Too Glib To Be Convincing

Matt Yglesias has little to add to our understanding of the pros and cons of bank nationalization other than it is easy and good, but all libs knew that already.  He does exhort people to "definitely read Kevin Drum’s bank nationalization primer."

I say nay.  My confidence in Mr. Drum waned in the early innings:

The amount you can loan out depends on your capital ratio, a number that's set in the US by the Securities and Exchange Commission. If you're required to have, say, a 5 percent capital reserve, that means your loan portfolio can be as high as 20 times your capital. That's $200 billion—and if you fudge things a bit, say through the creative use of off-balance-sheet vehicles, maybe you can loan out as much as $300 billion. If the average return on your loan portfolio is 5 percent, that means you're making about $15 billion per year with only $10 billion of your own money at stake. Not bad.

Let's see - the Securities and Exchange Commission regulates whatever is left of the securities industry; Goldman Sachs and Morgan Stanley, for example, fell under their purview until they became banks. Banks are regulated primarily by the Federal Reserve; it was in that capacity that Treasury Secretary Geithner did such a bang-up job overseeing Citigroup.

But set aside the regulatory alphabet soup, which will all be changing anyway.  In Drum-world our banking heroes have $10 billion of equity and $300 billion of assets.  Uhh, dare we ask a tedious accounting question about whether there are any other liabilities, such as deposits?  And do those liabilities have a cost?  The Drum-world bank is earning an other-worldly 150% return on capital and a 5% return on assets, since it apparently has a zero cost of funds.  Here in reality, let's flash back to a happier day for an example -  Wachovia in 2005 had somewhat less heady 1.34% return on assets and a 12.96% return on equity.  Whatever.

Pressing on, Mr. Drum takes through an economic downturn with attendant loan losses and deleveraging, then drops us here:

This is, roughly, what's been happening to the global financial system. Loan losses have reduced capital. Everyone is hoarding money. It's called deleveraging, and in plain English it means that credit markets are broken.

But things can still get worse. What happens if your capital is wiped out completely by loan losses? Then your bank is insolvent. The lights are still on, people still come to work, and bills still get paid, but there's no lending at all. And without lending, you aren't really a bank. You're a zombie.

No lending when the capital is depleted?  Did the assets shrink from $300 billion to zero as the capital shrank from $10 billion to zero?  That is a definition of a zombie bank that I have never heard before.

I have heard of zombie banks in Japan that rolled over existing loans and made new loans to zombie companies, companies with no growth or earnings prospects and no real hope of repaying the loans.  Why would the Japanese banks do this?  To avoid recognizing loan losses, oddly.  This practice of lending to the walking dead resulted in an ongoing misallocation of Japan's savings since new and innovative companies had a hard time raising funds. 

Could it happen here?  The circumstances are different.  We will come back to this point, but let's bash on with Drum, who cites the Lehman debacle as an argument against allowing a big bank to fail and then goes here:

Aside from allowing banks to fail, then, there are four main options. The first is to muddle through. The US banking system is still profitable, after all, and this means that over time insolvent banks will build their capital base back up and start lending again. Unfortunately, "over time" could mean years, and nobody wants a broken banking system for that long. (Japan tried this after its banking crisis of the early '90s, and the result is popularly known as the "Lost Decade.")...

Japan had more problems than a bad banking system, as noted.

Option No. 2 is for the government to set up what's called a "bad bank" that buys up the banking system's "toxic waste," loans that have gone bad and are likely to get even worse, eating up bank capital along the way. Unfortunately, the reason this stuff is called "toxic" is because the eventual losses from these loans are impossible to forecast. Are they worth 70 cents on the dollar? Fifty cents? Twenty cents? Nobody knows, and without knowing that, it's impossible to buy them up. There's still a plan on the books to attempt the purchase of toxic assets, but most observers give it little chance of success unless it's so heavily subsidized by the government that it amounts to little more than a massive giveaway.

"Most observers" is Paul Krugman.

