The problem with banks....

What in the world is going on with the financials? The government, the FED...so much as been done to bail out certain institutions and to assist others with transactions, liquidity, and a whole host of other issues. Why, in the face of that, are the stock prices still tanking and now there is a very real fear (though certainly not a government desire) of nationalization. What is going on today? Is there a way to define a particular problem or set of problems? The reason to ask this is that, from 2007, through 2008, and now into 2009, there have been issues. No one can say that they don't understand these issues. And, it started with the financial companies themselves taking write downs and cleaning house. If anyone recalls, the companies that took the biggest writedowns were praised, and others (Lehman, Bear) that didn't take the writedowns are now...well...extinct. The funny thing is that, investors then seemed to think, ok, that will work, everything will be good. And yet, it was really only the beginning. With a scary regularity, banks seem to continue to write down, write off, and mess more and more things up, getting killed subsequently in the markets without an end in sight. So, what on earth is going on?

"If governments have restored confidence in the banks’ ability to survive, why the renewed rush to intervene? And if governments continue to demonstrate support for the banks, why aren’t shareholders also rejoicing? The answer to both questions lies in concerns that not enough credit is flowing. Bankers themselves deny the charge that they are hoarding capital. Jamie Dimon, the boss of JPMorgan Chase, told investors last week that his bank “was making loans all the time”. Analysts at Credit Suisse reckon that British banks have increased their balance-sheets since June.

The problem is that even if individual institutions manage to grow their books, there is still a huge gap in financing capacity to fill. Analysts at Citigroup reckon that domestic banks provided only half of the credit available to British households and companies in early 2008, for example. Foreign lenders are under pressure to focus on their home markets. Last week America’s Treasury asked the banks in which it has injected capital to provide monthly reports on their lending activity: it is safe to assume that officials are more interested in loan growth at home than they are abroad. Corporate-bond markets are much livelier than they were but other non-bank sources of finance, such as the securitisation market, remain stagnant.

Replacing this lost capacity would be tough at the best of times. Right now, it is nigh on impossible. Demand for credit is lower, as companies and consumers retrench. Losses are surging as the economic climate worsens. Regions Financial, an American regional bank, reported a record $6.2 billion quarterly loss on Tuesday on souring property loans. Structured products still have the capacity to wound. Shares in KBC, a Belgian bank, plummeted by more than half between January 15th and 20th on concerns that it would take big write-downs on corporate CDOs (collateralised-debt obligations). Even staid custody banks are finding unpleasant ways to surprise: shares in State Street lost almost 60% of their value on Tuesday as it announced hefty losses on bond investments, among other things.

In these circumstances, the natural (and sensible) inclination of banks is to hold on to capital, not to run it down further by ramping up lending. Hence the renewed efforts by governments to free up banks’ balance-sheets. Hence, too, the violent sell-offs in many bank shares, as shareholders realise that the price of further intervention may be widespread dilution.

Public ownership may be unpalatable to many but it is just as difficult politically for governments to keep injecting money into banks without wiping out their owners. Tactically, too, the approach of injecting capital in the form of preferred shares rather than common equity, has its limits. The British government converted its preferred shares in RBS into ordinary shares on Monday because the former required such hefty dividend payouts. America’s capital injections to date have imposed less onerous terms, but its banks still need a reasonable level of common equity to act as a credible first defence against losses. With share prices so low, any more capital-raising is bound to be hugely dilutive (thereby reinforcing the urge to sell). It may not be imminent or desirable but the spectre of nationalisation haunts the sector."

This is an excerpt of an article from the economist. It hits on a lot of key issues. First of all, there is a sense that there is a global financial system and a global financial crisis, but that individual countries are going to focus inwardly before they focus outwardly, at least, in the absence of an emergency scenario. It simply isn't politically palatable to focus on problems of credit and issues abroad when there are so many issues at home, no matter where the situation concerns itself with. I think of this as a negative, not because I think the US or any other country should do something specific to help the global system ahead of the individual national systems...more so in that it is a limit. We were so quick to embrace globalization when there were no problems and when there were profits to be made. In a crisis scenario, maybe to a degree that the world has never seen at least financially, there could potentially be a broader, more global solution than just cutting interest rates across central banks. Maybe there could be a faster solution. Again, not saying I have the answer, just that the answer might be in other places than the ones we are looking.

Another key issue regards balance sheets. The way that I understand a bank balance sheet centers around a couple of important points. First of all, you have customer deposits and accounts. This is money that the bank holds, but it can also be demanded by the customers at any time. So it's a liability. Then, the bank makes money, typically, by lending money. This money leaves the bank, but it is expected to be received (hopefully) in the future. It is an asset. And then, we have what the bank does with its cash. Proprietary trading, whatever they do, looks to enhance the returns on cash instead of just having it sit there. Sometimes they structure securities that are supposed to have some type of return based on underlying assets, like houses. Maybe they sell these securities, maybe they hold them, or maybe they buy others from other banks. I think, personally, that we need to throw out any notion that there were any limits. No limits to how complex securities could be. No limits to how many could be sold. So, these were assets, either generating cash flow themselves or through their ability to be sold.

