Mr. Geithner’s new book, Stress Test, is an excellent read if you like the behind the scenes “real time” look at how the decisions were made during the greatest global crisis since 1907. I have always maintained that the bailout was necessary and the “fog and friction” of war time decisions are hard to criticize if the results met our needs. Yes, I would have insisted on all the banks CEOs resigning along with their Board of Directors. That is the minimum that should have happened. Jail? That would come under a whole other argument I believe would be defined by the word, fraud. The banks had legally created Special Investment Vehicles “SIVs” that off-loaded assets as actually being “sold” by the banks and then the assets were borrowed against by the banks. The “fraud” is the misrepresentation that the assets were “sold” to a SIV when in fact the SIV was wholly owned by the bank. This allow the banks to dramatically increase their leverage while representing that they had not. Jail time? Maybe. Termination? Certainly. We will never know because CEOs were not brought to the Courts for judgement.
Mr. Geithner in his book does not address the real cause of the crisis which was a lack of capital in the banks. In other words a highly leveraged banking system couldn’t pay the piper when the music stopped. Interestingly the solution to the crisis was for the Treasury to inject capital, TARP, into the banks to deleverage them while the Federal Reserve “bought bad assets” for a 100 cents on the dollar when those assets were trading well below par. Both solutions were designed to deleverage the banking system.
The main issue of no capital in the banks led to other “symptoms” popping up. First the banks would not trade with each other because of the lack of counter-party trust between banks. There was no trust. Counter parties wouldn’t trade or facilitate any financial transaction because they were well aware of their own illiquidity and leverage issues. Banks did not believe they would be paid for the other side of the trade. This led to a spiraling down effect on the markets as nothing could be bought or sold. Price discovery did not exist so bank’s balance sheets had no sense of value. Next issue was the the shadow banking system represented by the money market funds. Money market funds are mainly used as funding vehicles for the banks and other financial institutions like GE Capital. When the oldest and largest money market fund, The Reserve Fund, ”broke the buck” a large portion of the short-term funding capabilities of the banks was literally going to disappear overnight. US Banks funding requirements from the money markets funds was around 20% of the total funding needs of the banks. When you are leveraged over 30 times your capital base losing 20% of you funding is a catastrophic problem. We won’t even discuss the problem of borrowing “short” and investing “long” as any banker can tell you that it is a losing proposition when the assets can’t be sold because of market’s freezing up or prices declining to fast to liquidate.
So the powers to be decided on three stop gapped actions. First the Central Banks of the world led by the Fed guaranteed all interbank transactions. This helped sooth the counter-party risk problem and unclog the world financial piping and allow transactions to start moving again. Price discovery was a paramount concern when assets were trading at incredibly low valuations and balance sheets needed to be assessed. The Fed bought all the crap but what the system also needed was decent pricing on the “good stuff”. Second the US Government guaranteed all the money market funds for two years. This secured the short-term funding of the banks and removed the immediate threat of all the banks declaring bankruptcy all at once because of the lack of funding. You don’t have to be from MIT to know if a bank had $50 billion in capital and was carrying a $1.2 trillion balance sheet that a $240 billion funding short fall would wipe out the bank in seconds. Little did we know at the time that the money market fund guarantee was sowing the seeds of the European crisis two years later. But that is for another day. Three, the US Government changed the law of pricing of assets held by the banks. FASB 157 stated that debt instruments no longer had to be “mark to market” on a daily basis but could be held as if trading at par or 100 cents on the dollar. What is amazing is that the rule not only applies to mortgages but also to derivatives! This meant that banks no longer had to recognize unrealized, not sold, losses on their books making their balance sheets somewhat pristine. It was all BS but such is the power of the government. The law took effect on March 15th of 2009 and April 2009 kicked off the greatest stock market rally in history. I’m shocked!
