Bank Myths?

It’s no myth that the dow dislikes Obama. Take that to the bank!
Obama Daily Tracking Poll (dow)
Down huge again today…

Lewis’ comments seem to almost be preemptive. “The only way to fix banks is to nationlize them.” Who said that? No one, that’s who. He’s stirring up fear, next thing you know he’ll be crying “Socialism.”. It’s an old trick, perfected by Bush White House. Sorry Justin, this president is by for and of the people, not the Dow.

The truth is there is no one truth or one problem when it comes to what is ailing banks so no one, including Lewis, can isolate an answer. Immediately prior to failing what were all those failed banks doing? Posturing themselves to try to make it look that had assets that had value to be purchased. Absent an accurate and full disclosure by each individual bank no one, including Lewis or Geithner, can come up with a planned response to any given banks needs. As we have learned so vividly in the recent past banks are not making all their details public (i.e. Wachovia/Wells Fargo, Citi, etc).

I think if there was a quick fix, then we’d all be talking about A-Rod now. Let what’s been done by the adm. have a chance, without so much second-guessing. And I think that’s Lewis’ main point. Though, as someone jabbed by both a bank and a hospital into bankruptcy, I coulda done without the jab at ‘households.’

I agree with most statements.
Extending credit irresponsibly is how we got into this problem, not how we fix it. New ‘responsible lending’ coupled with price compression on homes has created a shortfall which needs to be addressed short term though.
Banks need to take time to fix their balance sheets. TARP buys this time.
They need to provide this same time to their most recent mortgages.
Mark-to-market accounting exacerbates the problem, by accelerating write downs. This is turn creates false negatives in analysis.
It took a lot of time to get here. It will take time to get out… and cooperation between banks, their customers and the government.

I don’t think we need to be taking the word of any bank CEO’s. Remember this: http://www.cnbc.com/id/15840232?video=682914860

In cited piece, Ken Lewis states flatly that “The companies that did the most to cause this mess are gone”.
Really?

