Bailing out banks: who's in, and who's out?

Wall Street's latest fascination with Washington comes over the subject of bank nationalization. Senator Christoper Dodd, Chair of the Senate Banking Committee, suggested nationalization might be necessary, sending the markets plunging. The White House wasted no time in responding at the daily press conference, noting, "[T]his administration continues to strongly believe that a privately-held banking system is the correct way to go, ensuring that they are regulated sufficiently by this government. That's been our belief for quite some time and we continue to have that."

Nationalization is scary to banks because it means some investors will be saved while others are wiped out. At the extremes, who's in and who's out is obvious. Holders of common equity will almost definitely be wiped out in nationalization; deposit holders would be made whole. The intermediate providers of capital, senior and subordinated creditors, counterparties to derivative contracts, trust-preferred holders, and preferred stock holders, have differing levels of ambiguity as to whether they would be bailed out, wiped out, or something in between. This ambiguity relates to the property rights the holders of these securities possess. This ambiguity causes tremendous problems.

First, capital that has no restrictions on its withdrawal will be withdrawn. That is, there will be a bank run. Since the FDIC insures deposits, retail deposits won't run, but other short-term funding will either be withdrawn, or for short-dated maturities, will be difficult to refinance with new debt (roll over). The FDIC stepped in to limit the difficulty in rolling over senior debt by agreeing to insure this debt through the Temporary Liquidity Guarantee Program, solving in part this problem.

The second problem is that existing securities will trade with every rumor floating around as to whether the banks will be nationalized or not, AND on every rumor of whether a particular secruity will be included in the bailout or not. This particularly relevant post on the very good Bronte Capital blog describes the problem with including different securities in different situations, as shown through FDIC takeovers of banks. Indeed, this is evident in the common stock fluctuations of the major banks through the course of last Friday - the higher a chance of nationalization, as determined by Dodd's statements, the lower the share price.

It is worth noting that while management is concerned about the common equity price (WSJ, gated) to which their personal economics is tied, the common equity price is of less concern to regulators. Banks could continue to operate at any equity price, as long as the creditors of the bank do not take the low equity price to be indicative of an imminent default on the bank's debts.

The third challenge is that it makes it difficult (impossible?) to attract new private capital. New capital providers are hesitant to invest when they face the possibility of losing their capital to nationalization.

Each statement by regulators, legislators, or the Administration increases the ambiguity banks operate under, necessitating new bailout programs, increasing security volatility, and limiting the ability of banks to raise new private capital. The Administration's current approach, denying nationalization as a possibility (even while other key decision makers discuss it's virtues), has little credibility. The market's are understandbly sceptical that the Administration would rule out a course of action that many noted commentators are advocating for. Instead, the Administration should clarify the property rights of these security holders under any circumstance.

Exactly what rights need be clarified? First, what banks would be considered for nationalization, if it should come to that stage. Clearly the government would have criteria as to what banks would be nationalized (or bailed out in some other fashion). Clarifying these criteria will allow borderline banks to have a clearer sense of their future. Second, and perhaps most importantly, the government must clarify what classes of securities and other claimants would be bailed out. A best guess, as a simple starting point, is that existing depositors, counterparties, and senior creditors would be made whole (including rollovers of existing debt), while subordinated debtholders and all forms of equity-holders (including preferred, trust, common, and all options and warrant holders) would be extinguished.

Merely this clarification would have several immediate effects. Debt holders would freely leave capital committed and would permit rollovers of maturing debt. Securities markets would immediately adjust: bank securities that would be protected under nationalization would trade to prevailing yields. Equity holders, while concerned about nationalization, would benefit from the banks' ability to again conduct business free from uncertainty of solvency concerns.

Paired with this announcement, the government could encourage additional private capital into the banking market by allowing equity capital issued after the announcement to be put back to the government at par (or some fixed ratio to par, say 90%) upon a nationalization event in the next five years (at which point it would convert to common equity). With this effective government guarantee in place, the banks would be able to raise equity capital in the private markets. If nationalization never occurs, the government never intervenes or uses any taxpayer capital. If banks are nationalized, it would not be due to the very fear of that nationalization, but rather a belief that banks are deeply insolvent and that no injection of capital would produce an attractive return. (That is, losses at the bank would be so great as to swamp earnings for years to come).

