Too Big to Bail: Lehman Brothers Is the Model for Fixing the Zombie Banks

Includes: AIG, BAC, C, JPM, LEH
by: Christopher Whalen

We've been hearing a lot from readers lately, as you might imagine. Many of them thank us for speaking frankly about the issues regarding the growing but soluble solvency problems facing the largest US banks. We appreciate the comments.

Click here to see our discussion yesterday on TechTicker with Henry Blodget regarding the Geithner plan for the banks. We tried to lay out in simple terms how we see the next few weeks and months unfolding regarding the larger banks. We also try to understand and articulate why the Obama Administration seems so reluctant to engage on the large bank solvency issue.

Notice that the Obama Administration remains in campaign mode, but with a crowd of people in the room who should have been left at the victory party. During one exchange last week on the performance of the Obama Administration to date, we ventured the opinion that our brilliant new leader resembles a young, inexperienced monarch, surrounded by the conflicted, incompetent family members and cronies tied to the now dead former king.

To this, a reader of The IRA replies: "The former king is alive and flourishing, with the former queen wandering the castle."

Another reader chides: "I think you're giving the Republicans in Congress too much credit" regarding fiscal restraint. He continues: "As far as I can tell, they're still trying to prop up the housing industry."

Fair point. But we sure are delighted to see Senator and former TX treasurer Kay Bailey Hutchison (R-TX) talk about haircutting the bondholders of the large banks. Bet she'd make a great Treasury Secretary if President Obama hasn't lost his desire to include Republicans in his government!

Memo to Joe, Carl, and Becky at CNBC. Get Kay on the Squawk Box pronto to talk about crew-cuts for the big banks. Readers of The IRA in TX will recall a certain episode involving Bank United Corp in the early 1990s that Senator Hutchison also remembers. More on regulatory discretion regarding who lives and who dies in a future issue of The IRA.

By the way, in her otherwise surprisingly good testimony last week, Elizabeth Warren agreed with our comment that the primary task is to deal with the housing sector, because that's where the meltdown started. Going even further, Martin Feldstein has said that the real estate sector that got the economy in trouble will lead it out. Yada, yada.

We'd never admit to being economists, but it seems like an awfully facile assumption, however politically correct, to look to a broken sector for leadership when fantasizing about turnarounds in the financial market and the economy. Our working hypothesis is that the speculation-crazed banking/real estate disaster has badly diminished the US economy, and horribly damaged the financial systems of some of our key economic partners. Look at places like Poland, Iceland and even China. This damage will only increase as long as resolution process for zombie banks continues to be postponed by the Obama Administration.

While you might think that Treasury Secretary Tim Geithner and his counterparts at the Fed are focused on helping the US economy, in fact they believe they have a larger mission, which is to maintain the Too Big To Fail banks. This conflict between what is good for the big banks and good for the US economy continues to widen as the financial pressures build on the US Treasury. But fortunately the available resources are forcing the issue as to expenditure.

A big obstacle to progress remains the insistence by the Treasury and the Fed that we go "back to the future" in terms of remaking the world of large New York dealers and securitizations, but fortunately rising pressure of financial reality is forcing Geithner to change his plans almost daily. Not surprisingly, President Obama prefers to be on the campaign trail rather than face the dismal discussions in Washington, but sooner or later Barack Obama must make his case to the financial markets.

As we noted in a post on TheBigPicture last week, "Bondholder Haircuts at Citigroup: At the End of Q1, the Children's Hour Ends in Washington," the Q1 2009 numbers at Citigroup (NYSE:C), Bank of America (NYSE:BAC) and JPMorgan (NYSE:JPM) are going to make clear, even to members of the Obama Administration, that talking about injecting new equity into the largest banks without first resolving these institutions is a waste of time and money.