The authorities at the
top (including Congress and the administration) should be taking action.
In the beginning there were ratings agencies, and they rated corporate
bonds from the very highest of credit quality (AAA) down to junk (CCC).
Now AAA means that the chances of losing money are very, very low. With
each level of increased incremental risk comes a lower rating. If a
corporate bond was at risk for losing just one dollar, it was rated all
the way down to junk. And that was fine. Everybody knew the rules of the
game.
But then investment banks asked the agencies to rate a large group of
home mortgages in a pool known as a Residential Mortgage Backed Security
(RMBS). The investment bank would divide the pool (the RMBS) into
various tranches. The highest-rated tranche would be given a rating of
AAA. Let’s say that the AAA tranche was 92% of the loan pool. The AAA
tranche would get the first 92% of all monies coming into the pool
before the other investors were paid (again, really oversimplified, but
that is the net effect). That would mean that the pool could have 16% of
the home loans default and lose 50% of their value before the AAA
tranche would lose even one dollar.
We all know now, though, that some of those AAA-rated tranches are in
fact going to lose money. And the rating agencies are now writing down
the ratings on the former AAA tranches.
I am not talking about the exotic CDOs and CDO squareds, or some of the
truly toxic securitized assets which are going to zero. What I am
writing about today are plain vanilla mortgages grouped together in
securitized pools.
I wrote three weeks ago, “The downgrades by Moody’s today of 2,446
different classes of Residential Mortgage Backed Securities will be a
real blow. Moody’s warned in a report last week that loss assumptions
would be increased for RMBS and that downgrades could be expected.
Moody’s is projecting that alt-A deals originated in the second half of
2007 will experience 25.5% losses of original balance, compared to 23.9%
of 1H07 deals, 22.1% for H206 deals, and 17.1% for 1H06 deals. The
rating agency in May expected average losses for 2006 and 2007 vintage
deals to reach 11.2% and 14.7%, respectively.” (The Big Picture)
Fitch and S&P are also piling on with downgrades. Most of them see
RMBS’s go from AAA all the way down to junk. This has some very bad
unintended consequences.
Let’s say a bank has a loan portfolio of 1,000 individual mortgages
valued at an average $200,000, for a total portfolio value of $200
million. The loan officers were not very good, and it turns out that 18%
of the homes went into foreclosure and lost an average of 50%. That
means 180 homes went into foreclosure and that the bank lost an average
of $100,000 per home, or $18 million overall. The bank was charging 6%
interest, so in a few years it would at least have its original
investment back, although the losses would eat into capital.
To make those loans of $200 million, the bank would need at least $20
million in capital, and so would need to go raise some money or reduce
its loan portfolio by selling the performing loans. The reality is that
for a bank to have such a large mortgage book, it would probably be a
much larger and better-capitalized bank. If it were not, it would soon
be taken over by the FDIC.
Note that the remaining 82% of loans are still performing and are
carried on the books at full value (again, oversimplified). There is
real value in the remaining loan portfolio.
But what if the bank invested in a RMBS that was rated AAA, and 18% of
the loans in the security went bad? Remember, the AAA tranche gets the
first 92% of income. The loss to the RMBS is 9% of capital. The losses
to the AAA tranche are only 1%. Hardly a catastrophe. Annoying, but
something you can deal with. Except for some very nasty rules.
Remember, a bond is downgraded to junk if it loses even $1. Now, let’s
take it to the real world.
Say a bank buys a $1-million AAA portion of that large RMBS. It can use
that AAA debt in its capital base, and can actually lever it up about
five times, as the rules only make the bank take a 20% “haircut” on an
AAA bond. But if the bond goes to CCC, the bank must now move the entire
bond to its “risk-impaired” portfolio. And because most institutions
cannot buy junk paper, there are very few buyers out there who will want
to buy it — mostly hedge funds and private capital. The price on that
paper might easily drop to $.50 on the dollar because of the potential
for a 1% loss.
The accountants, being conservative and living with new mark-to-market
rules, make the bank take a $500,000 loss. This directly reduces
regulatory capital by $500,000. Banks are required to have a maximum of
8% of risk-impaired assets as compared to solid capital to be considered
adequately capitalized. Keeping the asset on the books means they have
$1 million of risk-weighted assets. If they have to sell to get the
capital required to follow the regulations, they will lose $500,000.
And they lose this on an asset that the rating agencies say might lose
$1 ten years from now.
Again, at the risk of oversimplification, if they keep the security that
also means that the bank loses roughly $10 million in lending capacity.
They have to reduce their loan book or raise more capital.
Rating Agencies Gone Wild
Here’s the truth. That bond should never have been rated AAA to begin
