2009 – The Year Monetarism Enters Bankruptcy
Henry C.K. Liu

Part I:    Bankrupt Monetarism
Part II:  Central Banking Practices Monetarism at the Expense of the Economy

Part III: Stress Tests for Banks

This article appeared in AToL on May 13, 2009 as Credulity Caught in Stress Test

The Treasury’s stress tests for US banks in April 2009 was designed to ensure that US banks have sufficient capital to withstand worst case scenarios in an economic contraction. Ten months earlier, on July 16, 2008, and a full year after the global credit crunch had imploded in July 2007, the federal banking and thrift agencies (The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and; the Office of Thrift Supervision) had issued a final guidance outlining the supervisory review process for the banking institutions that implement the new advanced capital adequacy framework known as Basel II which establishes an international standard for bank capital requirements.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision of the Bank of International Settlements (BIS). Basel II, initially published in June 2004 during the global credit bubble, aims to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face in recurring financial crises.
I warned in AToL on  May 9, 2007, two months before the credit crisis: 
The historical pattern of a 10-year rhythm [1987, 1997 and 2007] of cyclical financial crises looms as a menacing storm cloud over the financial markets. …
Now in 2007, a looming debt-driven financial crisis threatens to put an end to the decade-long liquidity boom that has been generated by the circular flow of trade deficits back into capital-account surpluses through the conduit of US dollar hegemony.

While the specific details of these recurring financial crises are not congruent, the fundamental causality is similar. Highly leveraged short-term borrowing of low-interest currencies was used to finance high-return long-term investments in high-interest currencies through “carry trade” and currency arbitrage, with projected future cash flow booked as current profit to push up share prices.

In all these cases, a point was reached where the scale tipped to reverse the irrational rise in asset prices beyond market fundamentals. Market analysts call such reversals "paradigm shifts". One such shift was a steady fall in the exchange value of the US dollar, the main reserve currency in international trade and finance, to cause a sudden market meltdown that quickly spread across national borders through contagion with selling in strong markets to try to save hopeless positions in distressed markets.

There are ominous signs that such a point is now again imminent, in fact overdue, in globalized markets around the world  
Under Basel II, a bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as Exposure at Default (EAD), in the bank’s internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure. In general, EAD can be seen as an estimation of the extent to which a bank may be exposed in the event and at the time of a counterparty default. It is a measure of potential exposure as calculated by a Basel Credit Risk Model for the period of one year or until maturity whichever is sooner. Based on Basel Guidelines, EAD for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs. The contagion effect of a chain of EAD is a key component that makes loss estimates difficult to pin down.

Loss Given Default (LGD) is the fraction of Exposure at Default (EAD) that will not be recovered following default. LGD is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral and the degree of subordination. Theoretically, LGD is calculated in different ways, but the most common is Gross LGD, where total losses are divided by EAD. Another method is to divide Losses by the unsecured portion of a credit line where security covers a portion of EAD. This is known as Blanco LGD. If collateral value is zero in the last case then Blanco LGD is equivalent to Gross LGD. Different types of statistical methods can be used to do this.
Gross LGD is preferred amongst academic economists because of its simplicity and because academics only have access to bond market data, where collateral values often are unknown, uncalculated or irrelevant. Blanco LGD is preferred amongst some market practitioners (banks) because banks often have many secured facilities, and banks would like to decompose their losses between losses on unsecured portions and losses on secured portions due to depreciation of collateral quality. The latter calculation is also a subtle requirement of Basel II, but most banks are not sophisticated enough in their risk management at this time to make those types of calculations internally.
LGD is a common parameter in Risk Models and also a parameter used in the calculation of Economic Capital or Regulatory Capital under Basel II for a banking institution. This is an attribute of any exposure on the bank’s client. Under Basel II, banks and other financial institutions are recommended to calculate Downturn LGD, which reflects the losses occurring during a ‘Downturn’ in a business cycle for regulatory purposes. Downturn LGD is interpreted in many ways, and most financial institutions that are applying for Internal Rating Base (IRB) approval under BIS II often have differing definitions of what Downturn conditions are. One definition is at least two consecutive quarters of negative growth in real GDP. Often, negative growth is also accompanied by a negative output gap in an economy (where potential production exceeds actual demand).
