Should we believe the US Treasury’s stress tests?

The results of the US Treasury’s stress tests of America’s 19 biggest banks yesterday were less bad than many were expecting. Nine of the banks, including JPMorgan, American Express and  Goldman Sachs, were given the all-clear by the Treasury – they weren’t likely to need any more state support.

And the other ten banks, including Citigroup,Wells Fargo, Bank of America and GMAC, only needed $75 billion in fresh capital. That’s alot, but it’s alot less than the $480 billion that Nouriel Roubini, or ‘Dr Doom’ as the economist has come to be known, suggested the sector needed in February.

That means that, if the stress tests are correct, the government’s ongoing presence in the banking sector is likely to be limited, and we are unlikely to see the sort of mass nationalisation of the sector that many, including Roubini (and myself) thought we would eventually see.

Geithner declared that the results marked the end of a long period of uncertainty, and ushered in a new stage of transparency in the crisis.Markets, on the whole, seemed inclined to believe him, with equity futures up in the US.

Now, the debate has shifted quickly from a discussion of mass nationalisation to the question of letting banks fail. If only two or three banks need large amounts of capital – Bank of America, Citigroup and GMAC, for example – then perhaps there is less systemic risk in letting them fail, and the government should look to carry out an orderly winding up of these institutions in a way that protects depositors without bailing out private lenders.

That much was suggested by Roubini in the FT yesterday, who was quick to re-position himself after his original apocalyptic estimate was shown to be apparently wrong.

But are the stress tests really a step forward for market transparency, or instead a confidence trick? (more…)

Is Geithner breaking the law?

Just adding to my post below, there’s an excellent interview by Bill Moyers at PBS with William Black, an American academic expert in fraud, and one of the people who helped clean up the savings and loans mess in 1991.

Black points out that the FBI warned of an ‘epidemic of mortgage fraud’ as early as 2004, though the FBI didn’t do much about it, because 500 of its financial investigators had been re-tasked to the war on terrorism.

The FBI were aware that many banks were fraudulently increasing the size of their mortgage portfolios. These fraudulent ‘liar’s loans’ were then parcelled up by investment bankers, who never checked what they were selling, and given AAA ratings by rating agencies who also never saw the loan files on the mortgages that were securitised and then sold on to unfortunate investors.

When the rating agency Fitch finally looked at some of these files in 2007, it found ‘widespread fraud’, but by then it had already given many bonds a clean bill of health.

Black is refreshingly indignant at the free ride the banks are getting – he points out that UBS received $5bn in US tax-payers’ money, at the same time as it was being indicted for avoiding hundreds of millions in tax.

He suggests that the government is obliged to put insolvent banks into receivership under the Prompt Corrective Action law, which he helped to introduce in 1991.

The law was designed to make it mandatory to step in and put banks into receivership if they are insolvent, so as not to keep bailing them out while needlessly wasting tax-payers’ money.

As he puts it, by continually supporting insolvent banks, Paulson and Geithner aren’t (or weren’t) just being foolish – they’re actually breaking the law.

Another bank scam?

Schroders’  head of ABS, Chris Ames, thinks the Public-Private Investment Programme (PPIP) set up by US Treasury secretary Tim Geithner is in danger of being another big rip off of tax-payers:

We constantly hear that banks can’t get toxic assets off their books because there are no buyers. This is not true. The US secondary market is open – there is a price at which buyers will buy virtually any bond. So the problem isn’t primarily liquidity, the problem is primarily price. This seems to be the big elephant in the room that policymakers don’t want to talk about, but it’s quite obviously the case.

If banks genuinely need to get these assets off their books in order to begin properly functioning again, then if market prices were close to the banks’ holding values for those assets, they’d happily sell.

Many of the asset-backed bonds that the banks own, which were formerly rated AAA but now rated much lower, are sellable, in Ames’ estimate, at around 30 cents on the dollar.

But if banks valued them at their real price, they would be forced to make such cripplingly big write-downs, they would be declared insolvent. So at the moment, they are sitting on these bonds, too afraid to admit how little they are now worth.

The PPIP envisages banks selling off their toxic assets to authorised money managers, using some equity from the money managers, and a lot of leverage provided by the Federal Reserve and the US Treasury under the TALF scheme. It’s a hybrid, market-friendly scheme.

