FDIC seizes three more banks. Citibank has traded at around 45-50 as recently as mid-2007, today it closed at 3.77. So, it's lost over 90% of its value in a bit more than a year. Some analysts are predicting that all US financial institutions will be under government control in a year. Switzerland seems to be in danger of complete collapse, the way Iceland has -- it has banks that are so leveraged that the country doesn't have nearly enough resources to rescue it, in fact "A 16% fall in UBS's assets would wipe out not only all of its equity but 100% of Swiss GDP on top."
Sure wish I had a farm in some out of the way place that I could retreat to when the food riots start.
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There are over 8500 banks in the United States. According to the Washington Post article to which you linked, the FDIC has closed 22 so far this year. It is nor reasonable on this basis to suggest "all US financial institutions will be under government control in a year." There is more complexity to it.
I note in the article that Downey - the biggest of the three institutions just closed - was under the regulatory authority of the Office of Thrift Supervision, like Washington Mutual and IndyMac Bank. Another seizure reported in the article was of PFF Bank and Trust, also described as "a California thrift." These are savings-and-loans, not commercial banks. The capitalization of S&Ls has always been less adequate than that of commercial banks. Twenty-odd years ago we experienced a broad S&L collapse for this reason. It barely affected commercial banks.
The so-called bail-out is working in a different way than that represented in the press. Now it appears the government will not re-capitalize failing institutions.
You may not know that banks and thrifts are given what are called "CAMEL" ratings by FDIC - standing for Capital, Assets, Management, Earnings, and Liquidity. A number from 1 through 5 is assigned to an institution in each category, with 1 being the best, and 5 the worst. These are then averaged to give a composite rating, which is reported to the institution's top management and board, but is not made available to the public. Indeed, bank officers and directors are admonished in very strong terms that their CAMEL rating is not to be disclosed. The explanation for this has always been that government does not want banks that are badly rated to suffer runs due to lack of public confidence in them.
The newest representation is that government capital will not be made available to institutions with CAMEL ratings of 4 and 5 - those in the most trouble. Those having a rating of 3 will get it only if they can also raise capital privately. Government wants to place its capital with institutions rated 1 and 2. These will be expected to use it to buy failing banks, the 4s and 5s - or to increase their lending.
The capital is to amount to something between 1% and 3% of a bank's risk-based assets (essentially these are its loan portfolio). Between these end-points the bank may take as much or little as it wishes, or decline to take it at all. Given the usual ratios this could make government owner of up to about 20% equity in a bank, assuming it took the maximum amount allowed. 20% is not "control" - in ordinary understanding, control is the ownership of a majority of stock.
However, the capital will come with significant strings attached. It will be in the form of preferred stock, which will pay a 5% dividend. After 5 years the dividend rate will increase to 9%. Government permission will be required to pay any dividend to common stockholders, even after the 5% dividend has been paid on the preference shares. Government approval of officers' salaries will be required. There is anticipated to be some government direction of lending activities, though few particulars have been announced. Finally, government will be able to sell its preferred stock at any time, to any buyer, without prior consultation with a bank's management, directors, or common stockholders - even if the bank's common shares are closely held and not publicly traded.
Government will publish a list of banks that have not received government capital, with no distinction made between those that couldn't get it (the 4s and 5s) and those that just didn't want it. This appears to be a manipulative tactic to strong-arm good banks into taking government capital by creating bad PR for banks that refuse it, and to throw to the winds the caution previously expressed about disclosing CAMEL ratings.
It seems to me that much of the so-called bail-out is purely seat-of-the-pants navigation, but along comes what I have described above and it gives the impression of having been well thought through a long time ago. Perhaps they have dusted off some abandoned proposal of Rexford Tugwell's!
In any event, it seems sort of a nightmare version of Alexander Hamilton's Bank of the United States, in which you will recall, the Federal government held a 20% stake - just about what it will hold in a bank that takes government capital to the extent of 3% of its risk-based assets.