The calculation of LGD or Downturn LGD poses significant challenges to modelers and practitioners. Final resolutions of defaults can take many years and final losses, and hence final LGD, cannot be calculated until all of this information is ripe. Furthermore, practitioners are in want of data since BIS II implementation is rather new and financial institutions may have only just started collecting the information necessary for calculating the individual elements that LGD is composed of: EAD, direct and indirect Losses, security values and potential, expected future recoveries.
Another challenge, and maybe the most significant, is the fact that the default definitions between institutions vary. This often results in a so-called differing cure-rates or percentage of defaults without losses. Calculation of LGD (average) is often composed of defaults with losses and defaults without. Naturally, when more defaults without losses are added to a sample pool of observations, LGD becomes lower. This is often the case when default definitions become more ‘sensitive’ to credit deterioration or ‘early’ signs of defaults. When institutions use different definitions, LGD parameters therefore become non-comparable.
Mark-to-Market as Crisis Detonator
The central issue over capital adequacy related to risk exposure centers around the controversy of asset values mark-to-model against that mark-to-market. Basel II was instituted because mark-to-model value was considered inoperative, devoid of reality. Thus mark-to-market value was required at the close of each trading day. Yet mark-to-market is generally recognized as the detonator of the current credit crisis. Now, the Fed’s stress tests for banks have switched back to mark-to-model to calculate the capital adequacy of banks. 
The differential between the two values in a market failure can be more than total for assets to become “toxic” because of the interconnectedness of structured finance instruments. In other words, a bank exposed to counter-party default on one single credit instrument can affect the mark-to-market value of all other credit instruments in it possession and also those held by other institutions, even those on which it had no direct counter-party exposure.
The seemingly innocuous rise in default rate of the riskier unbundled tranches of an inverted credit pyramid can affect the credit ratings of the upper “safe” tranches to cause the whole credit superstructure to crumble much like the way the dead weight of falling upper floors of the collapsing World Trade Towers in lower Manhattan caused the collapse of the lower floors in an unstoppable cascade of mounting structural failures.
Credit Default Swaps
The banking system in recent decades has morphed into one that is inherently risk-infested on account of its precarious dependence on unimpaired counterparty credibility. The shadow banking system has deviously evaded the reserve requirements of the traditional regulated banking regime and institutions and has promoted a chain-letter-like inverted pyramid scheme of escalating leverage, based in many cases on nonexistent reserve cushion. This was revealed by the AIG collapse in 2008 caused by its insurance on financial derivatives known as credit default swaps (CDS).
AIG Financial Products (AIGFP), based in London where the regulatory regime was less restrictive, took advantage of AIG statue categorization as an insurance company and therefore not subject to the same burdensome rules on capital reserves as banks. AIG would not need to set aside anything but a tiny sliver of capital if it would insure the super-senior risk tranches of CDOs in its heoldings. Nor was the insurer likely to face hard questions from its own regulators because AIGFS had largely fallen through the interagency cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG would earn a relatively trifle fee for providing this coverage – just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant for the critical benefit, particularly in the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are “safe” but only that the risk was insured by AIGFP. For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.
Systemic Risk and Credit Rating
Thus there were two dimensions to the cause of the current credit crisis. The first was that unit risk was not eliminated, merely transferred to a larger pool to make it invisible statistically. The second, and more ominous, was that regulatory risks were defined by credit ratings, and the two fed on each other inversely. As credit rating rose, risk exposure fell to create an under-pricing of risk. But as risk exposure rose, credit rating fell to exacerbate further rise of risk exposure in a chain reaction that detonated a debt explosion of atomic dimension.
The Office of the Comptroller of the Currency and the Fed Reserve jointly allowed banks with CDS insurance to keep super-senior risk assets on their books without adding capital because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post 8% capital. But capital could be reduced to one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000 of risk on the books) if banks could prove to the regulators that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a collateral debt obligation (CDO) structure carried a Triple-A credit rating from a “nationally recognized credit rating agency”, such as Standard and Poor’s rating on AIG.
