Wednesday, October 1, 2008

The toxic-asset banking hazard

Lobbyists are moving to reverse the House vote against the Economic Stabilization Act of 2008 (which includes TARP), the Senate votes Wednesday, but the contentious debate is ongoing. While Congress is rushing to restructure a faulty bill, they should take note of the following: Recent government interventions have already hindered the recovery of the banking system.

It is well-established that the bill had problems

On September 24 – three business days before the House voted down the bill – 192 economists singed a petition that the bill had three serious deficiencies, where among other problems, fairness was a major pitfall:
“The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise."
Congress addressed, at least partially, the fairness issue when it rewrote the Treasury's proposal. In its latest form, if net-losses are incurred after five years, the President will submit a “proposal” to recoup the losses from the “entities benefiting from TARP.” However, two major pitfalls remain, ambiguity and long-term deficiencies (interference in the progress of capital markets).

The fundamental problem: In an attempt to restore confidence, the bailout plan interfered with the market’s own ability to restore confidence.

As Paul Krugman notes, this bailout plan is different from previous banking interventions:
“Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions….The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions.”
By intervening in the banking system to restore confidence, the government hinders the natural consolidation process, which by itself, could (nothing is certain these days) restore confidence without current and future taxpayers explicitly sharing the risk.

In order to restore health to the banking infrastructure, the “good” (solvent) banks must be separated from the “bad” (insolvent), and the bad banks should be left to fail. This can be done in several ways:
1) The US government can assume the bad debt (TARP), leaving only the crucially insolvent banks to fail. This is a no go (whew).
2) New and tighter government regulation (changing the minimum capital requirements) is initiated to weed out the bad banks as suggested by the UK Bubble. In the wake of new capital standards, the US government nationalizes the insolvent banks, cleans up the balance sheets and management structures, and then sells off the banks on the open market.
Or
3) The good banks will merge with some of the bad, thereby consolidating into a stronger system that cleans up its own mess. Banks will fail, but bigger banks with sufficient capital will emerge. Along the way, the government should encourage new regulatory measures.

Let’s look at an example

September 18: Morgan Stanley and Wachovia are in merger talks.
September 20: The U.S. Treasury proposes to purchase troubled assets (TARP announced).
September 21: Morgan Stanley and Wachovia deal is off. (the article cites regulatory issues as the incredulous catalyst for the failed merger).
September 29: House rejects the bill.
September 29: Wells Fargo & Co. stops merger talks (offered more than $20 billion for Wachovia without government facilitation); this would have been a good merger.
September 30: Citibank – facilitated by the government – merges with Wachovia. As part of the merger, Citi inherits $312 billion mortgage portfolio with toxic assets and inevitable losses, so the government caps its losses at $42 billion in exchange for $12 billion in stock warrants. What a deal!

I see two significant issues in the timeline (above):
1) The government bill interfered with the natural consolidation of the banking industry by simply proposing TARP.
And
2) By facilitating mergers on a case-by-case basis, the government likely prevented consolidations that would have occurred without government intervention.

By bailing out Bear Stearns, Fannie and Freddie, AIG, and facilitating mergers (WaMu), the government created yet another inefficiency. Why would a bank risk its own capital in full when the government is facilitating mergers left and right? This is not a moral hazard, per say, but I will coin a new term: toxic-asset banking hazard.

Definition (I use the wiki definition of moral hazard to outline my new hazard): toxic-asset banking hazard is the prospect that a party insulated from risking its own non-toxic assets when consolidating with another party with toxic assets may behave differently from the way it would behave if the U.S. government did not assume some of the consolidation risk.

Banks now believe that the government should and will facilitate mergers, which interferes with the market’s weeding out of the “bad” banks. This, in the end, foots the bill to taxpayers. I suspect that Wells Fargo stopped merger talks because the government – at the time (the Sunday before the House voted down the bill) – was not willing to facilitate the merger.

Conclusions

Clearly, restructuring and new regulation are warranted. If you asked me, regulatory forbearance (clarifying the mark-to-market accounting standards) is not the way to go. It doesn’t solve any problems, and simply pushes back the timeline of restructuring the banking system (a.k.a. consolidation and smart regulation).

One can only hope that the government will look at its actions carefully and come up with a working plan that is efficient, much less ambiguous, does not interfere with long-term capital expansion, and most of all, avoids costing taxpayers billions from the government facilitating mergers because of the toxic-asset banking hazard.

Rebecca Wilder

2 comments:

  1. What you are proposing is similar to the consolidation in the airline industry which, indeed, is weeding out the "bad". I'm with you and the traditions of the US which are to leave businesses alone to rise or fall on their own merits. Is there any chance the regulations will go back to pre-1999 and separate the investment houses from the banks?

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  2. Interestingly, The Senate is voting on the bailout before the House - definitely against the procedural rules of the Constitution!!!!!

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