The implication of government direction of lending activities is particularly disturbing. If you liked Fannie and Freddie you should like this.
The reason that the Community Reinvestment Act didn't really do much of the damage we've seen is that it could not force private-sector lenders to alter their underwriting standards. That was not true of Fannie and Freddie, which held or endorsed over 50% of the country's residential mortgages. They were mandated to make 52% of their loans by 2005 to mortgage borrowers with less than the median income in their area; and of these, 22% were to be to borrowers with less than 60% of the median income. By 2008 the latter target was to be 28%. These loans were to be made in amounts of up to 97% of appraised value. Fannie and Freddie met these goals faithfully every year, satisfying Barney Frank's proclaimed wish in 2003 to "roll the dice for subsidized housing." All we can say is that they came up snake-eyes. And no wonder!
We can expect more of the same sort of politically allocated credit when government starts to direct banks' lending policies. Loans will be made to borrowers on the strength of their membership in powerful constituencies rather than on that of their economic viability. And what about the provision that government's preference shares can be sold at any time to any buyer without prior consultation of their officers, directors, or common stockholders? Who do you suppose will be offered them? Certainly not their existing owners, nor people in the communities they serve! No, it will be the politically-connected.
Just as in Hamilton's day, these proposals offer great possibilities for jobbery, patronage, cronyism, and legitimized theft. We should be very apprehensive, not of "food riots," but surely of more subtle evils.
In general, I have to defer to you on matters financial. I wouldn't know a CAMEL from the eye of a needle. However:
- trying to pin the bulk of the blame for this crisis on Barney Frank is ridiculous. Is he responsible for the total collapse of Iceland's economy, or the impending collapse of Switzerland's? Subprime loans are only one small aspect of what is going wrong; the bulk of the problem seems to stem from the securitization of these loans and the creation of elaborate leveraged insurance schemes; none of that was done by Barney Frank (or subject to any regulation at all, as far as I know). Did Frank force UBS to leverage itself to the tune of 64 times its assets? That's one powerful congressman.
- Whatever role Frank may have played in promoting subprime mortgages, he had help from noted leftists like George Bush and Alan Greenspan. There seems to be enough blame to go around for that one.
- Iceland is already having food shortages. Of course, they are heavily dependent on imports, which they can't get now that their foreign exchange has collapsed. The US does not import that much food, but our food system is heavily dependent on foreign oil. We aren't Iceland, but clearly the financial collapse is capable of impacting the real economy at some point.
You will find it hard to dispute that the present financial collapse originated in the secondary mortgage market. Subprime loans are only part of the problem. More important is that too many loans, subprime or otherwise, were badly undercollateralized.
Fannie Mae and Freddie Mac either held in their own portfolios or securitized and sold over 50% of the residential real estate mortgages in the United States. In response to the collapse of Countrywide Financial in 2007, the GSEs were authorized to ramp up lending activities and in the months before their own collapse were making approximately 70% of all new residential mortgage loans in the country. Have you any idea what the magnitude of this is? It is certainly big enough for the collapse of these institutions' securitized mortgages to have serious international repercussions.
And Fannie and Freddie had been in repeated trouble. They were repeatedly called up before the Congressional committees that were supposed to exercise supervision over them. Efforts to restrain their lending activities (one led by John McCain in 2005) were repeatedly defeated. Democrats voted en bloc to do so, and attracted enough Republican votes to succeed. Christopher Dodd is another culpable party, probably more so than Barney Frank. Dodd was the single largest recipient of campaign contributions from Fannie and Freddie.
A lot of influential constituencies, other than low-income mortgage borrowers, stood to benefit from this irresponsible lending. Land speculators and real estate developers probably received the bulk of it, since the easy availability of mortgage money was almost completely responsible for puffing up the bubble in real estate prices for the past four years. All of this in the name of 'affordable housing!' Well, now that real estate prices have fallen to their lowest level in four years, we finally have it. Count on it, behind the bleating of politicians about the plight of the poor there is almost always a concealed agenda of selling some rent-seeking opportunity to some generous donor.
