Here is a good post on that topic, hat tip to Kevin Drum. It's not as simple as you think. So when someone says "The government should close down insolvent banks" he needs to specify which measure of insolvency he has in mind. It makes a big difference.
We should ask Bill Clinton for an answer. He may also answer the question whata banks is.
No, it’s not as complicated as you think and no we don’t have to specify which measure. All of this is already established by law. See the FDIC Improvement Act of 1991. Follow normal procedure is the word.
Gawd what an awesome post. It has it all.
Test 2 and Test 3 aren’t exceedingly relevant, or so it seems Okay, so banks will be solvent on a YTM basis, essentially meaning if they freeze themselves in time and don’t sell any assets or lend anything, they will be okay, so long as the crisis doesn’t get REALLY bad.
But that’s not what a bank is supposed to do. If Bank of America and JP Morgan are hamstrung because any changes they do will kill them, we have a non-dynamic banking sector, which means a non-functioning financial sector until we get new banks up and running.
Wasn’t able to read all of it…more comments later, perhaps
I follow that blog and that’s one of the best posts I’ve seen anywhere.
Thinking about mark to market accounting — if prices are set by buyers/sellers at the margin, then asset values measured by liquidation of large blocks should be generally lower than MTM values in a market that is generally rising and higher than MTM values in a market that is generally falling.
I really don’t think the FDIC has a “normal procedure” for Bank of America or Citigroup.
Exactly. BoA and Citigroup are both “universal banks” — they have both investment banking and commercial banking components. I would guess Citigroup has exposure to credit derivatives and mortgage backed securities. “Normal procedure” would mean screwing counterparties in the former case and liquidating in the latter case: the kinds of things we’ve been trying to avoid with the other investment banks.
Certainly, nobody is going to buy these banks (who has the money, anyway?) in a “speed bankruptcy” without the government taking over credit derivative exposure and limiting the downside risk on MBSs.
I’m learning (sadly without an herbal study aid) USA bankruptcy potentialities now. F.Salmon datamined the total number of uninsured deposits at USA banks as $2.7T. He thinks bank corporate bonds are too big to fail too: http://www.portfolio.com/views/blogs/market-movers/2009/01/27/what-makes-a-bank-too-big-to-fail
…which to me is absurd. If bank bonds can’t fail Soviet communism is a superior system to imposing a financial Military-Industrial-Complex. If States close schools while reckless derivative traders get their budgets…
Many issues to consider. The link considers the existing financial industry cannot handle the sheer scale of buying up assets of a large USA bank. Even with pork salaries. This suggests to me all assets in banks, moreso for larger entities, aren’t really worth what they are being carried as on their balance sheets. Whatever the time/window-shopping penalty of the assets are, should be what they are immediately written down as.
I guess what policy makers are worried most about right now is if they allow banks to fail and some $2.7T depositers to be wiped out, that the remaining rich people will pull their money from USA bank accounts. I’d guess this would trigger a whole bunch of capital ratios and say $0.7T wiped out causes $2T in capital flight, killing bank investment activities needed by many global actors.
My thesis now, that will probably be obsolete in a week, is to screw the bond and shareholders (only way out of long-term moral hazard I see is to penalize those who invest in shoddy companies). I’d guess there is a “panic level” (very vague here) of uninsured deposits that are needed for an “essential” level of investment activity; or perhaps time is the important variable and this panic needs to be avoided until inflation makes it inevitable or until the Yen-Dollar safety premium are lost?? If these essential deposits total $0.7T, I’d insure 25% of uninsured deposits. If depositors withdraw $0.6T, that leaves $2.1T of which 33% would now be insured. The idea would be to reward deposits.
The existing discussion about bank bond and shareholders misses the point all your cash over $250000 isn’t insured, and this uninsured cash is presently used to fund investment activites (like Citi building 3rd world grain elevators) that create jobs. In general I’m pro-nationalization, because existing bank management is incompetant.
Babar,
The question is, what would bank deposit rates be in the absence of FDIC guarantees? The large spreads Hempton points to are a result of high risk-based lending rates coupled with ultra-low risk-less (essentially) deposit rates. If the FDIC eliminated its guarantee tomorrow, deposit rates would spike and lending spreads would collapse. Now, banks could always attempt to raise lending rates even further, but not without impacting demand for loans. Given that most banks have under-provisioned for the past five years, its unlikely that the resulting spreads would be sufficient to cover provisions against loan losses.
John Hempton argues banks should not be nationalized because they can “profit their way” out of their problems. The problem is that the profits should belong to those effectively in a first-loss position: taxpayers. That doesn’t mean the government has to own the banks. Instead, they could take them over, wipe out equity and bondholders, and reprivatize them.
The “tradtional” banks need to expand. Those traditional banks that are insolvent, should be reorganized through debt to equity swaps. And then, the good, reorganized bank, should expand.
The shadow banking system only had value to the degree the investors really were willing to take the losses. If they are to be bailed out, then it is nothing but a gaming of the regulatory system.
david / capvandal,
thanks for the explanation — it’s clear. it’s another one of those puts that was previously priced low as it was out of the money, but now it’s closer to the money with a higher vol so it’s priced higher. typical for insurance.
this leaves me with one question derived from the analogy. if i buy insurance (presumably it is out of the money) and then i run into trouble, my insurance policy generally limits my payout even though this causes pain to the insurance company. in fact this is the utility of insurance: the premium is generally fixed at the beginning of a term. thinking of it this way, the banks are on the hook only their insurance premium, which was presumably determined a while ago (though i am not an expert in this) and the fact that the insurance policy is worth more to them than that is irrelevant; this fact does not enable the insurance issuer to any claim greater than the premium.
I think you’re missing something on FDIC insurance over the span of a cycle. In a normal business cycle, the insurance premiums are supposed to cover any losses, so the system pays for itself. In a deeper recession, the taxpayer does absorb losses, but the intent is to stop the problems of a few bad banks from affecting the system as a whole. The system is healthy, and the taxpayers are there essentially as a “backstop” to prevent contagion.
This, on the other hand, is a highly “atypical” cycle. The system as a whole is diseased. The taxpayer finds himself in a first-loss position for losses across a broad cross-section of undercapitalized banks. The solution is for those banks to raise more capital, either by tapping the capital markets or by converting bondholders into shareholders in bankruptcy. Either way, the CURRENT shareholders would be wiped out. The problem is that both avenues (capital raising and bankruptcy) are closed to the banks. Thus, taxpayers are likely to retain their first-loss position, and its rational for them to want to also capture any future gains. Capital that’s in a first loss position and captures gains is essentially equity. Nationalization just recognizes reality.
I’ve just learned what Credit Default Swaps are. They are insurance except the finance-conglomerate entity underwriting the insurance goes belly up when you need to use it.
CDS is useful but would function as designed if issued by actors seen/functioning as flight-to-safety players. I’m thinking the Central Banks of currencies seen as a flight to safety, USA Japan, soon EU, maybe someday an APEC trade arena player; these entities should get stronger (certain are this time around as strong dollar is hurting USA manufacturing recovery) comparatively during panic and are best in a position to cash out CDS’s. Perhaps major gold miners/currencies too (I don’t think even South Africa’s mines are large compared to their GDP though). Because of this flight to safety effect, if you are Japan and USA you can’t rely on currency devaluation in a recession. You need to instead use cheap loan rates to produce the same effect. God forbid this should happen under Republican watch; not to be political but tax cuts only indirectly hire people while public spending captures direct hires and the indirect spinoff.
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