But Ames says no money-manager will buy the banks’ toxic assets at the valuation banks need to charge to avoid insolvency. They’d pay fair value for the assets – around 30 cents on the dollar. And the banks can’t afford to sell at that price, while staying in existence.

However, Ames has spotted a loophole in the programme – it says that ‘any private investor’ can also bid for assets in the programme. So the banks could buy the assets from themselves, via an off-balance-sheet vehicle or a friendly hedge fund. All they would need is a small amount of equity from themselves, and a lot of cheap leverage from the Federal Reserve and the US Treasury.

They can then write-off those assets at the new price which they sold them at, even though they set the new price fictitiously high. And if the price then plummets, well, that’s the Fed’s problem, they bank-rolled the acquisition.

So there we have it. The program isn’t likely to get many assets sold by banks to the money-manager partners at appropriate prices. And if the loophole allowing private investors direct access to TALF funds isn’t closed, banks will be able to shift large amounts of their risk directly onto the taxpayer. Instead of punishing management and shareholders for poor investment decisions, it has the scope to give them a free pass.

Banks: utilities or casinos?

I was at a very interesting little conference at the Liberal Club yesterday, on the ‘future of the financial industry’.

The first speaker was Vince Cable, who added his voice to those, like Martin Wolf of the FT and Mohammad El-Erian of Pimco, who say banks should become, or are on their way to becoming, more like utilities than glamorous investment vehicles.

Cable basically suggested a two-tier banking system: some retail banks would be considered crucial to the payment system and the economy, and thus ‘too big to fail’. They would be managed like electricity utilities, with very strict regulation, and owned, he suggested, through some form of public-private partnership, or as mutuals.

Any other financial players would be treated like hedge funds, and ‘would have no claim on tax-payers’ money should they fail’.

Bank of England governor Mervyn King weighed up the pros and cons of a similar model in a speech to a group of bankers on March 16:

“There are good arguments in favour – to separate the utility functions of a retail bank taking household deposits and running the payments system from the casino trading of an investment bank, and good arguments against – the difficulty of maintaining a credible boundary between those institutions that are eligible to receive government support and those that are not.”

Martin Wolf is in favour either of a complete utility model, or of mechanisms to let big banks fail :

The UK government has to make a decision. If it believes that costly bail-out must be piled upon ever more costly bail-out, then the banking system can never be treated as a commercial activity again: it is a regulated utility – end of story. If the government does want it to be a commercial activity, then defaults are necessary, as some now argue. Take your pick. But do not believe you can have both. The UK cannot afford it.

Adair Turner, formerly a senior advisor to Merrill Lynch (before it had to be rescued by the US Treasury) rejected this division of banks into those we let fail and those that don’t, in his recent report. He came out instead in favour of banks putting aside more capital in the good times, to act as a buffer in the bad.

I asked Cable if he thought the government was fudging the essential unfairness of the present system, whereby banks have repeatedly kept the profits and socialised their losses:

“Yes, the government and Turner are turning their face away from the problem. At the moment, the system is obviously unfair. But the government wants to muddle through with it anyway. Turner’s argument is that hedge funds can grow so big that they acquire systematic importance and have to be bailed out.”

This is true – look at the example of Long Term Capital Management, the enormous hedge fund which threatened the stability of Wall Street when it went bust in 1998, because of the emerging market crises, and had to be supported by the Fed.

At the same time, hedge funds were then (and are today) unregulated. They are now going to be much more actively regulated by the FSA and SEC.This could prevent the rapid unsupervised growth of funds like LTCM – the FSA could have the power to intervene, and rein in the organisation’s balance sheet.

It seems to me that banks and hedge funds have enjoyed the largesse of tax-payers for far, far too long. It’s not just 2008: in the last 30 years, they’ve been bailed out during the 1998 crises (via the IMF), during the Latin American debt crisis (via Brady Bonds), and during the Savings and Loans crisis. They chronically over-extend themselves, and then turn to their friends at the Treasury and IMF for a bail-out, while tax-payers – whether in emerging markets or at home – shoulder the cost and the suffering.

Who is the bigger fool – the banks, for repeatedly getting into serious debt problems, or us, for repeatedly giving them the tax-payers’ money to go off and do it again?