Tuesday, October 11, 2011

Roger Altman and America's blueprint for saving Europe's banks

The Financial Times carried a column by Roger Altman titled America's blueprint for saving Europe's banks.

Having written a column for the Financial Times, I know that their editors select the title.  Regular readers know that I too have a blueprint for saving Europe's banks.  It is different than the blueprint described by Mr. Altman.  So we know that the blueprint in the column is not America's.

The question is whose blueprint does Mr. Altman describe?  Mr. Altman's?  Mr. Geithner's?  Wall Street's?

The financial crisis struck the US harder and more quickly than it did Europe. The complete freezing of credit markets required an immediate and overwhelming intervention – and the American fiscal and monetary authorities delivered it. Between the Federal Reserve, Treasury and the Federal Deposit Insurance Corporation, approximately $13,000bn of credit support was arranged for financial institutions in late 2008 and 2009. There was no alternative to this massive reaction, and it worked. US credit markets are now healthy, and the recapitalised banking system is stable. History will look favourably on the boldness of America’s response.
Actually, history will NOT look favorably on America's response as the facts show that it did not achieve either of the outcomes Mr. Altman claims.

US credit markets are not healthy.

For example, prior to the financial crisis, the private label residential mortgage backed securities market had reach $2 trillion in size and had several hundred billion of new securities issued each year.  Since the massive response by America, there have been less than a dozen new private label residential mortgage backed securities issued.

Perhaps a better indicator of the health of this market is to look at what happened to prices when the Federal Reserve attempted to sell $30 billion in private label mortgage backed securities it acquired as part of the Bear, Stearns bailout.  In trying to sell securities that represented 1.5% of the par amount outstanding, the Fed managed to knock the market price across the entire $2 trillion market down by 20%.  Price drops like this on essentially no volume are not consistent with a healthy market.

Not only did the Fed have this impact on market prices, but the Fed was unable to sell all of its holdings.

The recapitalized US banking system is not stable on the one dimension that matters:  market participants do not trust the numbers reported by the banks.  As a result, market participants question if they are solvent.

For example, prior to the financial crisis, US banks marked their securities to market.  As part of the massive response, the SEC suspended mark to market and introduced the concept of mark to make believe.  Mark to make believe is needed to value those private label mortgage backed securities because, as the Fed demonstrated, there is no market for them.  These securities are still on the bank balance sheets -- if they had all been sold, regulators would have forced the banks to move back to mark to market.

There was a far lower cost alternative to providing approximately $13 trillion of credit support to the financial system.  An alternative that would have restored health to the credit markets and the banking system.

I know because I presented this alternative to the US Treasury, the Fed and the FDIC prior to their embracing the massive reaction.  I know that the Paulson Treasury embraced this alternative as it actively recommended it. [For confirmation, please read 'The Financial Crisis:  An Inside View' by Phillip Swagel]

The low cost alternative was to create the 'mother of all financial databases' so that market participants had access to all the useful, relevant information in an appropriate, timely manner to assess the risk of and value structured finance securities and banks.

With this data, market participants could independently value private label securities.  With the ability to independently value the securities, liquidity would return to the private label mortgage backed securities market as investors could make buy, hold and sell decisions by comparing the market price to their valuation.

With this data, market participants would know which banks are solvent and which are insolvent.  A bank's solvency is determined by the relationship between the market value of the bank's assets and the book value of the bank's liabilities.

As this blog has said many times before, an insolvent bank can continue to operate until regulators shut it down - look at savings and loans for example.

With this data, market participants would know which of the insolvent banks have a franchise that would allow it to earn its way back to solvency - for example, Security Pacific was insolvent as a result of its loans to less developed countries, but the earnings from its franchise were sufficient to earn its way back to solvency.

With this data, insolvent banks could have tapped the private capital markets for equity as investors could evaluate both the risk and prospects for return on the investment.

Finally, with this data, market participants would know which, if any, banks should be closed.
In contrast, ... the world has watched a steadily deepening sovereign debt problem [in the European Union] metastasise into a full blown banking crisis. Global markets fear big losses on bank holdings of sovereign debt....
There is tremendous irony in this statement.  A significant contributor to the sovereign debt problem is that European countries stepped up as part of the big response with 20 bank debt guarantee programs, 15 bank recapitalization arrangements and significant fiscal stimulus.

