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With Geithner set to announce his plan for fixing the banks on Monday Tuesday it’s time to look at one of the biggest issues in the financial crisis: the fact that no one knows how bad the damage is.
Not only is the financial situation getting worse, but a lot of securities either really have no market (they’re hardly ever sold) or the market price is actually below their probable long term value. If the government is going to take over banks, or insure the securities, or set up a bad bank, they need to know whether they’re solvent and how risky the securities they hold are—how likely they are to go bad in the future. Once they know that, they know how much to pay, which banks to take over and which banks can be saved.
How to value securities to allow proper bank triage and surgery
- If the security has an income stream value it based on the income stream and then devalued based on the risk that is average for paper with that return. Take that value from securities which do trade on markets, even if this one does. (i.e. 20% return is junk bond status, sorry).
- If the security has no revenue stream but does have a maturity value, value it at maturity discounted for risk based on return. Again take the discount value from publicly traded securities with similar returns.
- If the security has speculative value but no guaranteed income or maturity value then you simply have to get some bids from the market and value it at those bids. In many cases this is going to be, literally, cents on the dollar. There’s no way around it.
The government takes these figures and calculates two numbers from it:
Assets – Liabilities: After revaluing all the crap, does the bank have more assets than liabilities. Is it bankrupt or not?
Cash flow: Is the bank cash-flow positive. Note that a bank could be bankrupt and have positive cash flow.
They then divide banks and other financial firms into four groups:
Cash Flow Positive and More Assets than Liabilities
This is a healthy bank. The government gives them no money, and puts no specific restrictions on them other than whatever general regulatory reform everyone is subject to. Tell them to go on their way and do what they want.
Cash Flow Positive But Less Assets Than Liabilities
You either nationalize this firm, hive the bad assets into a bad bank and then after some years sell the bank back to the private sector at a profit or you combine this bank with one or more of the next class of banks – those that are:
Cash Flow Negative But More Assets Than Liabilities
This bank can’t keep operating on its own, but combined with a bank with positive cash flow it could work out. Combine it with a bank with cash flow. If the government can’t find one, they shut the bank down in classic FDIC fashion, and sell off the assets to pay off the liabilities. Done right shutting down the bank should cause no adverse ripple effect since assets are greater than liabilities (but if the government wait for that to change, it could cause a ripple effect, so they shouldn’t hesitate, get it done!)
Cash Flow Negative and More Liabilities than Assets
FDIC takes these banks over. Don’t even bad bank them, just wind them down. They’re dead, they just don’t know it yet.
Now the next step after the government has done done all this—found out which banks are alive, which are wounded, and which are dead is that they offer to insure the securities. But instead of just blanket guarantees they offer properly done insurance which costs what it’s worth. You base default rates off the market, charge the right premiums and insure. Since you’re charging enough money to cover the losses, the taxpayer won’t take a bath on this, and it will also reassure investors. Some banks which are only slightly cash flow positive may go cash flow negative if they have to take out insurance, in that case they really belong to category four (they may not be dead yet, but the math says they will be soon) and you shut them down.
This process probably isn’t much like what Geithner’s going to propose Monday, but it should be. It’s based on three principles.
- Find out How Deep the Hole Is
- Perform Triage: Bury the dead, help the injured, let those only mildly wounded fend for themselves
- Make sure the damage to the financial sector doesn’t spread any further beyond the financial sector
We can only hope Geithner’s plan will do all three of these things.
Endnotes
i. For restarting lending, you do it in two ways – the banks the Fed takes over which aren’t dead you use to lend to consumers under FDIC direction, and the Fed just lends directly.
ii. If you’re setting up a bad bank, you must nationalize the firms you are taking bad assets off of, otherwise private investors get all the upside, and taxpayers get the downside
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Thank you for this most lucid explanation Ian. I’ve been wracking my brain trying to think about the bank issue – so much depends on the resolution of these problems.
Digg is open
Ian, you are so right.
I’m a simple American. Somewhat educated. A specialist.
You are so right on, in my opinion.
So many agree with you, but disagree with you.
You are always right on. Thanks.
Assuming that its an honest evaluation the GOP and banks will put political pressure to look the other way at funny assets.
I hope all this will be made public on the net.
What if the assets have down side if the economy goes down further.
A bank today might have a home mortgage that was worth $200,000 today its worth $100,000 next week its worth $50,000.
Will we need to monitor all the banks every few months if the economy keeps going down?
