What Will It Take to Stabilize the Banks?

There is considerable disagreement about how to handle the current severe financial crisis that has contributed mightily to the deep recession in which we find ourselves. Before we lay out our suggestions, it is important to underline a few ugly truths:

No one knows the right answers with certainty.

Although there are historical parallels for many aspects of the crisis, the combination is unprecedented. Answers that worked in the Depression, the Savings and Loan crisis, or Sweden in the 1990’s provide useful input, but there are dramatic differences between our situation now and each of those past crises.

Every available solution is bad and the best we can do is to find the least ugly answer.

A lot of culprits, both people and impersonal forces, dug this deep hole. We will have to pay a very high price to climb out again, a price we have already begun to pay.

The pain is not even close to being over.

How bad it gets depends on the economy’s path, as well as the solutions applied. Banks have not fully recognized the existing losses on their books and we know that the deepening recession will produce substantially more losses. Those additional losses will require still further aid from the taxpayers and will reduce the value of some of the investments taxpayers have already made.

I. BACKGROUND: HOW BAD ARE THE UNDERLYING LOSSES LIKELY TO BE?

Determining the right solution depends in large part on assessing how bad the credit losses will become. This in turn depends on a view of the depth of the recession. Table 1 compares the expectations for credit losses for U.S. banks and broker dealers in three careful analyses, all from January 2009.

Table 1: Projected losses on U.S. credit risk and effects on total banking capital ($ billions)

1. Average of estimates from Goldman Sachs and Roubini
2. Guaranteed amount * 80% reduction in risk-weighted assets * 6% “well-capitalized” tier 1 capital ratio
3. Author’s estimate for allocation of second $350 billion tranche
4. Author’s estimate based on historic earnings plus credit charges at FDIC-insured banks
5. Author’s estimate based on historic dividends at FDIC-insured banks, reduced for 2009 and 2010
6. Author’s estimate based on historic income taxes at FDIC-insured banks

The lowest estimate is from the International Monetary Fund (“IMF”) using their revised forecast. Goldman Sachs has published estimates modestly higher than the IMF’s. Finally, Professor Nouriel Roubini of the Stern School of Business at New York University, has published the most pessimistic major forecast. The table goes on to show the actual and potential sources of replacement capital and the net effect on system-wide capitalization.

Each forecast starts with a projection of losses from U.S. credit instruments (both whole loans and syndicated/securitized products). These loss estimates are substantially higher than those for “toxic assets” alone because many of the credit losses stem from more standard conservative loan types, such as commercial and industrial loans.

For example, Roubini’s analysis projects that under 40 percent of the credit losses would come from securitized products, the category under which virtually all toxic assets fit. Many of the credit losses will not hit U.S. banks because the risks were transferred to foreigners or non-bank buyers through securitization or loan syndication, so line 2 on the table is roughly half of line 1. Line 2 is shown in bold because this is our starting point, the projected aggregate effect of credit losses on the U.S. banking system.These large losses will be offset substantially by several sources of new capital.

First, there was approximately $510 billion of capital raised by U.S. banks and broker dealers through 2008, much of it public money. Second, the government reduced the needed capital for Citigroup and Bank of America by agreeing to guarantee all but about 20 percent of the potential losses from specified large pools of their assets. This guarantee was reflected in a lowering of the capital required to back these assets, producing the same net effect as adding an equivalent amount of capital while keeping the capital requirement flat.

Third, it appears that approximately $200 billion of the second installment of the TARP program would be available for capital infusions.Finally, the banks will accumulate substantial core earnings during this recession, prior to the effect of credit losses. We have already factored in the full effect of projected credit losses and should therefore not double count by using net income that also reflects those credit losses. Not surprisingly, banking is very profitable even in recessions, if one ignores the effect of credit losses.

One might object that the capital from these core earnings will not be available up-front, but the projected losses will also manifest over time and therefore will not diminish capital entirely on day one. This is true even without regulatory forbearance—some losses in this recession will not become evident until 2010 or even later.In sum, the banking system can be restored to the capital levels that held prior to this recession, which were considered more than adequate at the time, if the economy and credit losses perform as the IMF or Goldman Sachs expects. These forecasts are roughly in line with the consensus economic view.