Had the alternative of disclosure been adopted, global markets would not fear big losses on bank holdings of sovereign debt.  As they would know what these holdings are and could have adjusted their exposure based on their assessment of the risk.
Germany and France recently committed to producing a bank rescue plan by November 3 but have provided no details. This is a golden chance to ....
Adopt the disclosure driven solution that should have been implemented in 2008. 
Most crucial is that the financial equivalent of overwhelming force is applied. The goal is to restore market confidence in the banks, not satisfy technical requirements on capital ratios.   
To achieve this always requires a larger commitment than financial markets are expecting.
There is only one way to restore and maintain market confidence in the banks.  That is require that banks disclose their current asset and liability-level data so that market participants can assess for themselves the solvency of these banks.

Both the US and Europe have tried the bank recapitalization solution and it has failed to restore market confidence.

In the US, a prime example of the failure of bank recapitalization is Bank of America.  If the solution had worked, then why did the Fed not allow BofA to start paying dividends and why are analysts suggesting that BofA needs upwards of $200 billion of additional capital?

If it hadn't failed in Europe, then why is everyone concerned about the need to recapitalize the European banks?

The fact is that bank recapitalization only works so long as the host nation has the ability to keep bailing out its banks.  When market participants see this limit is reached, they precipitate a bank run as they try to get their money out.  This is exactly the experience of European countries like Ireland and Greece.

Only disclosure is a permanent solution for restoring and maintaining confidence in the banks.
The International Monetary Fund originally estimated that at least €200bn of new capital was required. Despite other lower estimates, this is the right target. 
Why is this the right target?  BlackRock's Larry Fink thought the right target was $2 trillion.
This rule of overwhelming force will be the hardest for them to follow.... But, Europe is facing renewed recession. If this banking crisis is not truly solved, that will materialise....
Truly solving the banking crisis requires disclosure.

Clearly, Europe is limited in its ability to stimulate its economy and recapitalize its banks.  As a result, Europe needs to be sure that it only uses what is necessary to recapitalize its banks.  The only way to determine what is necessary is for banks to disclose their current asset and liability-level data.

What will be hardest for Europe will be resisting Wall Street's call for a massive bank recapitalization prior to using disclosure to enlist the market in determining how much capital is necessary.

The US was unable to resist Wall Street and the result is unhealthy capital markets and banks that are not trusted by market participants.
... the banks need direct infusions of equity. The US Treasury initially designed the Tarp to acquire bad assets from the banks, but then reversed itself and only made such equity investments. It realised that the banks needed permanent capital more than the sale of dubious assets at low prices. If the euro-Tarp does not follow this pattern, its actions will not be taken seriously by financial markets. 
Actually, financial markets will take Europe's decision to pursue disclosure seriously.  Just look how they are using the additional data disclosed as part of the stress tests.
... the first round of bank investments should be made quickly and unilaterally. The US Treasury did not negotiate with the first ten banking institutions which, simultaneously, received Tarp capital. It determined the necessary amounts for each, developed identical terms, and directed that they be accepted. Realising their own fragility, the institutions agreed. 
Applying disclosure quickly and unilaterally makes sense.  No more discussion with the banks.  They recognize their own fragility.  The regulators should release the data they have collected from the banks to all market participants so that the market participants can analyze this data and help determine which banks are solvent and which are not; how much capital is needed to restore solvency and how to raise this capital.

At the same time, the regulators should require the banks to disclose their current asset and liability-level information to a data warehouse where it can subsequently be provided for free to all market participants.
... Europe can learn from an American mistake.
America's mistake was in not understanding that so long as there is leverage in the financial system, without accompanying disclosure, governments cannot inject enough capital to remove all doubt about the solvency of the banks.

Europe would be better off to disclose first and then address the issue of recapitalization.
Finally, bank recapitalisations should be accompanied by credible stress tests, like those Washington applied. The European Banking Authority’s tests continue to be too lenient, and markets do not believe them. Stricter tests, however uncomfortable the results, are necessary for restoring confidence. 
Market participants do not trust government run stress tests as market participants have no way to verify the results.

The source of confidence for market participants comes from the market participants being able to run the stress tests for themselves and this requires that each bank discloses its current asset and liability-level data.
That eurozone banks require injections of government capital may be a blessing in disguise. 
The beleaguered EU leadership now has a fresh opportunity to rebuild market confidence and thwart recession. It need only apply the lessons of America’s banking rescue, which are right there in black and white.
I agree.  The lesson from America's banking rescue that is right there in black and white is that disclosure of each bank's current asset and liability-level data must come before any actions are taken to recapitalize the bank.

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