Bad linky.
Digg it.
Thank you, Ian. A plan an economic dunce like me can understand.
What about Enron type loans to Corporations and Hedgefunds the company puts up its own stock as collateral the stock goes down the banks demand more collateral. The company goes under.
In this market we could see a lot of Enron’s, and or a lot of banks going under.
This is what the risk numbers are for, they should take much of that into account. Not that you won’t have to keep auditing, mind you, but the idea is to build a lot of that into the original valuation.
Reid’s up on CSPAN-2.
OT Tweety said Harry Reid is a very tough customer and very partisan.
I want Tweety tested for drugs.
Gotcha
Just what will make the banks not taken over by the Fed start lending again? I mean we gave them money already so why are they not lending?
Geithner’s plan on Monday any idea what he will say based on his past writings and will it help or hurt?
If you’re going to value securities based on risk adjusted returns you’ll need to use some kind of historical average. Right now spreads are a lot higher than they were before the credit markets dislocated in the summer of ‘07.
I say no more capital, let them surivive on their own or wind down and start new banks with TARP money. $350B at 9:1 leverage is $3.5T of new incremental lending capacity.
They are having to delever their balance sheets. Increased loan loss provisions inhibit their ability to lend and stay within the Fed Regs. Also, losses flowing through the income statement shrink the equity which decreases their capacity to lend in the much same way.
T-
Ok so the money we gave them was not enough.
That’s because risk is higher now than it was before. No, you have to use current spreads.
Since I’ve finally caught up with you, Ian, let me ask – do you think it’s fair to say that the problem in our economy right now is lack of spending, rather than lack of ready capital?
Ian
Too simple as the Banks don’t want to acknowedge the depth of the hole they are in, as it would probably start sharholder lawsuits…
So there will be a fudge…
You don’t take their word for it. You hire all the people they’ve laid off as auditors and you send them in. They know where the bodies are buried.
Both.
It’s also a problem with investment supply. There arent’ enough good places to put money, haven’t been for years. The industries of the future have been trying to avoid being strangled in the cradle.
I generally agree. Banks likely to be dead, like Citi, have huge portfolios of credit default swaps. At 9/30, the portfolio was in the range of $3.4tn in protection bought and sold. No one thinks the markets can absorb this crap and I don’t think we should have to pay for it. I think legislation is necessary to make sure we don’t have to pay up.
Well, I guess that’s my point about capital – it seems to be there, we added a buttload of it thanks to Hank Paulson, but they don’t feel like lending. Given the shape the economy’s in, I suppose I can’t blame them. Has capital really dried up, or is it just locked up? (Sorry if that’s a false dichotomy).
I think there is plenty of investment opportunity. The greedhead investors don’t want any risk. The greedhead entrepreneurs want all the return. The result is that there aren’t deals.
Nice ideas. If investors take a bath in a bank nationalization, what about the bond holders? If everyone else is taking a haircut in this, homeowners from the beginning and still, investors, the government, what about the bondholders?
The bondholders get what they get in dead banks. One way to recapitalize the other groups is to insist on debt to equity swaps.
Legislate all Credit Default Swaps null and void first, and there might be enough healthy tissue left for your plan to work on the survivors.
Oooo devious. I like it!
If you must work on a bank by bank granularity instead of just looking at their assets, then your plan makes good sense.
I feel there’s probably some rough edges which need work, but your idea of doing an evaluation and triage makes great sense. Probably the most difficult thing in evaluating is the dynamic situation the economy is in. It’s not exactly stable. A lot of these banks have been holding on, trying to ride out the storm, so they can recover full (or near full) value on their toxic assets. Any intervention is going to disappoint them to some extent.
Are any of these firms using Credit Default Swaps to protect against being wiped out? Does your plan include nullifying naked CDSs and doing something with the other CDSs?
Yeah, the financial sector has been so good at profiting that the Fed has had to steadily inflate the money supply for the real economy and that means now we have a financial sector with money to ‘invest’ and nowhere to put it because they took it out of the real economy. Add to that the rigidity of our economy and it’s inability to go into new energy sources and the like and where would you want to invest? Biotech seemed good, but nothing’s come of it that I know of. The Tech bubble showed people WANTED to invest, but in that case there wasn’t enough substance, so it burst (helped by the Fed and increased interest rates).
We need new real product, so they can invest properly. But, perhaps more important is fixing the system, so we don’t get into this mess in the future and so finance has more incentive to really put dough into real stuff than into fake products.