Drum gets lost tackling the mysteries of preferred stock:

Paulson's answer was preferred stock, a weird hybrid entity that counts as equity but is really just a thinly disguised loan. There's nothing inherently wrong with that, except that Paulson bought the shares on giveaway terms... [I agree that the terms looked like - a bailout.  -TM]

But the reason for those easy terms isn't hard to figure out. Basically, if Paulson had paid any more, he would have owned several of the banks he gave money to. Take Citigroup. So far they've received two capital injections from the government worth a total of $45 billion. But that's more than the entire bank is worth. As I write this, Citigroup stock is trading for less than $2; you could buy up the entire bank for less than $10 billion. But Paulson didn't want to own Citi, and the only way to make sure he didn't was to give it money on such absurdly favorable terms that $45 billion only bought a small share of the company. That's good news for Citi and the other banks that got easy money from the government, but both politicians and the public have gotten tired of such handouts.

Well, we are getting close to an interesting point.  The common stock of Citi may well be worth $10 billion; it does not follow that the original $45 billion is gone, since those were not purchases of common stock.  Back when the first TARP purchases were announced on Oct 14, Citi stock was at about $16; let's assume for simplicity that eight times today's price equates to eight times today's market capitalization, or about $80 billion.  A $25 billion investment of new equity would have represented government ownership of about 25% of the company (which would have had a revised equity of $105 billion).  As share prices subsequently fell, that $25 billion would have fallen in value as well.

Let's assume, with mad optimism, that the preferred government shares are worth $45 billion today (Laugh with me!).  In that case, the current value of Citi equity would be $55 billion (adding the $10 billion of common and the $45 billion of government preferred).  Now, suppose the second TARP of $20 billion had been in preferred, but the original investment had been in common shares at $16 dollars/share.

If the total equity of Citi is today worth $55 billion but the government preferred stake was only $20 billion, then the common must be worth $35 billion.  That is quite a comedown from the $105 billion when the first investment was made; in fact, it is a drop of 2/3, which suggests that the first TARP slice would have been now worth roughly $8 billion.  Ouch.  But bad news for the taxpayer is good news for the other shareholders - since the government shared the pain, the revised share price is about $5.33 rather than $2.

And why do we care?  We probably don't, much, especially since Citi's recent preferred-to-common conversion has changed all these numbers.  However, the concern with the common-preferred structure is that at some point, if the underlying asset values fall enough, then the common becomes essentially valueless and all the equity capital is represented by the preferred - this is the feared '"zombie" scenario. 

This is a problem in part because the preferred holders are not expected to act as owners (the government really did not buy the preferred with the hope of running the bank.)  Beyond that, the common equity holders have a distorted "Heads I win, tails they lose" incentive as they evaluate lending and investing opportunities.  If the bank owners can make enough lucky, high risk loans that pay off, maybe the common equity can come back to life.  If these risky loans go south, well, the preferred holders absorb yet more new losses while the common shares go from essentially valueless to even more essentially valueless.  This is not an incentive structure that encourages prudent lending (and fans of the late 1980's S&L bust will remember this lending scenario well.)

Drum then closes with an extended dream sequence about why nationalization works, based on Sweden's successful experience with two banks no one has ever heard of (Was one of them Fältskog-Ulvaeus Bank?  Maybe!).  Probably the most comical bit is this:

And there's one more thing about nationalization to keep in mind: We already do it all the time. The FDIC now takes over small banks every week, and among bigger institutions the government has already effectively nationalized Fannie Mae, Freddie Mac, and insurance giant AIG. And for the most part, life goes on as usual. If Citigroup or Bank of America were taken over, the board of directors would be dissolved, some of the senior staff would be replaced, shareholders and bondholders would take a hit, and the bank would continue running as normal except with a stronger capital base and government guarantees behind it. Then, in a few years, it would be refloated and put back in private hands. It's not as scary as it sounds.

