Original Link: http://online.wsj.com/article/SB124147831175584985.html
By MATTHEW RICHARDSON and NOURIEL ROUBINI
The results of the government's stress tests on banks, to be released in a few days, will not mark the beginning of the end of the financial crisis. If we are to believe the leaks, the results will show that there might be a few problems at some of the regional banks and Citigroup and Bank of America may need some more capital if things get worse. But the overall message is that the sector is in pretty good shape.
Chad CroweThis would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak -- $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions.
The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010.
The stress tests' conclusions are too optimistic about the banks' absolute health, although their relative assessment is more precise, because consistent valuation methods were used. Still, with Thursday's announcement of the results, it shouldn't be a surprise when the usual suspects emerge. We fear that we are back to bailout purgatory, for lack of a better term. Here are some suggestions for how to extricate ourselves.
First, while Treasury Secretary Timothy Geithner's public-private investment program (PPIP) to purchase financial firms' assets is not particularly popular, we hope the government doesn't give up on it. True, the program offers cheap financing and free leverage to institutional investors, which will lead to the investors overpaying for the assets. But it does promote price discovery and remove the assets from the bank's balance sheets -- necessary conditions to move forward.
And to minimize the cost to taxpayers, banks must not be allowed to cherry-pick which legacy assets to sell. All the risky loans and securities banks were never meant to hold should be on the block. With enough investors participating in the PPIP program, the prices of the assets should be competitive, and there should be no issue of fairness raised by the banks.
Second, the government should stop providing capital, loan guarantees and financing with no strings attached. Banks should understand this. When providing loans to troubled companies, they place numerous restrictions, called covenants, on what these firms can do. These covenants generally restrict the use of assets, risk-taking behavior, and future indebtedness. It would be much better if the government focused on this rather than on its headline obsession with bonuses.
For example, consider the fact that the government, while providing aid to banks, did not restrict their dividend payments. A recent academic study by Viral Acharya, Irvind Gujral and Hyun Song Shin (www.voxeu.org) notes that banks only marginally reduced dividends in the first 15 months of the crisis, paying out a staggering $130 billion in 2007 and 2008. While many banks have been reducing their dividends more recently, bank bailout money had been literally going in one door and out the other.
Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn't the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior -- and it's incredible that there are no restrictions against it.
Third, stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.
And we shouldn't hear one more time from a government official, "if only we had the authority to act . . ."
We were sympathetic to this argument on March 16, 2008 when Bear Stearns ran aground; much less sympathetic on Sept. 15 and 16, 2008 when Lehman and A.I.G. collapsed; and now downright irritated seven months later. Is there anything more important in solving the financial crisis than creating a law (an "insolvency regime law") that empowers the government to handle complex financial institutions in receivership? Congress should pass such legislation -- as requested by the administration -- on a fast-track basis.
The mere threat of this law could be a powerful catalyst in aligning incentives. As the potential costs of receivership are quite high, it would obviously be optimal if the bank's liabilities could be restructured outside of bankruptcy. Until recently, this would have been considered near impossible. However, in 2008 there was a surge in distressed exchanges of debt for equity or preferred equity.
Still, the recent negotiations with Chrysler's creditors suggest large obstacles. The size and complexity of large banks' capital structures make debt-for-equity exchanges an even taller task, particularly because creditors will want to hold out for a full bailout along the lines they have been receiving.
The government should be able to dangle an insolvency law as an incentive to cooperate. This will result in a $1 trillion game of chicken. But given the size of the stakes, and the alternative of the taxpayers continuing to foot the bill, it's the best way forward.