With CDS insurance, banks then could cut the normal $800 million capital for every $10 billion of corporate loans on their books to just $160 million, meaning banks with CDS insurance can loan up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital.  To correct this bypass is a key reason why the government wanted to conduct stress tests on banks in 2009 to see if banks need to raise new capital in a Downward Loss Given Default.
CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10, 000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years.
Default Correlation
Modeling the risks involved in credit derivatives revolved around the issue of “correlation”, which is the degree to which defaults within any given pool of loans might be interconnected vertically. Statisticians know that company debt defaults can be contagious within and even beyond industry limits. Historical correlations in corporate default and equity prices are normally used as a basis to project future correlations. But most of these historical correlation models do not include that fact that deregulated financial globalization has magnified correlation to the degree that even a small number of defaults would mushroom into catastrophic events of too-big-to fail dimension. Too-big-to-fail then is no longer enterprise specific, but has become systemic. This is beginning to finally hit on the consciousness of regulators to realize that even small individual mortgage or credit card holders have in fact also become too-big-to-fail in a perverse manifestation of debt-driven financial democracy.  
While margin payments do flow periodically between counterparties to rebalance changing risk exposures, the special conduits that hold CDO contracts insured by CDS are in effect non-regulated banks, much like hedge funds, with no requirements to hold reserves against a “Black Swan” event or a Minsky Moment that might cause a chain reaction.
A Black Swan event is a large-impact, hard-to-predict and rare occurrence that deviates beyond what is normally expected of a situation. This term was coined by Nassim Nicholas Taleb and summarized in his 2007 book: The Black Swan.
A Minsky Moment, named after economist Hyman Minsky (1919-1996), is the point in a credit cycle when investors develop cash flow problems due to spiraling debt they had been structurally compelled by systemic logic to incur in order to finance irresistible speculative investments offered by imbalance between the penalty and reward of risk caused by mis-pricing of risk, usually caused by excessively low cost of borrowing. At the point of a Minsky Moment, a major sell-off would begin due to the inability to find counterparty to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market-clearing asset prices and a sudden, sharp drop in liquidity. The term Minsky Moment was coined by Paul McCulley of PIMCO in 1998 to describe the Russian default that led to the collapse of hedge fund LTCM, as worked out by the late Hyman Minsky decades earlier.
According to the Bank for International Settlements (BIS), total outstanding CDS at year end 2007 was $43 trillion, more than half the size of the entire asset base of the global banking system. Total derivatives amounted to over $500 trillion in notional value, spread out in the balance sheets of Special Investment Vehicles (SIVs), Collateralized Debt Obligations (CDOs) and other conduits comprising the highly-leveraged shadow banking system. July 2007 was the month the credit market imploded.
On July 16, 2008, a full year after the credit markets failed im July 2007, the federal banking and thrift agencies (The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and; the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework known as Basel II. The final guidance, relating to the supervisory review, aims at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which had taken effect on April 1, 2008.
Big Payoff for Lobbying
During 2008, the financial companies that received bailout money from the Fed and the Treasury had spent $114 million on lobbying Congress and political campaign contributions. These companies received $295 billion in bailout money. Center for Responsive Politics Executive Director Sheila Krumholz said of this development: “Even in the best economic times, you won’t find an investment with a greater payoff than what these companies have been getting.”
Ms. Krumholz was correct that the campaign contribution was a fantastically good investment for the donors, but it was by far not the best.  The regulators’ relaxation on bank capital requirements from CDS insurance beat it by a mile. But the biggest windfall was from lifting of leverage limits.
Suicidal Leverage Ratios
The net capital rule created by the Security Exchange Commission (SEC) in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
Ever since the Great Depression of the 1930s, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated globalized credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary in 2006, and a year later had to deal with the global mess created by high leverage from which three of the five qualifying broker-dealers had collapsed.