 We do it all the time!  Uh huh - normally FDIC takes over some tiny unknown bank and pitches it to JP Morgan Chase or whomever later that day.  No one is standing by (or is big enough) to buy Citi or BofA.  The idea that FDIC has the time and talent to simultaneously take over both of them and run them smoothly (or at all) is at best untested and quite a bold experiment.  Well, not wholly untested - look how well the AIG experiment is going.

To introduce a bit of reality to this exercise, Justin Fox of Time actually looked at the Citigroup financial statements.  His gist - Citigroup has about $400 billion in assets that fall under FDIC and about $1.5 trillion that would, per Fox "be taken over by foreign governments or fail in pretty much the same unruly manner that Lehman Brothers did."

He realizes, as Drum apparently does not, that that is absurd.

Comments

[narciso]

You didn't even have to complete the first sentence in the link there, Tom, I know it's snarky, but he's Dalton and Harvard he should know better, right

[Jane]

TM,

You need another "o" in your "To"

[kim]

To glib, or not to glib, that is the glob, I mean blog.
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[TM]

Hmm, I lost 'em at "hello".

[kim]

I think big bonuses should be paid to journalists and bloggers who understand all this. Performance bonuses.

I'm serious. Someone's got to stop the demagoguery.
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[bgates]

You lost me at "Matt Yglesias". Does he really represent the best the 200+ JournaList members can do?

[kim]

And it's not going to be people like Dodd, Frank, Grassley, Obama, and Axelrod. They are pouring gasoline on the fire, and, heh, on themselves.
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[Fresh Air]

Another doufus masquerading as a financial analyst. Drum doesn't even know the difference between preferred and common stock? He doesn't know the difference between pre-money and post-money valuation? Yet he presumes his three-cent "analysis" has some sort of persuasive power? Only to the clowns who subscribe to that magazine he writes for, I guess.

[clarice]

While I digest this one--here's more on the brilliant turbo cheat:
http://www.americanthinker.com/blog/2009/03/geithners_unsung_role_in_the_b.html

[BC]

Has Kevin Drum ever been right about anything, ever?

[bad]

I initially read that as Too Gibbs to be Convincing.

Speaking of Gibbs, he isn't convincing the WH press corp that the WH didn't know about the AIG bonuses prior to last week.

"Only Geithner knew" is the spin....

ha ha ha ha ha ha ha ha

[Charlie (Colorado)]

Well, I just left a comment asking if it at all worries him that he has pretty nearly every detail wrong.

[matt]

are we following the Italian model (1922) or the German (1932) model or the Russian model (1918)?

Chris Dodd knew too..he wrote specific language into the bill protecting those bonuses. Owned lock, stock & barrell by Angelo Mozillo and AIG!

[ben]

"are we following the Italian model (1922) or the German (1932) model or the Russian model (1918)?"

The results will be the same,whatever the model....what great company though....Mussolini (1922), Hitler (1932), Lenin (1918), Obama (2008)

[daddy]

Top o' the morning!

Glad to see Chris Dodd, Barney Frank and Obama won't need my clan's help in re-destroying Western Civilization. They're doing a fine job all by themselves.

[Jim Ryan]

Zao an, daddy.

[Charlie (Colorado)]

Hmmm. GOP is now ahead in the "generic congressional" Rasmussen, Obama approval index at +5.

[narciso]

You have permission to banish them onto the ice floe, although Barney's not Irish, much like I've done with the Menendez Bros. Jose Canseco, & sadly Rick Sanchez. Also the math requirement seems to havee gone by the wayside at Harvard and Berkeley. Did they have editors or proofreaders at these fine publications, the Atlantic (Greeley's screaming I had nothing to do with this) and
well Charlie, at the Washington Monthly

[daddy]

Rush is tape-delayed out here, but he just said Shumer and Congress want to tax these contractually agreed bonuses at 100% of the total value of the bonus. Can somebody please tell me what was the percentage placed upon Tea by King George that so outraged our 1775-76 ancestor's that they revolted?