Professor Roubini, however, has a considerably more pessimistic forecast for the harm from this recession. For example, he is currently forecasting a 5 percent total drop in gross domestic production from peak to trough, while the consensus forecast is in the 3 percent range. (For those who follow economic numbers less closely, please note that the much-reported decline in the most recent quarter was, as always, given on an annualized basis, making it appear four times larger. The actual drop thus far in the recession is around 1.5 percent.) In addition, he estimates that housing prices will drop another 20 percent, at or above most predictions.

This grim forecast drives his estimates for credit losses, which are much higher than estimates from the IMF and Goldman. It is worth emphasizing this point. Roubini’s methodologies for projecting credit losses appear to be generally in line with those of the IMF. His figures are so much larger primarily because his view of the economy is grimmer. If he is correct, there will be a much larger capital hole to fill than is available from currently foreseen sources, which increases the pressure for nationalization or other drastic action.So far, this discussion has focused solely on the adequacy of capital for the entire U.S. banking system.

Clearly, a major capital deficit for the banking system as a whole would necessarily imply that a number of individual banks were undercapitalized. However, system-wide capital problems are not necessary for individual banks to be in trouble; the distribution of capital across banks is also important. The system could be adequately capitalized, yet individual major banks could be substantially undercapitalized but extra capital at other banks would offset the system as a whole.

II. THE WAY FORWARD: WHAT SHOULD BE DONE?

Restoring the financial system to permanent good health requires the right action on three fronts:

Recapitalizing the Banks:

Capital is the cushion that protects shareholders, depositors, and customers from the effects of banks’ mistakes and misfortunes. There have been so many of each that virtually all banks need more capital to restore the necessary cushion. This will be available over time from the private sector, but the taxpayer is the only realistic source for now of the “bridge” capital that will carry us through until private markets are restored.

Cleaning up the “toxic assets:”

The banking system owns large quantities of highly complex securities whose values are tied in complicated ways to the value of underlying mortgages. These securities have lost a great deal of value as house prices have plummeted. Even worse, it is very difficult at this point to know the true value of these securities, making it hard to know how safe the banks are.

Halting the recession:

The financial crisis affects the economy, but is also affected by it, as shown above. The stimulus package and the efforts to slow the decline in house prices, particularly through attempts to mitigate the problem of foreclosures, need to work in order to put a floor on the value of the loans and investments that banks hold. This topic is larger than we can deal with in this short paper, but it must be borne in mind when evaluating actions that focus more directly on the banks.

A. Recapitalizing the Banks

We largely agree with the steps to recapitalize the banks which were announced as part of the Administration’s Financial Stability Plan as well as the subsequent announcements concerning “stress tests” for the 19 largest banks . We do not see the need to nationalize banks on any broad basis at this point. It is better to wait to see whether the economy deteriorates so drastically that such a change in plan becomes a necessary last resort . There are two key points relating to recapitalization in the Financial Stability Plan.

1. Continued significant use of direct capital injections, but on tougher terms and more selectively focused on weaker banks.

Instead of buying ordinary preferred stock, the government’s shares would be converted into common stock automatically at the end of seven years if the government judged that the bank needed the capital. New injections of capital would be focused on banks weak enough to need the capital, but strong enough to be able to increase lending after receiving the new capital. (The strength of the banks would be measured in part against a new “stress test,” looking at a bank’s ability to withstand a significant worsening in the economic environment.)

This approach contrasts with the previous one of injecting additional capital into all but the weakest banks in order to restore confidence in the wider banking system.The Administration did a good job of balancing between pressures to “nationalize” the banks and a desire not to scare away private investment. Bankers are extremely unpopular right now and there is a strong push to extract a pound of flesh in exchange for any future capital infusions.

Many have argued that the government ought to buy common stock in the weak banks, rather than preferred shares, thus capturing more of the upside and receiving at least the potential for significant voting control. However, existing shareholders are extremely concerned about handing over large stakes in their banks at what they judge to be “fire sale” stock prices. Fears of exactly this kind of dilution of value have hit the stocks of Citigroup, Bank of America, and other banks that are judged to be potential recipients of such a government investment.If the government took a significant share of the common stock of some of the most troubled banks, the most vulnerable of the remaining banks would likely see their share prices decline sharply. This has two bad effects.

