As the financial world teeters on the abyss, US Treasury Secretary Henry Paulson proposed a $700bn rescue plan. Put aside the issue of the deal not getting past Congress. The key question is, would it have done any good?
Banks worldwide have declared losses of just over $591bn. But more than $434bn of extra capital has been raised from shareholders, sovereign wealth funds and others. That means the net contraction of the banking capital bases is only around $157bn. So $700bn should be more than enough. However, Paulson wanted to use the money to create a repository for banks’ bad assets, rather than to boost the banks’ capital bases. Yet the money the banks have already raised, they’ve used to boost their capital. So what makes Paulson think his idea is a better use of funds? Banking is basically the trading of debt off a leveraged capital base. Injections of funds into capital give you much more bang for your buck. Because Paulson’s plan is not so geared, it may still prove insufficient.
What should be done? In the short term, the answer is painful but relatively simple. Several countries have suffered system-wide banking failures in the past decade and a half. The best blueprint for recovery is the Nordic banking crisis of the early 1990s. That showed there are early-stage solutions that don’t need nationalisations, but involve larger banks absorbing smaller ones. So it is inevitable that more banks will consolidate. Also, banks can be split into “good bank” and “bad bank” chunks. “Good bank” assets, deposits and branch networks can be sold to willing buyers, while “bad bank” assets can be consolidated with other such assets into a government-sponsored trust. This can then gradually dispose of them, or run them to maturity. History suggests that such ring-fenced assets can ultimately return about 75% of their face value.
But what the Japanese and Nordic crises also show is that when a banking system overextends itself, there are few if any banks that don’t need help (not least because failing banks’ fire sales and shrinking balance sheets have a knock-on effect that slows the wider economy, pushing the remaining banks’ own bad debts higher). The Nordic countries saw their savings rates turn negative, just as the US did last year, due to rampant deregulated bank lending fuelling asset-price inflation. How many people here have likewise confused a large debt (mortgage) with an investment (property) that was expected to provide for their future? Just as in Scandinavia, many are about to find out that without upward property-price momentum, a large debt like this is just… well, a large debt.
We also need longer-term solutions to prop up the banks remaining after the initial shake-out. So what’s the answer? In a nutshell, the banks were seduced by a long period without recession. Financial innovation in a neglectful regulatory environment allowed them to become overleveraged. In a moderate to deep recession – the natural consequence of this – a bank might expect to lose 7%-8% of its assets after defaults have led to collateral disposals. So it stands to reason they would need that much capital to tide them over. When Lehman Brothers went bankrupt, it had a Tier 1 capital ratio of 11%. Clearly the regulators’ definition of “sufficient” capital is deficient. That’s because the regulator allowed banks to include some debt instruments (with ill-defined payback dates) as “capital”. They also allowed too much to be moved off the balance sheet; and worse, allowed far too many assets on the balance sheet to be zero risk weighted, so they didn’t count as a risk at all (because they were AAA-rated, insured or hedged, for example). That means that some banks let even their rather suspectly defined “capital” shrink to a tiny fraction of total assets. German giant Deutsche Bank has around $3 trillion of potentially loss-making assets, 75% of which are securities. This all teeters on just $40bn-odd of (proper “tangible”) equity. So in theory, a 1.4% average loss across its asset base would wipe out its capital.
No UK bank is that apparently exposed. But even so, if a bank has 5% of true equity capital, and total cycle-long losses reach 8% of assets, the extra 3% of capital (plus further funds to bolster the capital base) will be needed. Now that rights issues and sovereign wealth funds have been almost fully exploited, the buyer of last resort is always the government, usually via delayed-conversion preference shares. That way, managements know they must knuckle down to work to buy their banks’ equity back over the specified time, and governments know they won’t ultimately end up having a nationalised banking system. If the authorities force bondholders to shoulder their share of the burden, even taxpayers probably won’t see a loss. Everyone’s happy.
We don’t know why Paulson hasn’t followed this route – he may have to. But either way, the historical precedents prove one thing above all. Bank lending will contract severely and for several years to come. Rescuing the banks may well seem like it’s being done at the wider economy’s expense. But seeing banks forced to cut back on lending somewhat has to be better than the alternative – which is the complete disappearance of any bank lending at all.
• James Ferguson is an economist and stockbroker at Pali International. He also writes the Model Investor newsletter.
• Simon Nixon is away