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) program, allowed the broker-dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based computerized model for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
The leverage ratio - a measurement of how much the companies were borrowing compared to their total assets - rose sharply at Bear Stearns, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratio at the other firms also rose significantly. This advantage enabled the Big Five to go on a frenzy of acquisition, expanding risk to the entire financial system. The abuse of leverage was particularly severe in the hedge fund industry in which the Big Five were big players both in proprietary funds and as broker-dealer for large hedge funds who in turn were highly leveraged.   (Please see my October 30, 2008 AToL article: Killer Touch for Market Capitalism)
Government Bailouts and Bank Executive Pay
Banks that received bailout money had paid their top executives nearly $1.6 billion in salaries, bonuses, and other benefits in 2007. Benefits included cash bonuses, stock options, personal use of company jets and chauffeured cars, home security expenditure, country club memberships, and professional financial management fees.  The Obama administration has promised to set a $500,000 cap on executive pay at companies that receive bailout money, but the proposal would also allow banks to give unlimited amounts of stock to these same executives, presumably tying compensation to performance, even though much of the recent rise in the price of bank shares were the direct result of government bailout. The losses are still there, only now the taxpayers are paying for them rather than bank shareholders.
On January 15, 2009, the out-going Bush/Paulson Treasury issued interim final rules for reporting and record keeping requirements under the executive compensation standards of the Capital Purchase Program (CPP).
On January 20, 2009, Barack Obama assumed office as the 44th President of the United States.
On January 21, 2009, the new Obama/Geithner Treasury announced new regulations regarding disclosure and mitigation of conflicts of interest in TARP contracts. It was the first sign that Obama’s politics of change might not be what it sounded like to voters during the campaign.
On February 5, 2009, the Senate approved changes to the TARP which prohibit firms receiving TARP funds from paying bonuses to their 25 highest-paid employees. The amendment was proposed by Christopher Dodd of Connecticut as an amendment to the proposed $900 billion economic stimulus act then yet to be passed.  The fundamental flaw of TARP, the myth that the transfer of hundreds of billion of toxic assets from the private sector into the public sector can make them less toxic, was left unchanged while distraction on a minor point on executive bonuses was held up as a sign of the new populism.
The Bank Stress Tests
On February 10, 2009, the newly confirmed but still understaffed Secretary of the Treasury Timothy Geithner outlined his plan to use the $300 billion remaining in TARP funds, announcing his intention to use $50 billion for foreclosure mitigation and to use the rest to help fund private investors to buy toxic assets from banks. Nevertheless, this highly anticipated speech coincided with a nearly 5% drop in the S&P 500 and was criticized for being short on details.
On February 26, 2009, The Obama administration, in unveiling details of its financial-rescue plan, laid out a dark economic scenario it expects banks to be able to withstand, the starting point for what could become a significant new infusion of government cash into the banking system.
The first step in the latest effort to shore up the banking sector would be a series of “stress tests” to assess whether the largest 19 US banks can survive a protracted slump. To ensure banks can survive even if the unemployment rate rises above 10% and home prices fall by an additional 25%, the administration will conduct stress tests that will end up requiring some institutions to either raise private money or accept a bigger investment from the government. The tests assume a 3.3% contraction in GDP in 2009, which would be the worst performance since 1946. And it assumes home-price declines of another 22% in 2009 and 7% in 2010.
The stress tests assume an unemployment rate averaging 8.9% in 2009 and 10.3% in 2010. Because that is an average for a whole year, the tests envision the jobless rate reaching higher than the average in some months. The rate was 7.6% in January. In March the unemployment rate for California was 11.2%; for Michigan, it was 12.6%. The Fed said it does not expect the economy to deteriorate as sharply as the test scenarios, but it wants to be sure banks would be prepared for worst case eventualities. Yet many think the government’s dark scenario was not dark enough on both unemployment projections and inflation expectations.
Laurence Meyer,  former Fed governor (1996 – 2002), vice chairman of Macroeconomic Advisers LLC, a forecasting firm whose models are widely used in Washington and New York, told the press that “I don't have any problem believing the unemployment rate is going to move to 12% or that vicinity.”
Mr. Meyer said regulators had to strike a delicate realistic balance in designing their tests - a truly grim scenario such as the economy contracted by 9% as in 1930, 6% as in 1931 and 13% as in 1932 - it could force banks to raise more capital than they are capable of raising, driving them further into the government’s arms. In other words, the dreaded N word.  “You don't want to know the answer to some of the questions you might ask,” Mr. Meyer told the press.