First, many other constituents—such as lenders, trading counterparties, and rating agencies—take the share price as a leading indicator of changes in creditworthiness. As we saw in September and October, sharp declines in share prices can lead to a kind of run on the bank by these creditors and trading counterparties. Unfortunately, such runs tend to be contagious, weakening confidence in the entire financial system. Second, if investors are worried about the prospect of nationalization should the economy have another setback, it will take longer and be harder to entice new private investment into banks when the system starts to stabilize.In this context, the Administration’s plan to use convertible preferred stock is appealing, because this stock type causes less dilution to current shareholders, especially as the preferred stock can be bought out prior to conversion if the bank becomes stronger.

2. Measuring the adequacy of capital at the largest banks through a “stress test.”

Regulators are in the process of subjecting the 19 largest banks (those with more than $100 billion of assets) to a test to determine what effect a very severe recession would have on the adequacy of their capital . The results of the test will determine how much additional capital the regulators will push the banks to raise over the following six months.

The government will backstop this capital-raising by agreeing to buy mandatorily-convertible preferred stock in the form described earlier, up to the full extent of the capital need.In this key component of the Financial Stability Plan, the Administration is right on virtually all counts. It is right to insist on comprehensive, uniform stress tests to measure the effect on banks of a considerably more severe recession than expected. But it would not be helpful, as some have suggested, to move to a test of still more extreme conditions. That kind of test would create unreasonable pressure to take actions, such as sweeping nationalizations, that are quite unlikely to be necessary.It is right to insist that the banks temporarily carry additional capital sufficient to handle this stress case, since a large audience needs reassurance that the banking system can handle the worst case scenario. It is right to focus primarily on raising this cushion through additional Tier 1 capital, which includes a fairly wide range of capital instruments.

The government should focus on protecting depositors, customers, and trading counterparties of the banks, all of whom would benefit fully from the protection of Tier 1 capital.At the same time, as is rumored to be part of the plan, it would also be right to insist that enough of this capital be in the form of common stock, the purest form of capital, in order to reassure the stock market. This crisis has demonstrated how a sharp fall in a bank’s stock price can spook many constituencies of the bank, creating wider problems. However, this should not mean requiring an excessively high proportion of common stock in the capital structure. Beyond a certain point, federal purchases of common stock reduce the value for existing stockholders while simultaneously transferring too much risk to taxpayers.

B. Cleaning Up the Toxic Assets

The Administration will need to make some critical decisions soon on its plan to create a public/private partnership to buy “toxic assets” from banks . The plan was announced by Treasury Secretary Geithner on February 10th in terms of broad principles, with the mechanisms to be designed over the following few weeks. The idea is to move as many of the toxic assets as possible off the books of the banks, where they have been wreaking havoc by creating massive uncertainty as to the solvency of those banks.

The Administration has concluded that there needs to be substantial involvement from private investors who are, collectively, the party best able and most motivated to evaluate these complex assets. At the same time, the government needs to be involved in order to provide incentives to break the logjam that has held trading volumes in these securities to extremely low levels.The most fundamental question about the public/private partnership is the proper financial role of the taxpayer. In order to make the partnership work, the government probably must provide cheap financing for the private investors, combined with guarantees of the assets’ floor values and with a minimal emphasis on government co‐investing by directly purchasing toxic assets.

The Administration faces strong practical pressures to encourage private investors to buy toxic assets by offering financing and guarantees, rather than attempting to execute a large program of direct government purchases of these assets. There are three main difficulties with direct asset purchases:

• Treasury has at most $100 to $200 billion to commit to the toxic asset program without going back for new legislation, given other commitments. The Administration is understandably reluctant to ask for politically unpopular new legislation. It might not pass or, if it is passed, might be festooned with provisions that would undermine the goal of restoring the financial sector. Either way, it would use up considerable time and political capital.
• Such purchases would lack the multiplier effect that guarantees would have in bringing in private investment. Hedge funds and other investment funds would not value the government as a co-investor, soaking up a portion of the limited supply of attractively-priced assets. On the other hand, they would place considerable value on guarantees and on cheap financing, both of which are scarce resources in today’s market.
• It would also be difficult to multiply the size of the program by using money from the Federal Reserve, the only other body with the legal authority to commit to a program this large. The Fed has almost unlimited legal authority to provide loans or guarantees to private parties under “exigent” circumstances. However, it has a very strong preference to provide loans or guarantees only if they are backed by fairly low‐risk assets. (Among other things, it presumably worries about becoming a massive hedge fund for the government, investing in politically favored high‐risk ventures.) Partial guarantees from Treasury, combined with retention of some risk by private investors, can create low‐risk assets out of otherwise high‐risk assets, meeting the Fed’s criteria.

