Monday, March 30, 2009

Three Ring Circus

A friend of mine used to work for Ringling Brothers Circus. When he would come to town his father would collect a gang of us to go meet the clowns and the other marvelous bits of the crazy circus world. Josh played saxophone in the circus band and the stories he gathered in those years should keep him supplied with entertaining tales forever. That circus was a lot more fun.

The three rings going on now have more clowns than Ringling ever had with nowhere near as many laughs. (How many investment bankers COULD fit in that little car I wonder?) With so much going on at once it is difficult to focus on each aspect that we are mentally juggling without getting them mixed up. The three are, the investment markets, the banking crisis, and the economy. While inextricably bound, they do not march in lock step. Let's first look at the banking crisis.

With all the discussion of toxic assets and the Public Private Investment Program (PPIP), rescue plans and the FDIC, I find people generally have at most a smattering of knowledge of the problem, let alone the solutions. It is complex, but seemingly more so with the explanations coming from Washington.

First let's look at the fundamental financial structure of a bank. The balance sheet looks something like this.

Good Assets $90
Questionable Assets $10
Total Assets $100

Liabilities to Customers $65 (bank depositors)
Debt to Bondholders $30
Shareholder Equity $5
Total Liabilities and Shareholder Equity $100

Those $10 of legacy/toxic assets have turned out to be pretty lousy investments for the banks. They have been written down to reflect reality, let's say from $10 to $4. So now the balance sheet looks like this:

Good Assets: $90
Questionable Assets $4
Total Assets $94

Liabilities to Customers: $65
Debt to Bondholders: $30
Shareholder Equity: $-1
Total Liabilities and Shareholder Equity: $94

This is by definition an insolvent bank. Now the question is, what to do? If this were 1st National Bank of Anytown, USA the FDIC would walk on on Friday afternoon, take the bank over, wipe out the shareholders, make sure the depositors are safe with the $90 of good assets, pay the bondholders $25 of the $30 owed and reopen on Monday morning as a new bank. Equity holders would lose all, bond holders part, depositors nothing.

This is how depositors of banks are protected with sufficient capital in the system.

The owners are first on the line for losses, the bondholders are next, and the customers are kept intact.

Except now. Except for a few big banks. There have been 46 bank failures since the beginning of 2008. In most cases, the failed bank was acquired immediately by another bank. In several cases where an acquiring bank was not found, the depositors simply had checks sent to them from the FDIC for covered deposits. Obviously we are dealing with banks too big to fail, i.e. too big to exist.

How can a bank be rescued from insolvency? The first option is to provide additional capital through the sale of stock. This is what the Treasury did when it purchased preferred stock of banks making us the largest shareholder of some. This is a solution for immediate and temporary threat of insolvency. We can hope some of the money will be loaned but without restriction, bonuses, new desks are also on the list of uses. If the bank fails, the taxpayer, as an equity holder loses everything since we are down the priority list. There is no provision for placing taxpayers ahead of bondholders. That hole keeps growing and it is highly unlikely that there is the political will for additional congressional approval for more cash infusion.

So what now??

Enter the Treasury plan of a Public/Private partnership. Obviously if the bank can make the toxic asset go away that would help....almost. If the toxic asset, valued at $4, is bought by the taxpayer for $4, there is no balance sheet improvement, only a transformation from $4 in an asset to $4 in cash. Only by paying $6 in cash for $4 in asset value, do things improve. So the question becomes how do we get buyers to overpay?

We start with the FDIC agreeing to lend the money to a buying "manager", guarantee the FDIC will absorb any loss over 3-7%, juice it up with 6x leverage and finally have the failing bank begin buying toxic assets in the market before the plan launches at above market prices to at least create the illusion of higher prices at which the bank will then sell. And best of all, Congress didn't have to approve it. What happens when FDIC fails? Then congress will pony up rather than leave bank depositors uninsured.

All of this convoluted structure is in place for the sole reason of protecting the bondholders of the major money center banks. Why?

Why should the taxpayer have a lower security position than the lenders to Citibank? How is the American public responsible for the losses? Why are the bondholders of Citi not being "encouraged" to swap debt for equity avoiding insolvency and allowing the bank to recover by its own business.

If that doesn't work, the banks should be taken in to receivership, the customers defended, the management changed, the shareholders wiped out and bond holders contributing. The bank can be immediately reprivatized as an operating and profitable entity. The only impediment to solvency is the bondholder debt.

To big to fail or too big to save is really the question.

John Barnyak