[Charlie (Colorado)]

Daddy, it's gonna be doubly interesting since it turns out Chris Dodd's executive comp clause specifically excluded bonuses including AIGs.

[narciso]

That's confiscation, if King George, who we know was crazy but not insane, had tried the colonist would have sent a ship with muskets to 'persuade' him against such a course of action. I think their
reinbursement for campaign financing strategy hit a snag. Great way to alienate future campaign contributors by the way.

[Thomas Esmond Knox]

Obama returned his unspent campaign donations, right?

[Jane]

Precisely the point Thomas.

[DebinNC]

I saw on the news tonight that the committee which voted out Dodd's bonus exception amendment also defeated an amendment offered by Oympia Snowe and a Dem (Ron Wildmon?) to disallow bonuses.

[DebinNC]

Snowe=Wyden amendment would have precluded bonuses, but was defeated in favor of Dodd's protect-bonuses amendment. So, did this happen in Dodd's banking committee?

[hit and run]

Deb:
So, did this happen in Dodd's banking committee?

Well, Obama told us that http://hotair.com/archives/2008/07/23/video-obama-says-banking-my-committee-not-on-it/>the banking committee was his.

[DebinNC]

Turns out neither Snowe nor Wyden are on the Banking Committee. The press release said their amendment to preclude bonuses passed by voice vote and was added to the American Recovery and Reinvestment Act of 2009 in Feb.. Was it removed later on and replaced with Dodd's amendment? I feel like calling Dodd and the awol press something I'll regret.

[Charlie (Colorado)]

I feel like calling Dodd and the awol press something I'll regret.

I can't imagine anything you could call them that you should regreat.

Well, maybe "honest and objective".

[clarice]

Here's Dodd's story per his pals at the Atlantic:

"Sen. Chris Dodd, facing the lowest approval ratings of any Senate Democratic incumbent,is in political purgatory. But on the subject of AIG's bonuses, he doesn't deserve the bad rap. Dodd is being blamed for OKing a proviso in the American Recovery and Reinvestment Act guaranteeing previously sanctioned employment contracts. He faces intense political pressure because of his long-standing friendship with bankers and lenders, which has made him a key player in the negotiations between financial institutions and the government. In a statement yesterday, Dodd called on AIG executives to voluntarily refuse their bonuses. The truth is that the codicil was added in conference by mutual agreement of House and Senate Democrats and the White House. At the time, the administration worried about both the perception and the reality of government's interfering in the decisions and internal operations of the banks. Backstopping employment contracts was controversial to critics, but to an administration that was trying to work with the banks, it was an easy call. The worry was that the banks would suffer immediate and disasterous brain drain if the govenment could abrogate (the world of the week!) employment contracts willy-nilly. Apparently, no one at the Treasury Department or the New York Federal Reserve Board bothered to check on what those contracts actually contained - therein was the sin of omission, if you can call it that. How many tens of thousands of employees does AIG have? And didn't Geithner recuse himself from dealing with AIG?

As Conor Clarke noted below, title VII Sec. 111 of the American Recovery and Reinvestment Act permits the Secretary of the Treasury to recoup any bonuses or excess compensation from corporations accepting a threshold amount of TARP money.

In conference -- Dodd was not a conferee -- the following clause was added to reconcile differences between the Senate and House bills:

iii) The prohibition required under clause (i) shall not be construed to prohibit any bonus payment required to be paid pursuant to a written employment contract executed on or before February 11, 2009, as such valid employment contracts are determined by the Secretary or the designee of the Secretary.

Dodd, the chair of the banking committee, agreed to this language because most all of the stakeholders - including the administration - wanted it. But the original bill passed by the Senate contains Dodd's compensation limits without the carve out the exemption for bonuses. So there is no evidence that Dodd bowed to pressure from his contributors or that he was the author, the force of nature, behind it. "

http://politics.theatlantic.com/2009/03/dont_blame_chris_dodd_for_the_bonuses.php#comments>More B.S. from Dodd

[clarice]

Chris says that politics had nothing to do with it. Forget AIG is in his home state and contributed the most $$ to him.
Some mysterious people snuck that exception into Chris' amendment.

