Randomness (r_ness) wrote,

Bank solvency and the "Geithner Plan"

This is--as the author says himself--"a very long and wonky post". He himself says not to "bother reading it unless you are really interested in banks and the crisis." However, it does a fine job of explaining the problem and offering a possible way forward. While long, his post even managed to explain it to me, and I'm neither a chartered accountant nor a bank examiner. If you're interested in how one analyst looks at the banks, you should definitely give it a read: http://brontecapital.blogspot.com/2009/02/bank-solvency-and-geithner-plan.html

Some excerpts:
You can’t possibly decide what bank to invest (or for that matter short) without an understanding of where the politics is. If the government is going to keep giving money to banks (as per the Citigroup bailout) then you just have to own them. If the government is going to be harsh (as per the AIG bailout) then you want to run a mile. And they could be harsher than that. There are lots of possible outcomes – and the outcomes seem uncorrelated to the solvency of the institution.

The government policy is very hard to determine. Under the Bush administration there was no policy. Each financial institution in crisis was handled a different way – think Bear, Lehman, AIG, Fannie and Freddie, WaMu, Wachovia, Citigroup. No two deals were even close to similar. Ad-hoc – thy name is Hank Paulson.

We have gone from an administration which demonstrated that it had no plan to the “Geithner Plan”. The “scare quotes” around “Geithner Plan” are because it is unfair to even call the “Geithner Plan” a “Plan”. As far as I can see there is no detail – and if you don’t have detail you don’t have a plan.
The banks are thus under-reserved on an “held to maturity” basis. Heavily under-reserved. If you were to take correct provisions – many banks – not all but many – would have negative net worth. Few banks would meet capital adequacy standards. Given the penalty for even appearing as if there was a chance that you would not meet capital adequacy standards is death (see WaMu and Wachovia) and this is a self-assessed exam, banks can be expected not to tell the truth.
The spread between the origination value of a loan and its secondary value is huge. It simply makes no sense to originate new loans when you can buy old loans so cheap.

The irrationality of lending has dire economic consequences. At worst business just stops because they can’t get trade finance, working capital funding or any of the other basic services of modern banking.
The regulators in the US by-and-large forced banks to have a lot of capital. They were more lax in Europe and totally lax in the UK. The UK problems arise in part because the banks started the cycle massively capital deficient.
If a bank did a lot of trading (eg Citigroup) or originated a lot of loans for sale but was stuck with them at the end (eg Royal Bank of Scotland on its private equity loan book) then it is likely to be deeply insolvent on a regulatory standard because it needs to mark those loans down to a the very low market price. These institutions are squealing for a suspension of mark-to-market rules – and I would have some sympathy if I could get them to account for it on a reasonable yield to maturity basis with reasonable reserves. I don’t trust them – after all – they are bankers and they lie.
Government policy however has been arbitrary and capricious. The Hank Paulson plan was no plan. It was ad-hoc. The “Geithner plan” is so vague as to be meaningless. WaMu which was adequately capitalised but had a minor run (induced by leaked rumours of a government takeover) was confiscated. Citigroup – which – being a broker – is almost certainly insolvent from a GAAP perspective – and which had a major liquidity squeeze was given a big-fat-sloppy-kiss (lots of cheap government capital). In the WaMu case the intermediate funders had any rights confiscated. That I thought at the time was reckless and irresponsible. I still think that.

If the government doesn’t get a consistent plan – and that consistent plan does not appease intermediate creditors of banks (as argued in the “reckless and irresponsible” post) then we might as well nationalise the entire US banking system now – because almost all banks are dependent on intermediate funding – and that funding has fear-of-government.
Anyway – there would not be a crisis if people trusted – even if the banks were marginally insolvent. However banks have told lies – blatant lies – for so long that nobody believes them.
Now when a blogger or an analyst tells you a bank or the system is insolvent then ask them what definition of insolvency they are using and test them against that definition. Then test them against others – and work out – in the context given – whether the institution is solvent against the definition appropriate for the circumstances. People who do not think clearly as to definition of insolvent are being sloppy – and that includes most the bloggers I most admire including Paul Krugman. The context in which the banking system is insolvent is that (a) it is illiquid because people don’t trust it and (b) it can’t get enough liquidity because it has to sell assets into a market in which they are trading considerably below their “yield to maturity or GAAP price” and if you sell it at that price you reveal “mark-to-market” insolvency as per Roubini. However provided the banking system could remain liquid it is unlikely it will actually be insolvent though individual banks might be. [I should note that this is a US conclusion. The UK banks started much more thinly capitalised and I think they are insolvent.]

This is what the stakes are in the (so far incompetent) government policy as to how the banking crisis is to be dealt with. What is a marginal solvency crisis (and that is all it is on a yield to maturity basis) is being turned into the mother-of-all-liquidity-and-solvency crises. Sure the banks bought in on themselves by telling so many lies in the good times (so they are never believed now). But now the problem is beyond their ability to control.
Anyway, there's quite a lot of it, but if you read and understand it at the end you'll have a much better idea of what it means for a bank to be insolvent, and what the outlines of one possible solution might be.

(John Hempton of Bronte Capital is a former Australian and New Zealand Treasury official and investment blogger.)
Tags: money
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