Investment, Capital & Current Economic Recovery

I read two articles in the Wall Street Journal in the past two days that have me pondering, again, the condition and probable or appropriate future for US commercial banks.

The first Journal piece to cause me to return to this topic was Peggy Noonan's rambling weekly column in the Saturday edition. A colleague found it virtually unreadable, but pushing the notion that some sort of 'black magic' has now rendered America poor and ripe for a cultural return to simple times and universal Calvinism and/or Puritansim.

Then I picked up yesterday's Journal to read a silly piece in the Money & Investing section alleging that some investors, including noted James Paulsen of Wells Capital Management, see a positive outlook for the US economy and its banks. The article reported,

"Mr. Paulsen of Wells Capital expects consumers to begin borrowing more heavily against their homes and expects economic growth recovering amid a pickup in consumer spending and exports. Even if growth doesn't return to where it was, he says, the improvement should be enough to pull stocks up from their depressed levels."

Honestly, it's very difficult for me to envision, in the current environment of unemployment, credit card limit reductions, and depressed housing prices, that there will be a growth in borrowing against home equity. Or that banks would even lend on that basis.

The alternate view, as represented in the Journal piece, is that governmental intervention in fixed income markets has hopelessly tainted valuations and falsely colored markets as healthier than they would be with only private investment.

All of this matters, because so many people seem to believe that the financial system is the key economic sector and component that must be 'fixed' in order for the US economy to recover.

I don't happen to share this view. In fact, thanks to Depression-era changes in banking, now, more than ever, bank failures are not a big deal. They simply represent the failure of the business model of a company which happens to take federally-insured deposits.

That so many view the health of banks as a priority contributes to the Peggy Noonan school of 'black magic' belief.

As a colleague and I discussed these topics over the weekend, we engaged in a rather easy, step-by-step analysis of just how and why debt capital has evaporated from the global economy in the past two years, and how this constitutes a nearly-unprecedented deleveraging from which there is no easy, fast return.

To understand what began to happen in July of 2007, consider this example. Say a Citigroup SIV or Bear Stearns leveraged mutual fund has been created. These happen to be real examples. In each case, generally speaking, what was done was the following, albeit on a larger scale. The financial firm seeded a fund with $1B, and issued debt from the fund for another $9B, using the $10B to buy CDOs. The mortgage-backed instruments comprising the CDOs were assumed to have a robust future of rising value, thus providing a positive return to investors who purchased shares of the fund. The debt was relatively short term, being retired and reissued perhaps every 90 or 120 days.

If CDO values had, in fact, continued to rise, then fund shares would have risen in value, debt would have been repaid and reissued, and all would have been well.

But, instead, CDO values fell, as mortgage delinquencies and defaults began to rise. In fact, CDO values became so suspect that the debt-holders chose not to repurchase debt of the fund. To make a long story short, the fund's organizer, either Citigroup or Bear Stearns, did, in fact, have to essentially plug the funding hole, either because it was legally obligated to, or faced some serious consequences to its image if it hid behind the limited liability which it first claimed, as Bear Stearns initially did.

The accounting effects are simple and, despite Noonan's column, not at all 'magical.' The fund's value fell, so a loss had to be recorded. Suppose the value of the assets declined by 30%. The sponsoring bank's equity was wiped out, followed by a loss on the debt the bank had to supply to the fund. When the bank had to repay the outstanding debt at face value, it essentially owned the fund. The loss of value above the equity cushion resulted in the effective loss of value of the debt which the bank recorded on its books as having lent to the fund, in the amount of 20% of the fund's initial value.

Shareholders in the risky mutual fund held shares worth something like 30% less than their initial value. Since the bank had to fund the full amount of the $9B of debt paid off to creditors, but has to realize a net value of $7B in the fund's equity and debt positions, it had to take a $3B loss on realized value, either in its equity directly in the fund, or debt lent from equity.

Magnify this several hundred fold, and you see why late 2007 saw many then-existing large US commercial and investment banks, e.g., Citigroup, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Brothers, taking, together, hundreds of billions of dollars of writedowns in equity to reflect losses for which they had to account.

Because investment and commercial banks are allowed to use leverage far above that typically seen in non-financial companies, their expansion into vehicles like those described above allowed them to attract cash into debt securities funding such vehicles. This represented a private monetization of capital by levering bank equity on the order of 8- or 9-to-1x.

When the debt wasn't repurchased by investors, and the banks had to inject more of their own equity to repay it, they took outsized losses, in proportion to their apparent, initial exposure.

Throughout all of this, of course, depositors funds, up to the federally-insured maximum, were safe. If bank equity could not cover those deposits, then the FDIC would provide the balance, and, if necessary, after that, federal funds would be used to make depositors whole.

The rest of the bank's assets would typically be loans, which could simply be sold in the event of closure of the bank. Other businesses and operations would be transferable to other financial institutions, with losses being absorbed by equity shareholders in the bank and, then, debt holders.

To me, in retrospect, and at the time, I find the conception of the TARP to have been flawed and mistaken. It was never necessary, when we had the necessary tools for disposal of failed financial institutions readily at hand. Expansion of the FDIC staff and perhaps a revival of an RTC-style entity to manage and sell failed bank assets could more easily, and with less risk, have been afforded to simply close and process the detritus of financial institutions which had unwisely expanded apparent private capital by creating highly leveraged vehicles to hold structured financial instruments.

This effective shrinkage of leveraged capital, and the resulting evaporation of financial institution equity, has had a dramatic effect on the risk capital available to our economy at the current time. I doubt that some stimulus spending by the federal government, nor the purchase of assets by the Fed, will magically cause investor cash to suddenly flood into financial instruments of greater risk, thus instantly underpinning higher levels of economic activity at this time.

It's not magic at all. It's very sensible and understandable. Our financial institutions took unwise risks which came back to bite them much more forcefully and expensively than they ever imagined. Thus, their capacity to function as lending institutions has been affected. Some failed, some were purchased while still operating, and the net effect has been a loss of lending capital at this time in our economy.

I don't see anything having occurred in the past few months, or even weeks, to give one reason to believe that such capital is now on the verge of re-entering the US economy to drive activity back up to levels of a few years ago.