On a large scale the idea of taxing wealth has been used to inspire fear and therefore investment. Get them doggies movin’.
On a county-wide scale property taxes have that same effect. It’s usually done for education spending, but it has to also have some fear-inspiring stimulative effect.
The downside is taxing wealth hurts fixed-income people the same as price inflation.
Perhaps these Credit Default Swaps are a very bad idea because they let investors (at least) feel they’re safe and don’t have to make the best investments. I know I really don’t like the idea of people betting on someone’s failure (knowing they might try to encourage it into happening). Look at what happened in housing when the mortgage lender could sell off the risk — they went wild making stupid loans.
http://www.nytimes.com/2009/02…..38;emc=rss
As expected, the Feds are planning to buy the banks bad assets & recapitalize the banks. Everything to avoid Ian’s
1. Find out How Deep the Hole Is
2. Perform Triage:
3. Make sure the damage to the financial sector doesn’t spread any further beyond the financial sector
Why? Truth avoidance.
Wow! This really helps clear up the “how could we clean this up?” question. As a taxpayer, I am a reluctantly compulsory investor in this system as a result of TARP. It’s like trying to get out of the way of a speeding train and realizing that I can’t. I either pay now in the form of a devastated economy or I pay later in higher taxes for the repairs being made now. Thanks also to Cujo for relief from unnecessary guilt for trying to hold onto my cash.
I don’t know if this is above, but I heard tonight that G’ner will not be talking until the stimulus has passed….that was the update.
Ian, great post, thanks.
Don’t buy a pig in a poke, aka Caveat emptor.
Bullseye.
I think there’s a lot of opportunity in decentralizing the food supply and energy generation, via investment in a high voltage direct current (HVDC) backbone.
Delaying TARP2 until the Jobs Bill passes might be smart. Or at least until it gets past Collins and her merry band of citizen-haters.
Dugg
NEW YORK (Fortune) — The Obama administration is about to face its first significant financial test.
Treasury Secretary Tim Geithner is expected to lay out the government’s strategy for reviving the banking system in a speech Tuesday. The plan was originally set to be unveiled Monday, but the Treasury Department said Sunday it was postponing the announcement to allow Geithner and other economic officials to focus on trying to get the stimulus package in Congress passed first.
Also dugg here
Flipped it back to the top for a bit more sunlight since the stimulus news pre-empted it Friday.
Yeh, I heard bailout address to be on Tuesday, only after the Senate vote on EcStim.
‘Course if the Senate bill goes kablooey then that plan’ll be up in the air…
Why wouldn’t you start by declaring CDS’s null and void, and then repeat with CDOs?
Aren’t they a key reason that no one will admit, and therefore no one knows, ‘how bad it really is’?
why not let the failed banks fail?
If our economy is dependent on house and car sales, why not have the government make house and car loans directly, as with direct student loans, and forget about giving banks any billions of dollars at all?
Dugg.
Ian, the treasury will now speak on Tuesday is my understanding.
Who said that??? I didn’t. Is it possible that someone stole my handle?
Nevermind. I forgot this was an old post.
Updated the date, thanks all.
Declared all CDS’s invalid is certainly one option. It would simplify a lot of things, but it would also break things as well.
I do tend to think the government may as well start loaning direct, as I’ve suggested in the past.
that’s where I heard that idea . . .
I think we should look at properties and value them at the market value for them in 1985 shortly after Reagan devalued the dollar relative to European currencies and one year into the Reagan recession. It was also two years after deregulation of the S&Ls so properties had already been inflated to allow the first generation of thieves to use those properties in order to get unsecured loans from the banks they would later plunder.
We’re basically back where the economy was just as Reagan took over, unemployment at record numbers, dollar plunging in value, jobs moving overseas. Why not let houses be valued at what they were back then? At least it’s a baseline.
New post–>
With all due respect, I think your ‘back where we were in 1980′ is going to create problems for your analysis.
We’re not there.
We’ve had almost 30 years of military spending, but not new dams, and the electricity grid built in the 30s and 40s under FDR is in need of major rehaul.
In Reagan’s era, the Internet did not exist.
Much of what is known in educational research is pretty recent.
We didn’t have much data in 1980 about global warming; now we do.
Credit derivatives had not fundmentally undermined banking and Wall Street.
I read your point to mean, ‘Don’t Panic’, and I agree that humans are creative.