Indeed, the securitization of these loans and the actuarial unsoundness of the credit insurance on them greatly magnified the bursting of the real-estate bubble, but just as the mighty oak grows from a little acorn, this catastrophe may be traced back to its seed, which is the implicit socialization of risk in the activities of the GSEs. Those involved in originating and brokering the loans had no incentive to assure their soundness because they intended to sell them. If there was to be loss, it would be someone else's. Those who bundled and securitized the loans had no idea how really sound they were because they wrongly trusted their originators. Those who rated and insured the securities, and those who bought them, didn't worry too much about this either, because, after all, real estate is second only to cash as solid collateral, and besides, Uncle Sam will back them up, won't he? (and he did!)
This implicit socialization of risk, interestingly enough, has its parallels in the decade leading up to the crash of 1929. During World War I, Washington had intervened in the granting of credits to foreign borrowers in order to direct lending in a way that it thought most helpful to the war effort. With the coming of peace, this policy persisted. The American public was rich with cash accumulated through the purchase of war bonds, and began to invest the proceeds at a breakneck pace. Ron Chernow explains in his book "The House of Morgan":
"Washington watched the investing craze with a growing fascination and wondered how to exploit it politically. Even after a Republican president, Ohio newspaper publisher Warren Harding, captured the White House in 1920, his laissez-fair ideology didn't stop his administration from trying to mobilize the new Wall Street power. The paradox of the Roaring Twenties was that three free-market Republican administrations would confer new, semiofficial status on foreign lending, assuming the right to veto loans - something no Democratic administration would have dared to do, lest it be accused of socialistic tendencies.
"... At a White House conference on May 25, 1921, President Harding told Tom Lamont [of J.P. Morgan & Co.] and other Wall Street bankers that henceforth all foreign loans had to be certified by State, Treasury, and Commerce departments as being in the national interest. The secretaries in question - Charles Evans Hughes, Andrew Mellon, and [Herbert] Hoover - were there to back him up. Morgans had to notify other banks about the arrangement..."
According to Chernow, the administration rejected arguments that the debts of allied nations to America were effectively subsidies and should be forgiven. Instead it adopted a policy of barring loans to any foreign government that had not settled its war debts to the United States. Chernow writes:
"This was an extraordinarily shortsighted attitude that would weigh on world finance for a generation. The mountain of debt would retard world trade, undermine political leadership, and poison relations among the Western nations."
Furthermore, this political control of American credits to America's WWI allies forced them to take a hard line on the reparations owed by Germany under the treaty of Versailles. If the Germans didn't pay reparations to them, how would the Allies pay what they owed to Washington? German hyperinflation, economic collapse, and the fall of the Weimar Republic, ultimately leading to Hitler's rise, were the results.
Chernow continues:
"If Washington at first demanded control over foreign lending out of concern for Allied war debt, it soon grew accustomed to exercising its new power.... in remarkable testimony to governent-banker ties in the Diplomatic Age, Tom Lamont would state categorically that no sizable loan of the 1920s was made without Washington's tacit approval. The line between politics and finance blurred, then disappeared...
"Hiding behind Wall Street banks, the government could disclaim responsibility when countries were approved or rejected for loans. The banks, in turn, saw it as a security treaty, committing the government to protecting loans made under its aegis...
"With the Harding review process there came a notion - never explicitly stated, but always there - that a government safety net was in place, which would catch investors who fell off the high wire. As Lamont said, the government's stamp of approval 'led many American investors into buying foreign issues under the impression, whether so stated or not, that the Government had approved the issue or it could not have been made.' The arrangement encouraged a lot of wishful thinking and spared bankers unpleasant thoughts about what might happen in the case of default. There was an unspoken invitation to dispense with close examination of debtor nations. In the 1920s, Wall Street operated under an assumption of government protection, a notion that would prove illusory. But while it lasted, it created a mood of intoxication such as the Street had never known before and helped to trigger a decade of dreams that ended in the 1929 crash."