Issuing guarantees would allow for a larger program for a given level of authorized spending by Treasury. Treasury could provide private investors with guarantees that would cover declines in the value of the toxic assets below a floor value, with the guarantee stopping at a still lower valuation level that was considered unlikely to be pierced. The Fed could then provide guarantees from that level down to zero.

The Fed would provide its portion of the guarantee by offering “non‐recourse” loans, that is to say, loans which are secured by collateral, where the lender has no recourse back to the borrower if the borrower stops paying. A non‐recourse loan effectively contains a guarantee that, if the value of the collateral falls below the amount borrowed, the Fed and the Treasury would be stuck with the shortfall. Some protection for the Fed would be provided by over‐collateralizing the loan, securing it with assets initially worth more than the amount borrowed.

There is considerable precedent for this combined Treasury/Fed approach. It will be used for the new Term Asset‐backed securities Lending Facility (TALF) program and has been used to provide guarantees and non‐recourse loans to Bank of America and Citibank in the recent past.An example may be helpful here. A public/private partnership could be constructed that would allow for purchases of $1 trillion of toxic assets by private investors, such as hedge funds. In order to encourage this, Treasury would agree to provide, for a fee, a guarantee that the value of the investments would not fall by more than 20 percent, with the guarantee stopping at a 40 percent loss.

This would result in a maximum potential loss by Treasury of $200 billion, if the whole program were put in place and all the assets suffered a decline in value of 40 percent or more. (Private investors would have absorbed an equally large loss.) The Fed would agree to lend the investors up to 80 percent of the value of the assets on a non‐recourse basis, secured by the full amount of the assets. The loans would be priced to take account of the partial protection from the Treasury guarantee. The Fed would carry the risk that asset values fell by more than 40 percent, an unlikely enough event that it should still be able to provide quite advantageous interest rates.Recent leaks have suggested that there may be multiple investment funds, each of which might largely fund itself through debt with a government guarantee.

This would be a second way of providing cheap funding and federal guarantees against losses beyond a certain point. Either way, the taxpayers’ economic exposure would be essentially the same.

III. CONCLUSION

The Treasury and the Federal Reserve should move aggressively to stabilize the banking system and restore confidence; indeed, there is no higher economic priority at this time. The steps that need to be taken are pretty clear; indeed, they have been clear for awhile. There must be an adequate amount of capital injected into the banks and the troubled assets must be moved out of the banks or their impact neutralized.

Both of these actions will be very expensive for the taxpayers, involving significant risk of large future losses. The amount of money needed is not known as yet because we do not know how bad the recession will be which influences the volume of assets that will default as people stop paying on their mortgages or credit cards, and businesses declare bankruptcy. We do not share all aspects of Nouriel Roubini’s dire view of the economy, nor do we agree with his call for nationalizing the banks, but his forecast of a 5 percent decline of the economy from peak to trough is quite possible, indeed the drop may be even larger than that. So the costs of stabilizing the banks will be very large indeed. The sooner policymakers face up to that, the better.

For more details, please see Douglas J. Elliot: “Bank Capital and the Stress Tests” (March 3, 2009); “Bank Nationalization: What is it? Should We Do it?” (February 25, 2009); “Designing the Public/Private Designing the Public/Private Partnership Part I: What Role for the Taxpayer?” (February 20, 2009); “The Administration’s New Financial Rescue Plan” (February 10, 2009); Brookings Initiative on Business and Public Policy.  Also see Robert E. Litan and Martin N. Baily, “Fixing Finance: A Roadmap for Reform.” Fixing Finance Series: Brookings Initiative on Business and Public Policy (February 2009).

These articles and others are available at our website: www.brookings.edu/projects/business.aspx