But the underlying environmental, resources, population, and climate factors are far more serious — partly as a result of Reagan/Bush/Bush.
If this isn’t an EPU post?
I thought that CDS’s were contracts to cover losses for a certain time period? If so, won’t this problem go away on its own, assuming nobody writes new ones.
If so, how much longer do they run?
Anybody?
I was looking at it as a way of valuing one class of assets.
I agree we can’t afford to panic but we can’t afford to continuously reward the people/institutions that took advantage of an ideology to bankrupt the rest of us while they tried to sell it as a panacea.
I agree that credit default swaps are a way of avoiding responsibility for one’s loans. In fact, bankers who are defending CDSs practically say so. I read somewhere that the bankers are afraid they will lose a client if they don’t keep lending, so they just write a CDS to protect themselves. If they really believed in the customer, that wouldn’t be necessary.
Would it make any sense to allow for some type of tax credit for people to reduce student loan or credit card debt, provided the lender receiving the payment will lend the money to someone else?
CDOs are a different animal. They are shares in a trust. The trust holds actual assets, like mortgage notes, credit card receivables, even portfolios of bank loans. There are real values there, we just don’t know what they are.
The CDSs are just insurance for loans or CDOs. They are not backed by adequate reserves, set up for the purpose of making sure there will be enough money to pay if something fails. We don’t have a reason to support CDSs which were written without adequate care. The counterparty may lose money as a result of cancelling the instruments. It may even be that some of them were used as part of complicated trades trying some kind of arbitrage.
There isn’t any reason to privilege a CDS over any other debt, which is what happens with the requirement of posting collateral on a daily market basis. So screw them. They can be listed as unsecured creditors, and we grab the collateral back.
Yeah, they have terms, so you can wait them out, if they don’t go bad in the meantime. Take quite a few years to clear the majority of the backlog though. I’m not sure what the average duration is but my impression is that it’s 5 to 10 years.
The usual term is 5 years. If we outlaw them, it will take a while to work them out of the system.
A lot of CDS’s were used so that CDOs and other crap could qualify for high ratings.
HVDC backbone falls on the sword of “rights of way” and “NIMBY”
Yes, and that would be another category of CDSs that we shouldn’t honor.
Very nice overview, Mr. Welsh. Do you suppose Geithner is paying any attention to Elizabeth Warren at this point? I’d place more reliance on her assessments than any coming from Geithner or any of the the so-called “experts” he has hovering around him.
http://www.nytimes.com/2009/02…..rp.html?hp
Ian,
I was hoping you could shine some light on an issue for me.
I heard Jim DeMint mention that non-tax-cut stimulus is bad because it takes dollars away from people and then government decides how to spend their money for them. This makes absolutely no sense to me, because I don’t understand why it has to be funded using tax revenues. I outright reject the idea that 300 Million people can aptly focus their capital resources to the degree necessary to fill a 2+ Trillion dollar shortfall in productive capacity, so I didn’t get caught up in the validity of tax-cuts aspect, but the source of funding aspect puzzles me.
The fed is in a liquidity trap at the moment. We’re currently approaching a paradox of deflation, and in that condition the Fed can just print money to fund government induced build out without significant risk of short-term inflation; right?
We don’t have to borrow it to pay it back later, we can just make more of it (other than considering inducing inflation a form of borrowing). If we’re shrewd about what we’re doing we can control inflation down the road by raising interest rates to slow the economy in a deliberate and controlled capacity (preferable to the chaotic and dynamic unhinging that’s happening currently); post recovery of course.
If we’ve spent well in the interim; our quality of life, infrastructure, scientific commercialization and social services should be improved so dramatically that while GDP growth may be stunted during that time of controlled slowdown, you wouldn’t necessarily notice by looking around you or examining your personal or aggregate well-being.
So why do we have to borrow at all? Why does it have to be a redistribution of income from the people to the government? Why can’t the government just print money while the dollar is deflating, make ample use of what appears to be the only upside to a liquidity trap, and throw gobs of currency at modernizing our nation, investing in growth markets, and reinvigorating existing markets?
I’m sure I’m missing something simple, but it seems like being in a liquidity trap makes the prospect of massive government spending a relatively cheap proposition compared to times of other monetary conditions.
Krugman’s latest is up:
http://www.nytimes.com/2009/02…..nted=print
Great post Ian. Do you send these posts to newspapers and politicians who can use some of your ideas?