with, and it shouldn’t be rated CCC today. The ratings agencies took a
perfectly fine corporate bond rating system and tried to bootleg it onto
a security that has an entirely different set of circumstances. A
corporate bond is a bond from one company or one obligor. An RMBS might
have several thousand obligors. (An obligor is a person or entity that
is obligated to pay back debt.)
It was very convenient for investment banks to get the rating agencies
to use the corporate bond analogies, because that meant they did not
have to explain a new system. Everyone knew what AAA meant, or AA or
BBB. A bond buyer in Europe or at a pension fund simply looked at the
rating and hit the buy button. Easy. No need for a lot of research. Make
your purchases and go to lunch.
While I can’t go into specifics, I have looked into these bonds with
some real interest. Let’s assume that you can actually buy an AAA
tranche of an RMBS at $.60 on the dollar. That means that 80% of the
mortgages would have to go into foreclosure and lose 50% before you
would ever lose a penny.
There are AAA bonds selling at steep discounts that are composed of
mortgages with 80% loan-to-value in 2005, a 7% interest rate, and 90+
percent performing loans. These loans are being called in as mortgagees
take advantage of lower rates and refinance. And with Obama’s new
proposed lower rates, even more of these loans will be refinanced. If
you buy the loan at $.60 on the dollar, and it gets refinanced, you get
an immediate capital gain of almost 50%! If it keeps on being paid, you
get an effective rate of about 10%.
So, why wouldn’t there be a lot of institutions standing in line to buy
such a dream investment? Because banks fear the danger that the security
will get downgraded, just like the thousands of such instruments that
have already been downgraded, and then their regulatory capital will be
impaired. The technical banking term is that you would be screwed. So
you don’t buy what would be a very good performing asset, because of the
rules.
So, who can (and does!) buy? Hedge funds and private investors with
liquidity. But these “vulture capitalists” (among whom are many of my
friends) know that the sellers are operating from a position of
weakness. And because there are not enough of them to buy the bonds on
offer, the prices of these bonds are very low. Smart money managers are
raising money to exploit these distressed sellers.
So, in effect, we are giving banks taxpayer money while forcing them to
sell assets that might be worth $.95 cents on the dollar in a
less-stressed world. We are shoveling money in the front door while it
is being pushed out the back door to my friends at the hedge funds.
How much are we talking about? US banks and thrifts have $315 billion in
AAA non-agency (Fannie and Freddie) bonds, insurance companies have $190
billion, broker dealers have $75 billion. Overseas investors have $160
billion. Banks have written down about $700 billion in assets. The
majority of those losses have been mark-to-market write-downs and not
actual losses. Yet taxpayers are in essence paying them to sell, because
the rules say they have to raise capital.
Some simple rules changes would solve a lot of this problem. First,
let’s recognize that the root of this particular problem is the ratings
system. If an RMBS is likely to get $.95 of its capital, then it should
be valued at some number below that, but don’t make them assign it 100%
to their risk capital. That is like making the bank with the 1,000 home
loans in its portfolio write off all of them because 18% are bad. In
principle, there should be no difference.
Then, the Federal Reserve should call in the rating agencies and have a
“come to Jesus” meeting. They are at the heart of the problem, and they
need to fix it. They need to change their ratings system for packaged
securities like RMBS’s.
The I-Factor
Let me throw out one idea (there are likely to be a lot better ones, but
let’s get some ideas on the table). Let’s move away from using standard
bond ratings for multi-obligor securities. Why not rate a bond by the
percentage of capital likely to be returned? Let’s call it the
Impairment Factor, or I-Factor. If a bond is likely to lose 10% of its
capital, then it would have an I-Factor of 10%. An I-Factor of 0% would
mean the bond should see all its capital returned, and an I-Factor of
100% would mean that all the money will be lost.
Now, that tells investors something. That’s a useful statistic, as
opposed to “CCC.” What does CCC mean? Am I going to lose $1 or $1,000 or
all my money? CCC gives me no useful information if I want to buy or
sell a bond. And without real transparency, you end up with a world in
which a few very knowledgeable buyers can make a lot of money.
That is because there are a lot of AAA bonds that are going to zero, as
in 100% loss. If you are on an institutional desk and would like to
participate in getting some of the better values, unless you have a very
sophisticated team with good analysis software, you simply can’t take
the risk.
Further, if the rating agencies do their homework to figure out what the
I-Factor is, they will have all sorts of useful information that can be
disclosed about the security, such as average loan balance, average
loan-to-value, how many loans are at risk of default, where the loans
are, and scores of other details. Armed with that information, buyers
