washington Mutual. I, also, like the AIG model.

2) Most rational institutions will do what UBS, Merrill Lynch, Goldman Sachs (just recently with Warren Buffett) have done, i.e., they have raised additional EC, usually by selling preferred stocks.

Months ago, when Merrill sold 6 billion (as I recall the amount) dollars of preferreds paying 9%, I knew they were desperate, and that this was just an early domino.
Goldman Sachs, from what I have heard, is paying Buffett 10% for the preferreds. Keep in mind; this is after-tax money. The only reason for Goldman Sachs to take a desperate (GS also gave Mr. Buffett 43,000,000 warrants to purchases GS common @ $115 per share) action was because it knew it was experiencing an EC impairment and needed to raise additional EC.

Please keep in mind that pain is not all bad. It is a signal that something is wrong and indicates that the source of the pain (problem) must be determined, analyzed, understood, and finally the best alternative action must be taken.
We are experiencing pain regarding this financial phenomenon.

3) As a last resort, it would be appropriate for the government to establish a fund (call it the RTC 2.0 AKA Peoples' Financial Fund) and use those funds to purchase (just as have Mr. Buffett and others) preferred stock from institutions. The fund should follow Mr. Buffett’s lead and demand additional potential remuneration in the form of long-term warrants.
The stock would receive dividends and would have a convertible feature to convert to common stock, at the option of the fund.
Further, until certain parameters were met, the preferred ownership would assume voting control, thus the matter of executive compensation would be moot.
We either believe in capitalism or we don’t.

We will have displayed a pragmatic solution well within the parameters of capitalism.
The U.S. dollar will strengthen.
The next step would be to address the underlying economics with the basic problem being unbridled greed.
We should not have a "shot" stimulant as we did earlier.
We need to eliminate the largess given to the very wealthy, in error, by the Bush tax cuts, and to reduce taxes on the middle-class on a permanent basis.
This will have an immediate positive effect upon our economics and we will be on the path to a rational economy.

I will appreciate all comments regarding the foregoing.



Michael Z
Sherman Oaks, Ca.

2008 Sep 29 10:59 AM

[Ricknplano:]

We had a temporary problem when the money market funds went to negative territory. Extending government guarantees to those funds solved that problem within two days. But that put a scare into the markets, the institutions who hold large amounts of money market funds and into the treasury and Fed. Also the relatively low FDIC coverage of $100,000 makes wealthy depositors quick to create a run on any bank with a hint of problems. Raising the FDIC limit to a million dollars per depositor plus the gov't guarantee of money market funds was and is sufficient to calm and fix these markets...at least until the Sec of Treasury and Fed Chairman showed up at Congress saying the sky is falling, which created its own panic.

With several weak banks that should have failed, including WAMU, failing Congress has swallowed the Cool Aid and decided to use a sledgehammer to swat a fly. Yes there was some weakness in credit markets. Some banks needed to fail due to poor management but we have seen the good banks swirling around them like vultures waiting for the certain death. After the dust settles the same loan officers will still be making loans to the same customers but the bank name on the documents will change.

Some other tweaking of the credit markets like establishing an exchange for Credit Default Swaps (CBOE, Mercantile, et al) and reinstating the uptick rule and also reinstating the 8% margin limits that our good Senator Gramm got repealed in 1999, all these changes are sufficient to fix the markets.

Will my suggested changes prevent a recession? No, but transferrring wealth from taxpayers to banks will not either. Taxpayer cash for Wall Street Trash is a bad deal. Unfortunately convincing congress that the sky is not falling seem impossible.

2008 Sep 29 11:07 AM

[mikebrah:]

Considering the magnitude of this rule change, I am shocked more hasn't been made of it. This is the first I have heard anyone speak about it, and it is downright scary.

This really is frightening, especially considering that (like a gambler) even if this bailout works, there is great likelihood that it will be followed by a series of high-risk maneuvers.

This really feels like someone being down to their last few chips at a blackjack table and putting them all on the table. Even if it works, you still aren't anywhere near where you started and will likely repeat the move several times.

2008 Sep 29 11:08 AM

[SW Richmond:]

OMFG, I had no idea this had been done. This action reveals just how much money has gone missing, and how desperate the banks are for cash. Thanks for sharing this.

2008 Sep 29 11:29 AM

[Smarty_Pants:]

Great article, good comments.

I'd note one exception to a statement in the article. The author wrote:

"JPMorgan... was next to score a prize when Washington Mutual (WM) was seized. It was a good deal all around."