These securities are complex. True. But it's also true that there is always a portfolio of other securities that can be assembled with the same payoffs. What I mean is that if you have a portfolio of securities of which you know the prices generating some types of cash flows and you manipulate those cash flows to match a complex security for which you don't know the price, the law of one price states that you effectively now know the price of of the complex security. An over simplified way of looking at it, but the theory of arbitrage pricing is a classic one, and I have heard that you can assemble a portfolio of zero coupon bonds to basically match the cash flows of anything. Additionally, it is as though we forgot something. No matter how complex any of these things can become, there are people on the other side. These people need to pay their bills. The securities are worthless if not for that fact. It could be a car loan. It could be a mortgage. It could be a student loan. It could be anything. People stop paying, values drop. Simple as that.

So many would then address mark to the market. This article doesn't really go into that. Blaming mark to market 100% is probably a bit asinine. It's one of those things, like short selling. It CAN exacerbate problems and situations, but it doesn't CAUSE anything in and of itself. What seems to be the case would be the "opaque" securities based on the abilities of people to pay loans keep declining in value. They might decline b/c the value of the underlying houses are dropping. they might decline b/c people are losing their jobs, the economy is rough, and it's harder for people to pay back loans. There could be any number of reasons. So, marking to the market, prices on all of these things across the board need to drop. So, banks that thought they could get "some price" for these things now have to turn around and say, yeah, well, actually, we can't get that price, we have to accept a price substantially lower. So, they need to write down the value of their assets, etc, etc. And, it seems like this process doesn't end up exhausting itself. It would appear logical that many different types of people would be having more and more trouble paying their bills for more and more negative reasons about the economy. It make sense that these securities would be declining in value...continually, with no end in sight, down to zero.

So, it is a fact that they are sitting there on bank balance sheets, declining to zero. There is no reason why they shouldn't keep declining. So, banks will continue to need to write them down. The market will continue to punish banks for needing to do that. Talk about a vicious cycle. So, does this lead to nationalization? The only things that should logically lead to nationalization would be runs on the banks (which haven't happened) or a pulling of lines of credit. Low stock prices shouldn't do it. The fact that stock prices continue to drop needs to be looked at in only 1 way. Stock price is indicative of access to the capital markets. If the bank needs to raise capital, how much ownership do they need to surrender to get that capital. Usually, there is a set number of shares, and a set price per share. The problem is, if the government takes equity positions that would mean anything in terms of their amount, they would basically "buy the banks." So, preferred shares? There are limits here, like the article says. If they need to raise capital, how can they enter into huge obligations to continue to pay streams of interest? When would they stop needing inject capital, if we already realize that the complex securities will keep dropping in value further?

There needs to be a solution that addresses the problem, not one that sounds or looks good politically. The best proposal on the table is a single, large, aggregator bank. If this bank buys up all of these complex assets, then the banks themselves wouldn't need to take further writedowns in the future. John B. Taylor, professor of economics at Stanford, was able to do an empirical study showing that confidence, and not liquidity, has been the core of the issues witnessed in the markets. By this he means that adding liquidity isn't going to be the ultimate solution, rather, restoring confidence will play the most major role. To do this, he proposes that we in some manner take care of these "complex assets." Banks cannot continue to have to take these writedowns if there is to be a solution. There needs to be a visible, discernible end to the chaos. This aggregator bank could be a step in that direction.

It won't be the only step, and it will depend on a couple of KEY FACTORS. I can't even claim to know all of the key factors. I just have two thoughts. First of all, it needs to be as simple as possible in structure. Why are we where we are? We have lots of "stuff" that we can't understand. We need this aggregator bank, should we do it, to be a messenger of clarity. We can't have multiple banks. We can't have too many different structures and inter-relationships. We need to know exactly how it works and it needs to be easy to understand to serve its purpose. Then, there is the issue of price. It's a pure game theory type application. We cannot price them in such a way that motivates the banks to not participate. That is similar to what happened in Japan. They would rather have kept the assets on their books and take the write downs than sell to the aggregator bank. True, this crisis might be a bit different than that one, but the fact remains; we can't set up the bank and then have it not work. We need to set it up in a way that will work.

An interesting premise might be as follows. We know that certain banks need money anyway. We know that the government is giving them money. Why not interlock the two? They get money that they would get anyway, only we make them give up those securities as a condition to getting that money. They're already dictating dividend policy anyway and interfering in the "free market" system. I think it's silly that we're paying SOOOOOO much attention to the pricing question. It's an important question, true, but is it so important that we should let the entire thing hinge on it. Some team somewhere, for a fee, should be able to generate a reasonable pricing schematic. It only makes sense, and if saving the system was as important as they claim it should be...it only stands to reason that they would do whatever it took to get some prices on those things.