The tests were completed by the end of April but the results were not released until May 8 because banks were reported to have disputed the test results. The Wall Street Journal reported that as a result of intense negotiation with banks, the Fed significantly scaled back the size of the capital hole facing the nation’s biggest banks. As used in the stress tests, Tier 1 common capital ratio is an estimate of capital available to common shareholders as a percentage of a bank’s risk-weighted assets.
The Fed has told banks it looks at Tangible Common Equity (TCE) ratio that measures how much shareholders would have left after liquidation. TEC ratio shows the equity of a bank minus its preferred shares, goodwill and intangible assets as a percentage of tangible assets. The Fed wants TCE to be at lest 4% of a bank’s risk-weighted asset.  Citigroup’s TEC was only 1.9%, Bank of America 2.9% and Wells Fargo 2.9%.
Citigroup, which has already been bailed out three times amounting to $45 billion, reportedly needs to raise up to $10 billion of new capital as a result of the stress tests. Bank of America, which has had $45 billion in government aid, was found to need $33.9 billion. Regional banks Wells Fargo ($13.7 billion) and PNC Financial ($600 million) were also among the banks that would need to raise more capital.
Citigroup is believed to be considering a plan to convert more than $15 billion in trust preferred shares – a hybrid of debt and equity – into common stock. Since trust preferred shares are held by non-government investors, this conversion could enable government authorities to inject further funds into the bank without raising its stake beyond the 36% it has already agreed to buy. Citigroup would have to force holders of trust preferred shares to convert them into common stock, which ranks below those securities and does not pay a yearly interest rate, by threatening to stop paying interest if they reject the offer.
Banks have 30 day after the stress tests to give the government a recapitalization plan and up to six months to correct any capital shortfall. The Fed’s strong preference is for banks in need of fresh capital to either raise it through private capital markets or selling assets. For banks that cannot raise private capital, they may have to sell to the government big stakes in their common equity to meet capital requirements.
Unlike the Bush administration’s effort to pump $250 billion into banks, the Obama team did not commit a set amount of money to the effort. President Obama said after taking office that banks would need additional funds beyond the $700 billion rescue package approved by Congress in the fall of 2008.
The government’s investment would come in the form of convertible preferred shares, which institutions could choose to convert into common equity at any time. Regulators and investors have become increasingly concerned about the amount of common stock banks hold, since that is a bank’s first line of defense against losses. Regulators said they expect banks would convert the shares to common equity as needed to help protect against losses.
Many economists think most of the nation’s largest banks will likely have to raise more capital beyond the economic assumptions that regulators used. Under some circumstances, the government might end up owning majority stakes in banks.
Banks that get a government investment will have to comply with strict executive-compensation restrictions, including curtailed bonuses for top executives and earners. The requirement is shaping up to be a strong incentive for banks to repay or reject government investment. The securities held by the government will pay a 9% dividend -- higher than the 5% banks are required to pay under the Bush-era program -- and banks would be restricted in dividend payouts and from buying back their own stock. The securities would automatically convert to common stock after seven years. Banks that have already sold preferred shares to the government as part of the $250 billion program would also be able to swap the preferred shares for convertible securities that can convert to common shares.
Administration officials said the effort is an attempt to avoid nationalizing banks while making sure institutions can lend money. While officials said most banks are considered well capitalized, uncertainty about economic conditions is hindering their ability to lend money or attract private capital.
Treasury Secretary Timothy Geithner sought to discredit speculation that the government might nationalize banks, saying such a move is “the wrong strategy for the country and I don't think it's the necessary strategy.” Mr. Geithner, speaking on February 10 on The NewsHour with Jim Lehrer, said there may be situations where the government provides “exceptional support” but that the best outcome is if the banks “are managed and remain in private hands.”
Private Participation in Government Investment Plan
On March 23, 2009, Treasury Secretary Geithner announced a Public-Private Investment Program (P-PIP) to buy toxic assets from bank balance sheets.
