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How Will the Banking Crisis be Resolved? Causes and Possible Solutions

by Ryan Johnson and Rob Weigand.

The credit crisis and dire position of banks remain the major roadblocks to recovery of the U.S. economy.  Although the recession and credit crunch began in late 2007, thus far the injections of TARP capital have done little to stabilize the ongoing deterioration among larger banks. Many now blame former Treasury Secretary Hank Paulson for not laying out explicit guidelines regarding the purpose of the TARP funds, although his successor, Timothy Geithner, has been equally ineffective.  Banks had other ideas of what to do with the capital, which in most cases has been hoarded to shore up their balance sheets and ward off insolvency. Recently, the New York Times and Wall Street Journal have reported that the only bright spot can be found among smaller banks that specialize in more basic lending relationships, including US Bancorp, BB&T Corp and Keystone Financial. Larger banks, such as Citicorp, continue their slide towards partial or total nationalization as the only feasible solution, however.

Banks have been roundly criticized for their failure to lend because it’s generally believed that increasing the flow of credit will prime the economic pump and help curb the rate at which economic growth is declining – particularly on the consumer and bank-to-bank levels. This was a major problem early in the recession, as banks froze lending due to the inability to quantify risks with both consumers (due to plunging real estate values) and other institutions.  However, we propose that lending today may be at a fairly normal level given the severity of the current recession. The Wall Street Journal recently reported that a majority of banks have slowed lending at an average of 1.37% from the 3rd to 4th quarter of 2008.  Although it may sound scandalous that banks would decrease lending while receiving government funds intended to be loaned out, their actions appear more appropriate when the current state of the economy is considered.  The deepening recession has triggered a massive de-leveraging among households, which has dramatically reduced the demand for credit.  The same effect is seen among businesses, as the incentive to invest continues declining along with the ever-worsening economic outlook.  Moreover, it’s unrealistic to assume that lending will grow from the inflated levels of the past decade, especially as banks resume tighter lending standards.  The fact that overall lending is off only 1.37%, and that some banks reported increases in lending, is probably evidence that credit is beginning to flow more freely.  So, rather than fretting about the lending levels of banks that received TARP funds, everyone’s attention should be focused on the major reason banks were given the funds in the first place: de facto insolvency due to insupportably low levels of capital on their balance sheets. 

Like it or not, the financial sector will be unable to fully recover until a majority of the toxic assets are removed from banks’ balance sheets.  These assets continue pushing banks toward insolvency, with many already technically insolvent.  The insolvency stems from the large amounts of securitized assets that were financed with bank capital, which now stands at impossibly low levels.  In addition to this problem, banks have had to write down these toxic assets, leaving the value of their liabilities permanently lower than the value of their assets — the classic definition of insolvency.  The most crucial problem with these illiquid assets remains the inability to value them, which is an unintended consequence of the last administration’s and Alan Greenspan’s misguided obsession with the ability of markets to regulate themselves.  Virtually all securitized mortgage contracts contain nonperforming loans at many times the rate originally predicted.  The potential for further defaults, as the housing market continues to plummet, makes it impossible to forecast the future cash flows of these securitized assets.  If the housing sector continues to struggle and defaults rise further, as they are predicted to do, the market will continue to devalue these assets, which just keeps pushing banks closer to insolvency (Nouriel Roubini’s “death spiral” scenario). 

What to do with the toxic assets leaves banks and regulators in a true quandary.  In order for banks to benefit from the sale of these assets, their value must be high enough to keep banks from becoming insolvent.  If the price is not sufficient, banks will continue to hold these assets in hope of a rebound in the housing sector (which is unlikely if history is any guide — home prices would be expected to stagnate for a significant period after they reach bottom).  The ultimate extent of mortgage defaults and their effect on the value of these assets remains unknowable, which provides banks with further incentive to hold out (essentially risking all or nothing on a desperately deep out-of-the-money call option).  On the other hand, no private company or government agency has incentive to purchase these toxic assets, given the unquantifiable risks.  There should be an increased urgency to create a market mechanism to establish the value of these assets so the banking sector can purge them from their balance sheets and move forward.

Exactly what plans are in place to value toxic assets and shore up banks’ balance sheets?  Surprisingly few, up to this point. On February 10 Treasury Secretary Geithner unveiled his plan to bail out troubled financial institutions.  The plan included the development of a Public-Private Investment Fund (PPIF) — an attempt to obtain as much as $1-2 trillion of financing to create a market for these toxic assets, which would allow a more accurate assessment of their value.  This is also an attempt by the government to limit taxpayer exposure and allow private equity to benefit from potential gains resulting from “cents on the dollar purchases” of these assets.  This plan, which in our assessment was generally on the right track, has been mercilessly criticized for its vagueness.  Geithner’s lack of details regarding the organization and implementation of the investment fund triggered a sharp and protracted market selloff that continued through February 23.

It is imperative to restore confidence in the financial sector by dealing with the toxic assets in a timely fashion.  Banks will be unable to resume anything resembling normal operations until they are relieved of these assets.  For those who believe that Geithner’s public-private fund is flawed and will take too long to obtain the needed results, the only remaining solution appears to be temporary nationalization of insolvent banks.  The most well-known proponent of this strategy, Nouriel Roubini, was recently quoted in the Washington Post explaining that

“Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.”

  More recently, Roubini continued to sell the idea to fiscal conservatives by telling the Wall Street Journal that it was also the most cost effective solution. The severity of the situation is perhaps best underscored by conservative leader Lindsey Graham’s warning to his colleagues “not to get hung up on the word nationalization.” Whether the next move is Geithner’s public-private fund or nationalization – Citicorp appears to be the first likely victim of this fate – there should be no doubt that every day without a solution contributes to the worsening of the financial crisis.

You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand. Ryan Johnson can be contacted at ryan.johnson@washburn.edu; Rob Weigand can be contacted at profweigand@yahoo.com.

Categories: Market Commentary