Will Bank Recapitalization Require US Government Sponsorship?

The Wall Street Journal on Monday said US regulators have been . John Dizard argues in the Financial Times that :

We don’t, however, have a lot of time to avoid the self-reinforcing contraction of the financial system that is the precursor of a depression. So while the philosophical and legal arguments over the next bank regulatory regime are being worked out, the American and European banking systems have to raise a lot of new capital, and raise it now.

It would appear that the scale of new capital issuance required for the banks is so large that some form of official sponsorship is required to make the effort work. The longer the capital-raising exercise is put off, the larger it will have to be, and the greater the degree of government sponsorship….

One of the interesting aspects of the crisis is how some mid-level and lower-level people in the financial institutions are far more coherent and direct than their leaders. It’s as if they’ve already given up waiting for upper management to give a sensible View from the Top. I could pick out a number of papers and documents from the various banks and dealers, but a pretty good example was published at the end of last month under the auspices of the US Monetary Policy Forum. Called “Leveraged Losses: Lessons from the Mortgage Market Meltdown”, it was co-authored by a group including David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyup of the University of Chicago, and Hyun Song Shin of Princeton.

Since the estimates were drawn up more than 15 minutes ago, they’re already out of date, but they’re not a bad place to start. The group estimates that the losses on mortgage paper will ultimately total about $400bn, with about half of that being incurred by “leveraged US institutions”. They go on to estimate that new equity raised so far from investors such as the sovereign wealth funds is of the order of $100bn. A series of calculations based on conventional banking economics leads them to estimate that “under this baseline scenario, the total contraction of balance sheets for the financial sector is $1,9800bn”.

This is before estimating any longer term increases in the losses incurred from lending to the corporate sector, or from other consumer lending such as auto loans or credit cards. Furthermore, it is before taking into account the cessation of much securitisation activity, and the consequent requirement for a shift to what the central bank people have described to me as “the new on-balance-sheet world”.

It does not, therefore, take much of a leap in imagination to suggest that the US banks need to raise well over $100bn in new Tier One capital, and perhaps more than $200bn. They also need to do it quickly, so as to avoid that spiralling destruction of capital.

Those are big numbers. Given that the mark-to-market theology would, without much of a stretch in interpretation, tell you that some major institutions would already have something less than the capital they need to support their business, one might reasonably ask why the investing public would give them more money. After all, you can buy big piles of mouldering securitised paper on the open market, without the management value subtracted offered by the Citigroup board.

The answer is the franchise value of the banks. Because they will be given positive yield curves, effective monopolies for making markets in government-sponsored securities, and will be cossetted with easier accounting rules in future, they are gigantic rent-paying machines in a risky age.

However, that point has to be driven home by the central bankers and regulators. So the hundred billion, or hundreds of billions, in new equity issues will need to be effectively co-sponsored by the Fed, along with a row of other eminent suits from the government.

Also, the issues will be so large that some queuing will have to be administered, or at least sanctioned, by someone with apparent independent authority.

None of this should be necessary. The bank boards should be able to take the lead on their own. But they can’t, without the legal and political cover that would be offered by effective and open government endorsement of new capital issues.

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Yet it isn’t at all clear who will give them the dough. Private equity firms have never been keen about low-growth (in normal times) regulated businesses, and the major firms are pulling in their horns in the face of big losses.

We’ve reported sightings as of a month ago that sovereign wealth funds were turning down further requests for dough from struggling US banks, and no wonder. Their earlier infusions are under water. Worse, in China, there has been ongoing criticism of the governments $3 billion, whoops, now $1.5 billion stake in Blackstone. The fact that Citic invested in Bear Stearns, and now Bear is rumored to be at risk of insolvency, will not doubt lead to further public outcry. Thus, even if the powers that be thought a US financial player might make a good invest, they will be reluctant to pull the trigger. They’d have only personal and institutional downside.

Conventional wisdom is that sovereign wealth funds will increasingly invest in the US via private equity and hedge funds, in part because using those channels will reduce political opposition (the SWFs would be passive investors). But per above, with private equity firms getting headline for faltering results, and hedge funds blowing up on a regular basis, it’s a tad optimistic to think sovereign wealth funds are lining up to write checks for large US funds, Indeed, they are likely to regard emerging market as more promising venues for growth.

Thus, Dizard’s exhortation comes too late. It will take considerable US government arm-twisting for US financial institutions to raise the equity they need.

So look for government officials to act as investment bankers to the banking industry. However, it probably won’t happen under the Bush administration, which is wedded to the idea of private sector solutions. That means, per Dizard’s warning, the recapitalization will come late and therefore be more costly than it would have been otherwise.

It’s too bad that the Administration is ideologically opposed to having Hank Paulson play a role he’d be good at.

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11 comments

  1. Anonymous

    and explain to me why you think it would be a good idea for the government to back-stop the banks?

  2. Yves Smith

    Neither Dizard nor ! said the government should backstop fundraisings. It is pretty well known that the Fed orchestrated AlWaleed’s investment in Citi when it teeteed on the verge of bankruptcy, and also brokered the DeutscheBank purchase of Bankers Trust when it was going under. Dizard used words like “endorsement”. Basically, the Fed and Treasury are going to wind up hawking (and hocking) our banking system.

    And why do they need to do so? Look at the Asian financial crisis. Indonesia’s GDP fell 13% when the hot money left and its banks collapsed. Riots and a change in government resulted.