It wasn't such a good deal if you were a shareholder or a bondholder. If WM was really under water, then the shareholders might not have much of a leg to stand on, but the bondholders got completely shafted by government edict. If WM had gone bankrupt the first people in line to get their money back would have been bondholders. Now they get nothing. Zip.

Was WM really sooooo bad that it wouldn't last until the weekend when a bailout could salvage the business? Just one more day? Really???

The torpedoing of WM by FDIC served two purposes for the banks:

1) Scare-mongering for Congressional doubters and
2) Instant deposit base bonus for JPM at nearly no cost to them.

Only one word aptly describes the FDIC action and that is "Criminal".

Note: Commentor owns neither WM stock or bonds. Just disgusted at criminal acts of government agents stealing from unsuspecting common folk yet again.

2008 Sep 29 11:34 AM

[Redsox1:]

Will this also affect credit unions that have my money?

2008 Sep 29 03:42 PM

[Ronald Pires:]

dlaw:

You didn't specify which conclusions you disagreed with, but just on a guess, I'd say it was tying the bailout to acquisition funding. And no, I can't prove that. My case of course was made on the close timing of all of these events.

To that end (and since I wrote this article), Goldman has announced its intentions to purchase $50B of insured assets, Wells Fargo has attempted to buy Wachovia, and Citigroup has succeeded in doing so. And all of this in the entire timespan of two weeks since the deposit rule change. There's clearly a buying frenzy out there for these assets.

Also, from the Financial Times, "Lending Woes Threaten M&A Deals" ( link.ft.com/r/M2ZOXX/C... ), which speaks of funding for mergers and acquisitions drying up. Certainly if the bailout is not specifically endorsed by these parties as for acquisitions of insured deposit assets, the money from it will end up there because it's not likely coming from anywhere else soon..

Now of course, none of this activity so far is based on funding from the bailout because it simply hasn't happened yet. So far, we're just looking at distressed institutions seeking shelter among themselves from otherwise certain demise. Still, there is a definite pattern of seeking insured assets coming from this group, and the rule change undoubtablely is playing a major role in the specific decisions we are seeing.

Remember though, there are still the regionals (and locals) that have suddenly become very attractive to these majors. We'll have to watch to see how much of this happens, but if I was betting (I'm not; I don't), I'd probably be looking for long options on the regionals.

2008 Sep 29 09:36 PM

[Ronald Pires:]

Redsox1

Credit unions are depositor owned. At this point, they are probably safer than Treasuries (and they are certainly paying more than short term Treasuries.)

2008 Sep 29 09:39 PM

[Ronald Pires:]

Mikebrah

Well said. Since I first learned of the deposit rule change (change,my butt ... they just tossed it out), I've been trying to scream it out to others. (Thanks to Seeking Alpha for the help.)

And I agree with your extension of my gambling allegory. If Paulson is risking insured deposits, he indeed sees himselfas down to his last few chips. With a game that is far from over.

2008 Sep 29 09:58 PM

[Ronald Pires:]

Smarty_pants

You are correct. Shreholders and bondholders indeed did not do well. I didn't mean to imply they had.

I tend to write in a very literary style, and my words here were quite flip (and intentionally so). It made for a better storyline. Obviously no one is making out well in this. My intent was merely to highlight that among all of the losers, a few of them at least have a few crumbs left to be happy about.

And yes, it was quite convenient as scaremongering also. The banks however are just following the numbers. Insured deposits are now an irresistable acquisition. Whomever gets the most lasts longest.

2008 Sep 29 10:37 PM

[David in D:]

Thanks for sharing this. I had no idea. I wish there were a way for a broader readership to find out more about this. Very helpful, thanks.

2008 Sep 29 11:13 PM

[Rogelio:]

Do we know what is the fundamental cause of economic downfall and crisis? Yes, yes, we can blame on the housing slump. But, have anyone actually look into the statistic, that the housing started to decline when the gas price started sharply increased about 3 years ago.

We might say how in the world gas price has anything to do with the housing slump, but as the matter of fact, it does. As the gas price started to increase, for those who were barely making it, had no choice but to forwent the house and swallowed the high gas price to continue to go to work to make a living.

We are petroleum based economy. As the gas price continue to rise, it hit even more people and more houses went into foreclosure. Moreover, as gas price continue to rise, everything went up in price, because everything required gas to transport. This affected people in every ways: from food, clothing, furniture, daily necessities and more. Paying all of these material things, a lot of time come before paying the house payment, which is usually the biggest chunk of our payroll.