Remembering that half of the liabilities of C, BAC and JPM are funded out of the bond markets and not via deposits, it should be clear to one and all that the US taxpayers are not in a position to subsidize the bond holders of these three banks, representing some $1.5 trillion in debt, if the deposits of these banks are to be protected. Some people, indeed, many people believe that we must avoid another Lehman Brothers type resolution where bondholders take a loss, but to us the only scenario where depositors of C, BAC, JPM do not take a loss is if we haircut the bond holders.

There are no easy answers here, but the guiding principle left by the Founders that bankruptcy be used to quickly and finally resolve insolvency is instructive. In that sense, Lehman Brothers is the ideal example, not something to be avoided. The model of the conduct of the Lehman liquidation by the US Trustee is an excellent archetype that should be carefully studied and considered as the Obama Administration considers the next move. If we are going to consider a restructuring for General Motors (NYSE:GM) and what remains of Chrysler, then Washington better be in a position to talk with finality about resolving the big banks at the same press conference.

What is required in Washington is an adult conversation, between the US government on the one hand and the holders of the bonds of the largest banks on the other. Many of the bond holders of the large banks are foreign governments, central banks and investment funds and not a few of these sovereign names are in really serious financial difficulties. Since the receiverships for Lehman Brothers and Washington Mutual, where bond holders took a near total loss, these foreign investors have been vocal in demanding that US taxpayers protect them from further harm.

But to deflect these cowardly, expedient arguments, the US government must be willing to lead by example to show that there really is only one way to restore confidence in zombie banks: use receivership to wipe out the common and preferred shareholders, conserve the deposits and sell the good assets to new investors, and then restructure the remaining operations of the bank to maximize recovery to the bond holders and other creditors.

Such a process as Lehman is painful and politically very difficult, but remember that nobody is surprised now. The definition of "systemic risk" is when markets are surprised, but these are political distinctions. Repeat after us: "there is no such thing as systemic risk," at least that can be measured scientifically. SysRsk is a political concept, a manifestation of fear and uncertainty. As the Fox told the Little Prince: "All that is essential is invisible to the eyes."

We all mostly understand the problem now. The swiftest and surest way to restore market confidence is to create solvent banks and begin the process of rebuilding the global markets for both finance and commerce. That is why we say that the competent and efficient handling of the Lehman Brothers liquidation by the US Trustee, SIPC, other state and federal regulators, and most important the professionals of the US Bankruptcy Court for the Southern District of New York is the model for dealing with the large banks.

Days, weeks and months are precious now. If we delay and pretend that this problem will just go away with time or that the markets of yesterday will miraculously be renewed, then the economic slump will indeed worsen and we shall have all talked ourselves into a bona fide global economic catastrophe. Here's our two key points again, distilled from our previous issues of The IRA and the many comments we have received from you:

1) Finality for the Banks: The US should announce an open-bank conservatorship for C before the Q1 results drop and be prepared to include BAC, JPM and WFC, in that order of urgency. The deposits of the institutions should be explicitly conserved, but the bond holders and other creditors must be put on notice that their position is a function of the net recovery from the parent holding company a la Lehman Brothers. Keep in mind covering all deposits is a huge concession and may require a subsidy from the FDIC unless the bond holders take the loss. The process of conservatorship for C could go on for years and would ensure that consumers and other customers of the bank are protected.

2) Finality for Markets, Homeowners: As per our previous comment, 'Can We Fix the Banks, Help Homeowners, and Rebuild the Mortgage Markets? Can Do.', the Treasury should begin a systematic process for an at-the-market buy-in all of the extant toxic securitizations, transfer ownership of these assets to the Deposit Insurance Fund and then use the receiver powers of the FDIC to reorganize the DE trusts that are the issuers of the notes. Start with the paper on repo to the Fed. Once the FDIC gains legal custody of the collateral, it can then sell these assets through the resolution process now ongoing with financing backed by the Fed. Our preference is to see these loans sold to community banks with branches near the property, a move that would immediately enhance the quality of these credits and also make modification/refinancing more practical. Either tasks requires manpower and the thousands of solvent American community banks in the US are the mechanism to make foreclosure abatement a reality. But any and all buyers should be encouraged.

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