Major US stock market indexes rallied on the day of the announcement, rising by over 6% with bank stocks leading the way.  P-PIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from bank balance sheets. The FDIC will provide non-recourse loan guarantees for up to 85% of the purchase price of legacy loans. Private sector asset managers and the Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the Treasury TARP money, private investors, and from loans from the Federal Reserve’s Term Asset Lending Facility (TALF). The initial size of the Public-Private Investment Partnership is projected to be $500 billion. Economist Paul Krugman has been very critical publicly of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors. Banking analyst Meridith Whitney, who first raised questions about Citigroup’s soundness, argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs. Removing toxic assets would also reduce the volatility of bank stock prices. Because stock is a call option on firm assets, this lost of volatility will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.
Four small regional banks on March 30 2009 became the first financial institutions to return the federal money they had received under the government’s banking bailout, leaving a program that placed restrictions on their executive compensation and other spending. Northern Trust of Chicago repaid more than $1.5 billion after a hail of criticism from Capitol Hill over its lavish entertainment spending at a golf tournament in suburban Los Angeles. Goldman Sachs, Wells Fargo, JPMorgan Chase and Bank of America are among the biggest banks that have said they are aiming to return the government’s bailout money to avoid ceilings on executive pay.
On April 19, the Obama administration outlined the conversion of banks bailouts payments to equity share holdings. Top economic advisers determined that the nation’s banking system could be shored up without having to ask Congress for more money in the immediate future. In a significant shift, White House and Treasury officials claimed what was left of the $700 billion financial bailout fund could be stretched further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock. The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5%.  Converting those loans to common shares turned the federal aid into available capital for a bank — and gave the government a large ownership stake in return.
While the option avoided a confrontation with Congressional leaders about putting more government money into distressed banks, it was nationalization through the back door since the government could become the largest shareholder in several of the largest banks. The Treasury had already negotiated this kind of conversion with Citigroup and had said it would consider doing the same with other banks if needed. The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity. After the conversion, the Treasury would end up with about 36% of Citigroup’s common shares, which come with full voting rights. That would make the government Citigroup’s biggest shareholder, effectively nudging the government one step closer to nationalizing a major bank. Nationalization, or even just the hint of nationalization, is a politically explosive step that White House and Treasury officials have fought hard to avoid.
Now the administration appeared to have adopted a policy of debt to equity to make up for any shortfall in capital that the big banks might confront in the near term. Taxpayers would be taking on more risk, because there is no way to know now what the common shares might be worth when it comes time for the government to sell them.
Treasury officials estimated that they would have about $135 billion left after left after the Treasury completes its $100 billion plan to buy toxic assets from banks and after it uses $50 billion to help homeowners avoid foreclosure. In practice, it could be more than a year before the Treasury uses up the entire $100 billion in the toxic-asset programs and uses up the $50 billion budgeted for homeowners.
But the biggest way to stretch funds could be to convert preferred shares to common stock, a strategy that the government seems prepared to use on a case-by-case basis.
Ever since the Treasury agreed to restructure Citigroup’s loans, officials have made it clear that other banks could follow suit and convert their government loans to voting shares of common stock as well. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults, such as commercial mortgages and credit cards.
The Obama budget for 2010 includes $250 billion in additional spending to prop up the financial system. Because of the way the government accounts for such spending, the budget actually indicated that the Administration might ask Congress for as much as $750 billion. The most immediate expense of up to $75 billion came when federal bank regulators completed “stress tests” on the nation’s 19 biggest banks. The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.
By the Treasury becoming a major shareholder, and perhaps even the controlling shareholder, in some financial institutions could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.
Those were the very kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks in fall 2008.
The effects of the TARP have been widely debated. The New York Times found that “few [banks] cited lending as a priority. An overwhelming majority saw the program as a no-strings-attached windfall that could be used to pay down debt, acquire other businesses or invest for the future.” The report cited several bank chairmen as stating that they had no intention of changing their lending practices to “accommodate the needs of the public sector” and that they viewed the money as available for strategic acquisitions in the future.
May 10, 2009
Next: Government Life Support for the Comatose Auto Sector