If the gas goes down to a little bit over $1 as it was 2000, we will be back on our foot economically in a short time. At a little bit over $1 in gas price, most of people would right away have one to several hundreds dollars more to spend every month. With this, our economy will be back running smoothly in a few months. With more spending income available will also make the housing for affordable.

Rogelio

2008 Sep 30 04:44 AM

[squawk:]

MichaelZZ:

RE: "The only reason for Goldman Sachs to take a desperate (GS also gave Mr. Buffett 43,000,000 warrants to purchases GS common @ $115 per share) action was because it knew it was experiencing an EC impairment and needed to raise additional EC:


Goldman did the deal with Buffett because it needed to bring the firm into regulatory compliance after converting to a bank holding company. As an investment bank, its leverage was capped at 40:1; as a bank holding company the cap is 12:1. Given Goldman's balance sheet & market conditions, the best strategy was to raise its equity capital rather than reduce the debt on its books. For every $1 of equity raised, it was able to cover $12 of debt on its books. 'Nuff said. Otherwise, good, well thought out post.

2008 Sep 30 12:25 PM

[Socialism c...:]

The real problems:
1) The Frank/Dodd/etc cabal that pushed for more home ownership several years ago, thus creating this subprime mess. This was *not* W's fault.
2) An overgrown behemoth of a government that sucks the people dry...and we have let it continue growing far too long.
3) We...who have allowed credit-based living to become an accepted reality.

Time to cut this corpulent, bloated, untenable, irresponsible, wasteful government back to size. And time to cut taxes drastically...back to a just and reasonable level...not to exceed 15% total in Federal taxation for *any* American.

That, friends, is what we need to insist upon.

2008 Sep 30 02:20 PM

[poet1:]

so, if there is no bail out $$ for the little banks, and they fail, and jp, gs eat them up, we'd soon be left with just 4 banks running the usa? and if any bank fails, they pay depositors second? if there is any money left?

2008 Sep 30 09:52 PM

[motor2:]

Something strange happened to me at Bank of America. Had an acct already, but opened new one on 9/10/08. Deposited $300,000 ck from another local bank on 9/24. Hold was placed for 5 w days to be released 10/1 (received notice). Then today received letter BOF was holding all $300,000 til 10/3 saying they have reason to believe ck will not clear. It cleared Fed 9/24 & BOF 9/25, which is too late for local bank to send back (6 days). I called BOF & was told they did it on case-by-case. When pressed for reason I was told they can. I have filed complaint with OCC, but am worried.

2008 Sep 30 10:53 PM

[Ronald Pires:]

Poet1

The FDIC is committed to paying all claims for insured dollars, so you will always get paid, even if the FDIC reserve fund is exhausted. In that case, the FDIC would by law borrow money from the Treasury, even if that money had to be newly minted. Sorry if I gave you the wrong impression. Here is the problem I was getting at however.

Say a banks folds and the FDIC reserve is empty. Say the Treasury gets newly minted money to pay the depositors off. (It will likely come to this eventually.) That's inflation.

Now let's say that bank couldn't pay a single depositor back. It was flat broke. FDIC has a new dollar printed for each insured dollar. But it doesn't stop there. Under this new rule change, it has to print a second new dollar to cover the fact that each dollar was not only insured but also used as collateral. The FDIC is responsible for paying DOUBLE the amount of deposits lost, the original lost dollar AND the collateralized dollar.

Now say the failed bank was able to pay back half of the depositors. The FDIC gets a newly-printed dollar for each dollar for each insured dollar the bank couldn't pay, but then needs an additional TWO dollars for the collateralized debt.

Now obviously, the more that can be paid back out of the failed bank's own funds, the better it is for the FDIC. I don't mean to imply otherwise. Rather that when the FDIC reports lost deposits for that bank, its actual liability is at least twice that and possibly more.

One additional item. This rule change insituted under these conditions literally DEMANDS the creation of these new mega-banks we are now seeing form. If even one of them fails, the FDIC could in the conceivable future be on the hook for a trillion dollars. That's not inflation anymore; it's hyperinflation. And THAT'S the gamble Paulson has taken with the mere stroke of his pen.

2008 Oct 02 08:42 AM

[poet1:]

yikes

2008 Oct 02 03:55 PM