can make rational decisions.
And if you modify the rules so that banks and other institutions can use
those bonds (with an appropriate haircut) as part of their regulatory
capital, then you immediately get a large number of buyers into the
market, and that will make prices go up and mean that banks will need
less taxpayer money.
The current rules were written for a time when banks actually bought
corporate bonds. They made sense back then, and still do. But applying
those ratings to asset-backed securities makes no sense. We need to
change those rules now.
Marking assets to market when there are no markets is illogical. I have
spent some time looking at these securities. Like kids, they are all
different. And some are really different. Yet we make a bank mark an
asset down because one that is in the same broad class is impaired. Like
giving every 13-year-old in school an “F” in math because one kid
failed.
Further, we don’t make a bank mark down the value of a loan on its books
if interest rates increase. The loan, if sold into a market, would
indeed not be sold for book value. But the bank keeps it at book value
on its books, and simply realizes less interest. If we made banks mark
down their assets because of interest-rate increases, we would lurch
from one bank crisis to another with every interest-rate cycle.
Let me be clear. I am for full transparency. If an asset is only worth
ten cents on the dollar, then mark it down. We do not need zombie banks.
For whatever reason, the Obama administration seems to be afraid to use
the “N” word (nationalization). If a bank is insolvent, yet deemed too
big to fail, then take it over, repackage it, and sell it back to the
private market with some options that will allow for taxpayers to at
least have the potential to get their money back. But do it quickly
rather than dithering, as is happening now, because that will just cost
more in the long run.
But as a start, change the accounting rules so that we stop shoveling
taxpayer money in the front door to banks and out the back door to hedge
funds. That can be done quickly if the administration simply says “do
it.”
Let me quote this note from Gary Townsend, which I wholeheartedly agree
with:
“The problem, of course, is that the MTM (mark-to-market) results have
little to do with the intrinsic value to a bank of a loan or a security
that it plans to hold to maturity. In a bank, the decline in a loan’s
value is offset with a forward-looking provision for loan losses. The
decline in the loan prices net of loan loss allowances is not due to
credit deterioration; it’s the result of the distortions and speculation
in the world’s financial markets. Mark-to-market accounting isn’t
improving the transparency of bank accounting. It has reduced it, with
enormous and growing damage to our economy and prospects.
“The Financial Accounting Standards Board has said that it will issue
new guidance on the application of FAS 157. That’s encouraging, but can
anyone recall when the FASB has been timely? The damage from this
misguided rule is already huge, widespread, and growing daily.
Mark-to-market accounting creates a powerful negative feedback loop.
Actual or imputed FAS 157-related losses weaken capital ratios and
undermine confidence in the financial system generally, which weakens
the economy and adds pressure on loan pricing, causing more FAS 157
losses, and around we go.
“This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you
listening?”
And let’s add President Obama, Ben Bernanke, Barney Frank, Chris Dodd,
and Larry Summers to the list of those who should be listening. I know
that some of my readers will have access to these people. See if you can
get them to focus on this problem, and let’s move on to the next problem
– housing.
As a final note, I know that some regulatory bodies are in fact paying
attention to this while others are not. Good on the ones who are
listening. As for the others, the adults in charge need to make sure the
kids are playing nicely in the sandbox.

It has not been Obama or his economic team that has ben talking about nationalizing the banks.
There have been some Democrats talking about it, but it seems to me that the greatest noise in that direction has come from Republicans.

Somebody got to stop the bank executives from looting billions from public legally!!!

I am a former banker who worked for Mellon Bank and then went to Poland to help with the transition of that banking system to a Western model.
I agree with almost all that Lewis said in the article. What puzzles me is how the populist reaction has turned into an over-reaction. Northern Trust (which has maintained 91% of its pre-crisis capital is not the same as Sun Trust which has retained 14% of its. Rep Frank was wrong to attack them for sponsoring a golf tournament for charity.
I would like to see what the balance sheets would look like if the FASB mark to market rule were suspended.
I would like to see what the portfolios would look like if the SEC were to reinstate the uptick rule.

BarryBaseball,
If the points put forth by Ken Lewis in the WSJ were fundamentally sound — and, on the surface, they certainly appear to be — then the banking industry collectively ought to have chosen a spokesperson with more credibility. Both Lewis’s demeanor and history of selective disclosure work against him.