This approach would minimize the disruption caused by nationalization rumors, would reopen the private capital markets, and would help to align interests. Managers could be compensated on un-guaranteed equity, re-establishing the investors balance between fear and greed. They would have the incentive to avoid nationalization by raising substantial new capital and making prudent lending decisions - they would fear losing their equity stake. On the flipside, they would want to deploy capital intelligently to maximize the return to their equity stake - the greed to maximize their options.

This solution is clearly a bridge approach - the market and regulatory failures that brought the current crisis into existence still need remedy. Other issues would also need to be considered - restarting lending, moral hazard, and agency costs - before implementation. But, this approach would stabilize markets, limit the intervention of government into the private markets, and rely predominately on private capital, virtues all.

Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Taxes
Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

Spending
The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.


The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

Capital Purchase Program

This morning Secretary Hank Paulson made a statement regarding the $250B Capital Purchase Program component of the financial rescue package. Critics of the CPP and TARP question the role of government in the capital markets and believe that the US Government is privatizing profits, while socializing losses.

Although drastic, CPP and TARP are well within the bounds of Treasury’s duties. The following is an excerpt from Department of the Treasury’s mission:

The Treasury Department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. The Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions.

CPP is the direct result of the later two goals. Paulson notes in his statement, “Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital.” The restored confidence should open up the credit markets, prudent deployment of capital will enable sound businesses, aspiring students, and honest homeowners to continue the sustainable growth the United States has exhibited since 1776.

Additionally, the Treasury is utilizing market mechanisms to institute additional regulation. Qualifying Financial Institutions (QFI) will only have access to CPP if the institutions agree to caps on executive compensation, clawback provisions, and bans on golden parachutes. The Government is not ruling with an iron fist, rather the Treasury is providing a carrot for banks and thrifts to exercise increased prudence and to incent greater alignment of interest between all stakeholders.

In the near-term, the Treasury may have socialized losses; however, Paulson highlights the CPP is an investment by the Treasury, not an expenditure of the Treasury. The CPP investments will be in the form of preferred stock (5% dividend yield) with warrants for common stock. Assuming confidence is restored and sustainable economic growth persists, the warrants should provide the Government with substantial upside. As Tier 1 Capital, CPP investments will improve the banks’ capitalization and coupled with an improved balance sheet through other TARP initiatives, bank common equity valuations should improve.

Such investments are not risk free; the Treasury cannot guarantee a return OF capital, never mind a return ON capital. In April TPG appeared to have structured their way into a sound investment of preferred equity in Washington Mutual; however, the investment has turned out to be an expenditure. In reviewing the Interim Final Rule for the TARP CPP, as noted earlier, the qualifications are focused primarily around corporate governance and are not focused on the soundness of the preferred equity investment. A return on capital should yield a return to a prosperous United States.

For more information see the CPP FAQ and Application Guidelines.

Sliding down the slippery slope

The slippery slope is getting particularly slippery in Washington, D.C., especially with an election around the corner. Congress is considering a bailout of the automotive industry, with $25B of government loans up for grabs. Thanks to (unavoidable?) bailouts of Fannie Mae, Freddie Mac, and AIG, Detroit's Big 3 are feeling particularly confident in their ability to secure the loans . Both John McCain and Barack Obama have come out in support of this policy, despite McCain's (and George W. Bush's) previous opposition to a bailout. This support certainly makes sense if you are trying to win Michigan or Ohio (with 18 and 21 electoral college votes, respectively), but does it make sense economically? Perhaps not.

First, there is the sheer cost: the $25B have to come from somewhere, and the government is already straining with a large deficit. Second, there is reputational risk to consider. Is the U.S. as firmly commited to free markets as it urges other countries to be?

An appropriate rebuttal asks why Wall Street (Bear, Fannie, Freddie, AIG, et al) deserves bailouts while Detroit does not? One good reason is that the large financial institutions are being bailed out due to their effect on the rest of the economy. The effect of a Fannie/Freddie/AIG bankruptcy would have far more wide-ranging effects than the failure of a U.S. automaker.

Not only are automakers less intertwined with the rest of the economy, but Detroit is also looking for a better deal than Wall Street. Detroit wants loans without warrants attached, as they were in the Fannie/Freddie and AIG bailouts. And in return, Detroit promises to begin building more competitive products. More importantly than building better cars, Detroit promises to have disproportionate influence on the election in Michigan and Ohio... and it seems that fact is likely to be the deciding factor.

Let's hope the government gets an appropriate deal for taxpayers in the process, one that includes warrants, and, possibly, new commitments to CAFE standards.