Chernow goes on to recount in a subsequent chapter the great missteps made under government direction of credit in the Far East and in Latin America. Latin American bonds were aggressively flogged to country banks and individual investors during the 'twenties. I remembered when reading Chernow's account that some years ago, a observation made by one of our directors who had put together a little history of my bank by going through old board minutes. He noted that we had remarkably few bad loans to our own customers during the Great Depression, but that we did own a bond on the Republic of Panama that defaulted in 1930. I'm sure the then-officers of the bank thought it was as solid as many recently thought GSE mortgage-backed securities were.
As Mark Twain observed, history does not repeat itself, but it rhymes. What foreign debt was in the 'twenties, the GSEs' securitized mortgages became in the last few years. In both cases, behind the extravagant and thoughtless extension of credit lay "a notion - never explicitly stated, but always there - that a government safety net was in place, which would catch investors who fell off the high wire."
This is the constant peril of politicizing the allocation of credit. Can you possibly believe that more of the same is going to be a remedy?
Like I said, I don't feel equipped to argue the details of finance with you, but plenty of people differ from your analysis, ie here and here. And I wish someone would answer the basic question, which is why all these secondary institutions, who were not subject to CRA or any regulation at all, made such obviously risky leveraged bets. This seems like a massive failure all across the board in the findancial industry. There was an article today in the NYT about how this happened at Citigroup, but it seems to have been happening all over, and I don't really understand why. Pinning it all on the CRA and congressional Democrats seems ludicrous -- I know that's a major wingnut talking point right now, but it makes little sense and is contrary to the facts.
I think we basically agree that government shouldn't be in the business of bailing out failing banks and other financial entities. However, since there is a revolving door between the government and the large financial institutions, it is almost certain that it will continue to do so.
Of course Fannie Mae and Freddie Mac were not subject to CRA. However, they were subject to even more detailed direction in their lending, both as to the percentage of appraised value at which they were to lend (up to 97%) and the percentage of their total loans that were to go to borrowers with income below the median or with income below 60% of the median. This direction began under Congressional mandate in 1992 and took specific form in directives from HUD to the GSEs starting in 1996. And, as noted, Fannie and Freddie either held or securitized and sold an absolute majority of the residential real estate mortgages in the U.S. As noted, this represents a stunningly large amount of money.
Secondary institutions that facilitated the making of these bad loans grew up in response to the incentives provided by the GSEs. I do not recall store-front mortgage brokerages existing in any significant numbers before the 1990s. Similarly, the role of credit-rating agencies and credit-insurance providers in giving deceptively favorable ratings to mortgage-backed securities, and guaranteeing them at unrealistically low premiums, began at the same time.
It is all well and good to say that these were "obviously risky leveraged bets" with the twenty-twenty hindsight we now have. But the risks were not obvious at the time, in large part because (to borrow Chernow's phrases) there was an "unspoken invitation to dispense with close axamination" of the debtors' creditworthiness, and "a notion - never explicitly stated, but always there - that a government safety net was in place, which would catch investors who fell off the high wire."
Of course "there is a revolving door between government and the large financial institutions." This is in large part the reason why we have had such a catastrophic collapse.
Some wise person long ago observed that politicians can no more repeal the business cycle than they can the law of gravity. However, their attempts to do so often create a greater problem than the one they are endeavoring to solve.
You are probably of an age to remember public-service advertisements featuring Smokey the Bear and the slogan "only you can prevent forest fires." It was not until many years later that forestry experts concluded the diligent effort to prevent forest fires of which these ads were part actually had resulted in worse ones. It led to accumulations of such huge amounts of highly flammable scrub plants and bushes that when a fire did take place, it was a catastrophic one. Instead of a small fire now and again that would have cleared away the scrub but left the tall trees standing, there were huge conflagrations that destroyed everything.
There is a parallel here, I suggest, with political efforts to interrupt the business cycle. Instead of ending it, they have succeeded only in lengthening its period and increasing its amplitude.
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