If you believe in Chris, clap your hands boys and girls.

[clarice]

The always amusing Glenn Greenwald, citing the always astute Jane Hamsher, says Dodd is being set up by folks at Treasury..

http://www.salon.com/opinion/greenwald/2009/03/17/dodd/

HEH--Time for the Administration to get another bus..there's no room under the Full of It Express.

[kim]

I love Greenwald on the Dodd misdirection: 'Engineered by Obama's Treasury officials, enabled by a mindless media, and amplified by the right-wing press'. What that boy said. I'm shocked. Shocked, I tell you.
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[kim]

Dang, you beat me to it.
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[clarice]

I regard this spineroo in the Atlantic as a classic non sequitir:
"Dodd, the chair of the banking committee, agreed to this language because most all of the stakeholders - including the administration - wanted it. But the original bill passed by the Senate contains Dodd's compensation limits without the carve out the exemption for bonuses. So there is no evidence that Dodd bowed to pressure from his contributors or that he was the author, the force of nature, behind it. "

Why wouldn't those lobbying for his big $$ contributors and in state corp AIG, get to him at the conference stage even if they hadn't hit him with this exception before the Senate? Everything was going so fast and under the radar..

[centralcal]

Thank you, Clarice, for your great work.

Happy St. Paddy's day Senator Dodd. I hope . . . well, I don't want to blaspheme on a Saint's day.

[kim]

I wouldn't be surprised, clarice, if that bill no one read but the lobbyists, is chock-a-block full of similar scandals. Republicans, Ho.
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[clarice]

You're too kind,cc..

[daddy]

No CC's not Clarice,

Your work is consistently wonderful and you sincerely deserve such complements from all of us.

[Ann]

there's no room under the Full of It Express.

Classic Clarice! Bravo!

[clarice]

Thank you all--it's entirely too generous.

[bad]

I agree with CC, Ann, and Daddy, Clarice. Many thanks for the info.

In fact, thank you everyone for helping me sort through this.

The Dem blame game is starting to heat up. Too bad most of the DC republicans are too looney to take advantage.

Today I heard Grassley defend his suicide remark as one he's been saying regularly since Oct.

[clarice]

Well, not every Rep in DC is stupid. Cantor's playing this one just right and we should all helpo him by getting the truth out about the bouses, and Geithner and Obama's role in them and what an idiotic charade their fit about the bonuses is.

[bad]

In January, Reps. Joseph E. Crowley of New York and Paul E. Kanjorski of Pennsylvania wrote to the Federal Reserve and the Treasury Department pressing the administration to scrutinize AIG's bonus plans and take steps against excessive payments.

"I at that point realized that we were going to have a backlash with regard to these bonuses," Kanjorski said in an AP interview. In a meeting with Liddy later that month, he said he told the AIG chief that "all hell would break loose if we didn't find a way to inform the public ... and that we should take every step to put that information out there so we wouldn't have the shock."

Kanjorski and Crowley knew and wrote a letter to the Treasury Department. Where is that letter now?

In addition to not answering phones, treasury doesn't read mail.

LUN

[Fresh Air]

Not to be too crazy here...

But doesn't anyone have a problem with this wide-scale demagoguery of some people doing what they were paid to do and receiving compensation in accordance with a contract?

Boehner was denouncing the bonuses earlier today. I understand the political temptation. But to do so is intellectually dishonest in the extreme. Whether they deserved the stay-puts or not, they did stay put, presumably to help unravel the mess at AIGFP. I find the rush to condemn this stuff by Republicans incredibly unseemly even if politically advantageous. It reminds of the Tories attacking Tony Blair over Iraq. It's a fundamentally unsound position to favor government abrogation of contracts, claw-backs of payments, etc.

The denouncements should be that no one took a look at this situation ahead of time, either with respect to the terms of the TARP money or the Porkulus that contains Dodd's Magical Exemption.