The book Stress Test leaves us wanting on many levels but the most important is that Mr. Geithner punted on the main issue of the crisis, the lack of capital. Even the name of the book refers I believe to the optically successful stress tests of the US Banks and not on the facts that the Central Banks had guaranteed the To Big To Fail banks. TBTF is a bigger problem today than before the crisis as the banks are now around 40% larger because of the crisis led mergers. There remains an implicit guarantee of the banks by the governments that can not be denied although the banks insist it is not true. The markets, the final arbiters, believe that the governments will never let the TBTF banks fail because of the dire consequences and the markets are correct. And I for one hope we don’t let them fail. This implicit guarantee allows the banks to fund themselves at artificially low rates, at US Government rates, instead of rates that would be reflective of their risky leveraged business models. I believe that the TBTF banks could not exist for a week if forced to pay the rates the markets would command without the implicit government guarantee. This means that the banks would have to de-lever quickly and considerable to survive. When I refer to the banks I am also referring to Goldman Sachs and Morgan Stanley. They are included because of the counter party risk that they bring to the big banks. If one of the two went bankrupt there would be little left of the global banking system in short order. This is where the Fed had to develop the notion of “systemically important financial institutions”. If you are a major counter party to the financial system you are also a major danger. It has nothing to do with deposits.
The banks have continued to be undercapitalized, leveraged, for if they were forced to de-lever their business model could/would not support the existing compensation structure. I know we talk about being a global competitor and how we would be at a disadvantage but all politics is local and the vote is for money not competitive advantage. We must read carefully the statements made by banks for their intent is to obscure not to enlighten. Banks now say, “we are in far better shape than we have been for a long time” or “we are completely different in how we manage the bank” since the crisis. These statements are true and false at the same time. Pre-crisis the banks average Tangible Common Equity (TCE) was around 1.4% and today it stands around 2.9%. Why is this important? If a bank suffers losses those losses can ONLY be written off against TCE. So, pre-crisis was a ridiculous 1.4% and frankly we got what we deserved. That we allowed the banks to leverage themselves to that level was criminal. But being 2.9% is equally bad. Is it better than 1.4%? Of course. Will it matter in a crisis, no way. Lets go bank to the earlier example. A bank has $50 billion in equity or TCE. It maintains a $800 billion book. 800/50 = 16. The bank is 16 times leveraged. Lets make the book $600 billion or 600/50 = 12. Twelve times levered. If the bank “book”, investments, trade down 10% the bank loses $60 billion. The bank is wiped out by more than $10 billion. The sad part is that if the bank lost just $10 billion it would be effectively bankrupt because it would lose the ability to self fund it’s debt. How do we know this?
The banks were forced to create a living will because of the Dodd/Frank Bill. This living will was to explain how the US Government would liquidate the bank if it was caught in a crisis and “failed”. One of our largest banks has around $240 billion in capital and runs almost a $3 trillion balance sheet. In their living will the bank estimated that if it incurred a $30 billion loss of their $240 billion in capital they would be effectively bankrupt. Why you ask? Because the bank said they would be unable to self fund because of the loss. Interesting to note that the living will of the bank also pointed out that the US Government would have to immediately make good on overpriced securities, thank you FASB 157, to the tune of $200 billion plus. Think about this fact. If FASB 157 did not exist the bank would have less than $50 billon in TCE instead of $240 billion. Now that is what I call cooking the books!
The situation is much worse than described here because we have not discussed that the capital of a bank is formulated with capital that is slotted Level 1, Level 2 and Level 3. Or the fact that there is netting of a bank’s notional derivative positions. These situations deserve their own time and space. Suffice to say the complexity of the banks balance sheets is so great that we have little to no transparency that is even worth discussing. The banks want it that way.
The Stress Tests that the banks had to endure led to the ultimate and inevitable conclusion that they were recapitalized and safe. US Banks proudly and defensively point out that TARP was repaid and with a profit. That they really didn’t need the money but the government forced them to take it. Banks insist that the business model is viable and we are all over reacting. That their compensation to do “God’s work” is justified.
What the banks don’t mention is that TARP was the smallest and least expensive remedy that was employed by the US Government to save them and that the other solutions employed were worth trillions of dollars to the banks. Some of these solutions still remain in place today saving them tens of billions of dollars per year in funding costs. All these issues and much more are ignored by Mr. Geithner in his book.
Mr. Geithner’s narrow but important oral history leaves us knowing only that the seeds of our ultimate demise have been sown and as of yet reaped
