Too Big Not to Fail? (Page 5)

This is the second in a three-part series on the economic crisis.

'Net Worth? I Don't Got To Show...'

In the four months since receiving the first TARP Installment, the US banking industry has become a supersized version of the US auto industry--on the verge of bankruptcy, kept afloat by government capital, loans and loan guarantees, with no long-run strategy other than to continue its well-funded lobbying efforts and heavy campaign contributions and to occasionally show up in DC before toothless Congressional committees for well-choreographed rituals of contrition.

Since October 2008, the net worth of the entire US banking system-- all 8,367 domestic-owned US banks--has declined by $420 billion, to just $540 billion. In other words, TARP was one of the worst investment decisions in corporate history--the banks' net worth has declined by more one dollar of equity value for each additional dollar of TARP funds injected.

Indeed, the net worth of two of the largest banks in the system, Citigroup and Bank of America, is now around $30 billion, less than half of the $70 billion in government capital that they have received from TARP I, on top of $424 billion of federal loan guarantees. Not only has their own "value added" during this period evidently been negative. For a fraction of the funds we've given these two banks, we could have stopped begging them to clean up their balance sheets, restructure their mortgages, stop wasting money, change their compensation plans and initiate sensible new lending programs. We could have bought a controlling share, hired new management from the droves of idle bankers now out on the street and re-privatized them at a profit for taxpayers in two to three years--just as successful "turnaround nationalization" programs have done again and again in these situations, from Norway to Chile.

No wonder that growing numbers of critics--not just hard-core lefties and Nobel laureates like Paul Krugman and Joseph Stiglitz but even pragmatic politicians like South Carolina Republican Senator Lindsey Graham--have started to break the taboo and talk explicitly about "nationalization."

But in an important sense the taboo had really already been shattered by TARP I, last year's expansion of FDIC deposit insurance and all the other new federal loan guarantees for the bank. In effect, these already "nationalized" the banks' debts. Now we're just talking about the other side of the balance sheet, where there might at least be some value, if only under new management.

The Toxic Alternative

Geithner is hardly unaware of this short-term nationalization approach to the credit crunch, or of the success it has in many other markets. But he has apparently rejected it in favor of a much more costly and uncertain route--establishing a public-private bailout fund that will somehow entice the banks to sell off their lousy assets and still have enough equity left to survive as private entities.

The limitations of this approach are best understood by taking another close look at Citigroup and Bank of America, two of the most troubled institutions in this story. On their most recent balance sheets reported to the FDIC, these two big banks alone accounted for $4.1 trillion of official on-balance-sheet "assets"--mostly loans and federal securities, but also a hefty amount of potentially dodgy mortgage-backed securities and other asset-based securities.

Right off the bat, therefore, at least by the accounting numbers, these two top banks alone now account for more than 30 percent of all the assets outstanding in the entire US banking industry. Indeed, the top fifteen banks account for over 60 percent. This represents an incredible increase in banking industry concentration since the early 1990s, when Citibank and Bank of America held just 7 percent of all US bank assets, and the top fifteen banks held 21 percent.

This increase in industry concentration was hardly an accident. It originated in the desires of bank executives to grow, boosting market share, short-term earnings, stock prices and the executive bonuses driven by those metrics. But it also reflected the gloves-off stance that Congress, regulators and antitrust enforcement took toward bank expansion during this period. And that, in turn, was probably related to the more than $1 billion contributed by the financial services industry, their lobbyists and law firms, to politicians of both major parties since 1990, which turned the Senate Banking Committee the House Financial Services Committee and other key Congressional committees, in effect, into wholly owned subsidiaries of the banking industry.

Now how much might all these assets on the banks' balance sheets actually be worth? There is no active exchange for most bank assets, especially those that are hardest to value in this environment, like mortgage-backed securities. And by law, the banks are permitted to value the assets on their books at "fair market value"--in essence, whatever their accountants tell them they are likely to be worth, given historical experience with loan losses. But the difference between these accounting numbers and today's market value for these assets may be huge--up to half or more of book value. And the banks have a strong incentive to hold on to the loans and hope that things get better, rather than sell them off right now at whatever the market will bear. After all, as soon as they start selling down one loan bundle, they may be required to "mark to market" all similar ones. And the resulting writedowns might well be enough to wipe out all stockholder equity, leading to insolvency.

This whole situation is reminescent of the 1980s Third World debt crisis, when banks like Citibank, Morgan and Chase resisted for years the demands of policy makers and developing countries to write down or sell off the billions of overvalued loans on their books--for no other reason than, as one former Chase banker put it, "a rolling loan gathers no loss." Similar behavior occurred during the prolonged Japanese debt crisis of the 1990s, when banks stubbornly resisted the efforts to get them to "mark to market" because several of them realized they would be bankrupt and no longer with us if they did so.

There's not really much moral culpability here. At ground level, from the standpoint of any individual bank, this behavior is understandable. After all, they have just gone through a period of careless underwriting, and are trying to reduce their loan losses and improve their capital ratios--just like most bank regulators want them to do. The larger banks have balance sheets that are best described as follows: "On the left side (assets), nothing is right; on the right side (deposits and other capital), nothing is left." And since the economy is still slipping at an unpredictable pace all around them, no loan officer is eager to take on more risks. So it is hardly surprising that in the last quarter of 2008, even as the TARP money started to flow, US bank lending suffered its sharpest decline since 1980. It also makes perfect sense for them to resist selling off its loans and securities at what may eventually turn out to have been fire-sale prices.

While all this may be well and good for bankers, however, for rest of us it means that even after all those trillions in federal bailouts and loan guarantees, the economy is still starved for credit. The fact that major banks as a group continue to sit on all these lousy loans at book value, rather than selling them off and writing them down, means that they don't have much room on their balance sheets and in their capital/asset ratios for new loans. So the credit crunch continues. And banks that we eventually may find out were really insolvent may walk around in a trance for months or even years, like a scene from Night of the Living Dead. We're not talking about restoring the loose lending of the 2005-2007 bubble; we're talking about the essential liquidity needed to keep the wheels from coming off, stimulate demand and stem the decline in housing prices.

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