Nov 18

Let’s Say You Run a Bank…A Modest Proposal


…You wake up Monday morning and realize that loans are defaulting at faster rates than expected. You just increase loss reserves and go back to work, but…

…You wake up Tuesday morning and your CFO tells you all of your investments, including your loans, must be ‘marked to market’. That means recognizing losses on your loans before they actually happen, but that’s OK because that’s why you’ve got a loan loss reserve. Unfortunately, the ‘market’ is not what you expect to lose, but what other investors think the loans are worth. And, lo and behold, those investors think they are worth a lot less than you do. It does not matter that you intend to hold those loans until they pay off, default or otherwise disappear from the balance sheet. What matters is what others think they are worth today. And those others don’t have all of the information on the loan that you do, so, naturally a lack of ‘transparency’ produces a discounted price versus true value. Oh well, you say, I guess we’ve got more losses to take. But, then your CFO tells you those losses will eat into capital and without enough capital, you’ve got no bank. So…
…You wake up Wednesday morning and hear about the TARP program. What, they won’t buy are underperforming assets? That’s bad news, but wait…they will give us capital. Will it be enough to make up for our ‘mark to market’ losses? No, but, hey, some capital is better than none when you’re facing a viability problem due to the silliness of ‘mark to market’ for assets you intend to hold until the end of their time.   And, this will keep those pesky depositors from pulling money out of your bank, ‘chosen’ as a survivor by the US Treasury. So…
…You wake up Thursday morning and enter your bank’s credit committee meeting. “How’s loan production?”, you ask, since good loans earn more interest than investing in those low interest rate Treasury bills and notes. “What loan production, chief?” the committee says, “We can’t make loans until we fill that hole in our capital provided by those ‘mark to market’ losses.” “I knew that TARP capital would never be enough,” you say, “but what can we do, but sit tight until we have enough accumulated earnings to fill the hole. And when, Mr. CFO, will that be?” “Time heals all wounds,” murmurs Mr. CFO, who retires to his office and the blinking Bloomberg showing more bad news in the financial markets.   So…
…You wake up Friday morning and talk to your fellow bank CEO’s. “What are you guys doing with your TARP money,” you ask. “Holding on for dear life,” your peers say. “Well, if we can’t help ourselves, it’s back to the government for more help before we can increase loan production.” This thought gets you to stare at the list of the worst assets held by your bank, REO, real estate owned better known as foreclosures. “If only…”  And the week ends.
That’s the impact of the TARP in a nutshell. Woefully short and only addressing part of the problem. There are many potential solutions to the current financial crisis, some good, some bad, some a bit of both.  Thus, we pose our own modest proposal:
–          Forced closings/mergers of the weakest banks (we saw that with PNC and National City, one would hope for more) Use the TARP (and it will take even more cash) to assist in recapitalizations when needed. As we saw in our little vignette above, total capital contributions should equal total losses before the banks will loosen the credit reins.
–          Purchase of ALL foreclosed real estate from the balance sheet of all financial institutions at today’s market value by a newly created agency of the US Government. This agency can then manage the assets while taking them off the market for the foreseeable future. The agency would indeed become the biggest landlord in the country, but would help put a floor under real estate prices…one of the fire starters of the current financial crisis.
–          Follow the lead of the FDIC in working with portfolio lenders to restructure loans in foreclosure with the goal of improving the present value of expected cash flows from any restructuring.
–          Recognize that in the best of circumstances the recovery of the financial and real estate markets is a multi year project.  And, yes this has real impacts on your investment strategy.
Now, if you ran a bank…wouldn’t you like this modest proposal? This would be step one in getting the banking system to support the recovery of the real economy.
Will we see this solution? Probably not, but it will be interesting to see what future solutions are presented by the new US administration and how they compare to these proposals.