John Hussman is always a good read. This week, in Buckle Up, Hussman is railing about the policies in Washington. Let's tune in.
The misguided policy response from Washington has focused almost exclusively on squandering public money and burdening our children with indebtedness in order to defend the bondholders of mismanaged financial institutions (blame Paulson and Geithner - I've got a lot of respect for our President, but he's been sold a load of garbage by banking insiders). Meanwhile, I suspect that the little tapes in Bernanke's head playing "we let the banks fail in the Great Depression" and "we let Lehman fail and look what happened" are so loud that he is making no distinction about the form of those failures. Simply letting an institution unravel is quite different from taking receivership, protecting the customers, keeping the institution intact, replacing management, properly taking the losses out of stockholder and bondholder capital, and issuing it back into private ownership at a later date. This is what it would mean for these banks to "fail." Nobody is advocating an uncontrolled unraveling of major financial institutions or permanent nationalization as if we've suddenly become Venezuela.
Make no mistake. Buying up "troubled assets" will not materially ease this crisis, nor will it even improve the capital position of financial institutions (see You Can't Rescue the Financial System if You Can't Read a Balance Sheet). Homeowners will continue to default because their payment obligations have not been restructured to any meaningful extent. We are simply protecting the bondholders of mismanaged financial institutions, even though that bondholder capital is more than sufficient to cover the losses without harm to customers. Institutions that cannot survive without continual provision of public funds should be taken into receivership, their assets should be restructured to better ensure repayment, their stockholders should be wiped out, bondholders should take a major haircut, customer assets should (and will) be fully protected, and these institutions should be re-issued to the markets when the economy stabilizes.
The course of defending the bondholders of insolvent institutions is not sustainable. Do the math. The collateral behind private market debt is being marked down by easily 20-30%. That debt represents about 3.5 times GDP. That implies collateral losses on the order of 70-100% of GDP, which itself is $14 trillion. Unless Congress is actually willing to commit that amount of public funds to defend the bondholders of mismanaged financials so they can avoid any loss, this crisis simply cannot be addressed through bailouts. Bondholders have to take losses. Debt has to be restructured. There is no other option - but the markets are going to suffer interminably until our leaders figure that out.
Bailing out the bondholders is impossible. So is Having Your Cake And Lending It Too, a policy pushing banks to lend more while chastising them for taking bad credit risks. And the problem I have with nationalization is there is no clear understanding as to what it means. See Nationalization Revisited for details.
Reluctance Nationalize Citigroup
Citing the Institutional Risk Analysis and BusinessWeek in Who Bears the Burden for a $3 Trillion Mistake? a case was made as to why the Fed was reluctant to own more than 50% of Citigroup.
Institutional Risk Analysis: "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."
However, the government is avoiding taking a 50% stake in Citigroup hoping to avoid pressure by foreign governments for the US to make good on a full repayment of bank bonds. If the government limits its stake to 40% or less, US Government guarantees of bank debts may be skirted, or at least postponed.
Now that the common and preferred shareholders have been wiped out, we are approaching the time where as Michael Mandel at BusinessWeek suggests "bondholders are going to have to take a big haircut".
Returning again to Institutional Risk Analysis: "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."
Are Any Adults In The House?
Why is it so hard to have that "Adult Conversation"?
The answer is Obama is listening to the wrong people (Geithner and Bernanke) and/or there is some other threat being made. I am more inclined to believe the former although there is no doubt pressure being placed on the Fed for Citigroup to and other banks to honor its preferred and corporate debt as well as SIVs kept off the balance sheet.
Off Balance Sheet Accounting
On June 4 the Financial Times wrote US banks fear being forced to take $5,000bn back on balance sheets.
Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books.
The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.
Not Practical To Tell The Truth
Not to fear, On July 30th, the FASB Postponed Off-Balance-Sheet Rule for a Year as described in Not Practical To Tell The Truth.
The Financial Accounting Standards Board postponed a measure, opposed by Citigroup Inc. and the securities industry, forcing banks to bring off-balance-sheet assets such as mortgages and credit-card receivables back onto their books.
FASB, the Norwalk, Connecticut-based panel that sets U.S. accounting standards, voted 5-0 today to delay the rule change until fiscal years starting after Nov. 15, 2009. The board needs to give financial institutions more time to prepare for the switch, FASB member Thomas Linsmeier said at a board meeting.
"We need to get a new standard into effect," Linsmeier said, though "it's not practical" to begin requiring companies to put assets underlying securitizations onto their books this year.
On July 23, the Citigroup CEO said Citi Off-Books Risks 'Well in Hand'. Clearly it wasn't.
And while some off balance sheet SIVs have been brought back on the books, how much wasn't, and what's it worth? More importantly does the Fed feel there is some implicit guarantee of those SIVs?
What we do know is the Fed did come in, at taxpayer expense and guarantee Fannie Mae and Freddie Mac debt. The largest beneficiaries of that move were PIMCO who bet on the move, and foreign agency holders like China.
Stop Squandering Taxpayer Money
The issue of SIVs has been in the back of my mind for a long time. I still do not know the answer as to whether the Fed feels an implicit obligation to guarantee those ventures or not, and there may be $5 trillion or more of them luring around.
Heaven help us if Obama continues to listen to Geithner and Bernanke because "squandering public money and burdening our children with indebtedness in order to defend the bondholders of mismanaged financial institutions" is not only hopelessly misguided policy, but unsustainable as well.