Tuesday, April 28, 2009 0 comments

Well, looks like we don't need to wait until May 4th for bank results

I thought there would be lot of suspense until the week of May 4th, when the bank stress test results are to be revealed, but it seems the media has killed the suspense. The Wall Street Journal is reporting that Bank of America and Citigroup have been told to raise capital (don't have access to original article so here is a summary from Calculated Risk.) Both banks are supposedly in the process of responding with rebuttals. It's not clear if other potentially distressed banks, such as Wells Fargo, Fifth Third Bankcorp, and others, have also been told to raise capital.

By not nationalizing banks—admittedly very difficult to do this in America since conservatives tend to be completely against it and it seems to run somewhat against American character—I wonder if the Obama administration is going to end up zombifying all the other distressed banks as well. If the government gains sizeable ownership, which it will if preferred shares are converted to common or if it purchases a lot more common shares, and chooses not to break up these megabanks, it will likely hurt private banks. It will be very difficult for private banks to compete against government banks (particularly if the govt cuts off cheap funding to the private banks while providing cheap financing to the govt banks--although no indication that this will occur any time soon.)

Another major reason the government is reluctant to seize the banks is because it will cause massive losses for bondholders. The government is trying to avoid the Lehman outcome. John Hussman has favoured the alternative—to let bondholders take losses, as they would in a true free market— and he points out what he thinks is really happening with the current approach:

As a result [of forcing Bank of America to Merrill Lynch even though the CEO wanted to back out], instead of Merrill Lynch's bondholders taking a loss on their bonds, or swapping their debt for BofA equity, those bondholders will now be made whole for all of the losses that Merrill incurred, with 100% principal and interest, right alongside of the bondholders of BofA that are being protected. That's what these bureaucrats want during their stint in government service, that's how they advise our elected officials, and then their revolving door takes them right back to Wall Street. This thing is run by investment bankers and corporate bondholders for the benefit of investment bankers and corporate bondholders.


Of course some would argue that Hussman is downplaying the systematic risks. They would argue that these banks are too-large-to-fail and hence letting their bondholders take haircuts will send ripples all acros the world.


The way I look at it, there is no "right" answer in this situation. The difficulty in the solution is to allocate the losses to various parties. The government can't save anything here; the losses are real and you can't turn back the clock. So, do most of the losses accrue to bondholders (Hussman's preference)? Or do they accrue to taxpayers (Bush administration solution last year)? Or does it accrue to competitors and bank customers (Obama solution right now)?

As I speculated above, the current Obama strategy will likely lead to zombification of select banks. You will prevent the bond market from locking up and save bondholders, while also seemingly saving taxpayers (for the most part.) But, like Japan, keeping these banks alive will suck up capital from other parts of the economy. Competitor banks on strong footing may suffer; customers of banks may see poor service and high costs (generally the case with government-run operations.)

Regardless of whether the government follows the current zombification strategy or the nationalization strategy, I think it will be difficult for the government to exit their ownership. Some, such as Nouriel Roubini and Paul Krugman, are advocating a quick-nationalization-and-subsequent-privatization, as was done in Sweden, but I think it will be difficult for the government to exit easily here. The current American problem seems much greater in scope and complexity than, what little I understand of, the Swedish situation.


In summary, it looks like the regulators have threatened some banks already. It remains to be seen what the final oucome will be. There is no perfect "right" answer and it all comes down to who is going to take the losses. When someone defaults on a $600,000 home that is only worth $300,000, who will cover the loss? I have my own personal opinion of what seems best but, as investors, we should prepare for all scenarios. Given the behaviour of the stock market in the last few days, it is possible that a lot of the negativity is already incorporated into stock prices.

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