Banking Sector Band-aids Just Won’t do It
We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector:
- The plight of equity-holders should be ignored;
- Long-standing rules governing bank ownership shouldn’t be compromised in a panic; and
- Bank balance sheets won’t heal unless deep pain is felt, and preferably as quickly as possible.
Bank Equity Holders: Out of Luck
Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae and Freddie Mac - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders. This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out. GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it’s payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. And those risks have been borne out. And you are busted.
Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things
can and do happen. It’s high time that equity investors understood this. And I’m not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:
The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.
Exactly.
Don’t Play Games With the BHCA
2. The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me. Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?
We have the example of TPG/WaMu, which, I’m afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees. The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I’d be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I’d have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.
Good Bank/Bad Bank as a Way to Move Forward
The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it’s potential losses are so unclear.
What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a “Citi Bad Bank”) or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital. This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now - in order to lay a strong foundation for future growth.
Note to Bank Managements: Take the Medicine - Now
3. Bank management’s steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books. And as it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don’t address the issues of transparency. Mr. Paulson should devote more calories to this issue and less to bailing out the GSE’s and protecting their common stockholders. Yes, the GSEs are hugely important, don’t get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.
Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool’s game. Get to it.
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COMMENT:
AUTHOR: Mark Harrison
EMAIL: Mark@yourpropertyexpert.com
URL: http://markharrison.wordpress.com
DATE: 07/26/2008 03:59:07 PM
Speaking as a European / Brit, I’ve never quite got my head around the US GSEs.
Everything I could read about them made me believe that they WEREN’T in anyway guaranteed by the government… but everyone in the markets seemed to act as if they were.
After the appalling mess my Government made of the Northern Rock fiasco, let’s hope that G7 Governments realise that even a hint of bailing out shareholders (as opposed to mortgage holders) massively REDUCES confidence.
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COMMENT:
AUTHOR: dave
EMAIL: dave@epiphanyresearch.com
URL:
DATE: 07/27/2008 02:14:46 PM
Great commentary, if only it was directed at different companies. Busting out the equity gang ain’t quite right when DC set and fixed the game. GSE’s were rigged for the start, DC passed when the accounting scandals broke, DC pushed to loosen capital requirements after the subprime slide was in full bloom. The Govt screwed it up, leaned on these US Gov created, infected beasts to firm the mortgage market up to the benefit of both Wall St and Main Street, and it may have gone BOOM. DC is on hook, and they will absolutely spend our money to get off.
Same as it ever was.
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COMMENT:
AUTHOR: Investor
EMAIL: investor@gmail.com
URL:
DATE: 07/29/2008 05:52:19 AM
Bank equity holders should suffer the consequences as they should. But what is there to like about the BHCA? The line between securities underwriting and banking has blurred over time. There is the shadow banking system and the real banking sytem and the Fed would like to regulate the two similarly so as not to provide arbitrage opportunities. If that is the case, why should these entities be kept separate?
Good bank/bad bank structure only works if the government is willing to put up some money. I have been involved in bank rescue work for over 10 years and have never seen this work without gov’t money. The problem is in deciding how to split the good bank and bad bank and how to assign value to the two pieces. In an environment like today, any mark-to-market prices is going to be a large range of valuation and I don’t see how parties can come to an agreement. Your suggestion sounds great in theory but it won’t work in the real world. Unless gov’t money is involved, only real option is to keep raising new equity and if it requires offering investors protection against future diluteion, so be it. If there are investors who are willing to put up capital without protection, that is great but I am sure there are none and that is the reason the protection is offered. Look at what happened to Temasek on the ML transaction. Why is that not a good deal for everyone involved?
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2 years ago
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