  3. Francois

    “And why do they need to do so? Look at the Asian financial crisis. Indonesia’s GDP fell 13% when the hot money left and its banks collapsed. Riots and a change in government resulted.”

    Bingo! My calendar indicates we’re in 2008, a presidential election year. how many decades would the Republican party stay in the opposition if they didn’t do something?

    It is rather hilarious to contrast what the US said to Asian Countries when they got their pepitos dipped into the hot grease compared to what the US Go-vermin is doing right now at home.

    Question to Yves: Are there any rumors that upper management at these banks are going to remain in place as if nothing happened?

    I mean, in case of overt nationalization, shareholders and management are brought to the woodshed and beaten silly. The unstated rationale is obvious: Let Professor Pain teaches as only He can do.

    On the other hand, if management does not suffer any dire consequences, then I can’t see how we could avoid a repeat of this mess in the near/medium term future, when the next bubble perks up.

  4. Yves Smith

    Francois,

    If this country doesn’t start managing things better, we are going the way of Argentina. Our situation (huge current account deficits, fragile banks, overheated real estate markets) is a carbon copy of the conditions in the countries hit worst in the 1997 crisis. The only thing we have going in our favor is our reserve currency status and our nukes.

    Unfortunately, America either hauls business people before Congress and calls them bad names for ten minutes or sends them to jail. We don’t have more nuanced stages between those two punishments. We also have a bankruptcy system that generally keeps the incumbent management in place. I suspect we’ll see that too.

    Of course, if they did what Lee Iacocca did in the Chrysler rescue and take a salary of $1, that might not be so objectionable.

  5. Francois

    Yves,

    Thanks for the prompt answer. The only 3rd way I know that could keep management in check would be to rewrite shareholders’ rights law.

    Something is definitely wrong when >50% of shareholders vote against the CEO (remember Eisner at Disney?) and management is legally entitled to ignore it.

    And yes, bankruptcy laws should give shareholders the absolute right to kick management’s keister out of the corner office in a New York minute.

    I do not know what’ll take for that to happen. Me think Professor Pain has full employment guaranteed for a long time.

  6. Francois

    “Of course, if they did what Lee Iacocca did in the Chrysler rescue and take a salary of $1, that might not be so objectionable.”

    LOL!

    Oh! I’m sure some CEOs would accept the offer…as long as the rest of us accept a salary quoted in Zimbabwean currency or no more than 25 n’gwees per month.

  7. a

    “If this country doesn’t start managing things better, we are going the way of Argentina.”

    I’m not sure what you mean here. This country has been overspending for a generation, by borrowing from overseas. That’s already water under the bridge.

    So the country can manage things better, if you mean stiff the foreigners who lent us that money, and start anew. But other than that, the piper will have to be paid.

  8. CrocodileChuck

    Yves, Francois

    I was on the ground in Indonesia in 1997/98. Note: the economy actually contracted 17% in the first year after the collapse; and this in a rapidly growing country.

    Yves is ‘spot on’: the US is well advanced in becoming a banana republic-crony capitalism, regressive taxation, rampant and outrageous corruption, lack of reliable news, economic statistics/data; residential ‘fortressing’, etc

    The world needs the USA to step up and exhibit some moral authority and backbone.

    The time is now.

    CrocodileChuck

  9. Yves Smith

    a,

    Huge borrowing from overseas may not be a problem IF the money is going into productive investments. But borrowing to fund consumption and overinvestment in housing (which as far as I am concerned is consumption, just accounted for differently) is a formula for disaster.

  10. Lune

    Our situation is I think analogous to Iraq (bear with me; this won’t be too OT :-). As much as people argued whether going into Iraq was a mistake in the first place or not (and I was anti-war from the beginning), the question now is what to do to manage the mess we’re in, not what to do to the people that took us there.

    Similarly, as much as I may want every finance CEO and anyone who made >1mil bonus in the past 5 years on Wall St. to be perp walked out to Riker’s Island where he can find a new meaning for the term “invisible hand”, it’s probably not the best thing for the country moving forward.

    That said, I really think there’s a danger in offering government money with no strings attached, with some vague plan that we’ll extract concessions later. This industry needs a new regulatory scheme perhaps even more comprehensive than the one from the New Deal era. And the only way we’re going to get it is to put it on the table before we loosen the government purse strings. Yes, it will take time. And there will be more pain and uncertainty while we wait. But that means our esteemed economists and financial columnists and all our other financial brains should be putting out ideas for regulation posthaste, not ways for the govt to open the spigots. The money part is easy. If the industry accepts an appropriate new regulatory scheme, then bailing them out won’t be hard, and will be politically much easier because govt officials can honestly tell the public that it’ll be different this time.

  11. crmorris

    One of the best things about the Greenlaw-Hatzius paper is that it triangulates to its $400B estimate for subprime losses three ways — top down, bottoms up, and via ABX as of 2/28/08. They all give the same number. That is, the ABX had it on the nose, despite all the moaning about the cruelties of mark-to-market. So we should pay attention to the signals coming from the other indexes for leveraged loans, etc.
    Since only govts will be able to recapitalize the banks, I’d vote for our own, but only AFTER ratcheting down stated values and taking writedowns,and on terms like the Arabs have been getting. We could convert some of the huge trove of Social Security Trust Fund treasuries into bank tier one capital. No increase in deficit and will improve SS returns. As in Northern Rock,should be on real economic terms. Shareholders and execs get treated as the textbooks say they should.

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