It should come as no great surprise that the reaction to the much-anticipated “non-nationalization” of Citigroup (NYSE: C) announced today was underwhelming. The market has spoken, hitting Citi’s shares hard, and analyst comment collected at Alacra Street Pulse is overwhelmingly negative. A few sample comments:
“How much longer are we going to have to go through this? At this point, it’s just plain embarrassing. Can’t we just grab the place, chop it up, and sell off the pieces? What the market’s telling us this morning is that that outcome is inevitable, so we might as well get on with it.” - Henry Blodget at Clusterstock
“So for about 100% of the market value of Citi, plus insurance guarantees worth of as much as 500% of its value (~$275 billion), we got less than 1/10 of a company that in total was worth 1/5 of our investment.” – Barry Ritholtz at The Big Picture.
We would avoid the shares as it is unclear whether this is the last round of capital restructuring, which means that existing equity may be further diluted in the future. – Richard Ramsden at Goldman Sachs
Meanwhile, Egan-Jones, the credit research firm, said in a note to investors that it believed Bank of America (NYSE: BAC) was “next in line” for a government infusion of equity, according to DealBook.
According to Egan-Jones’s calculations, Bank of America will need $100 billion in equity within the next 100 days. That is in addition to the $45 billion in cash and $120 billion financial backstops that the government already committed to shore up Bank of America’s capital base.
A recent paper by the Bank of England’s Executive Director for Financial Stability suggests that stress testing needs to go beyond individual banks to incorporate their impact on systemwide risk.
The B of E’s Andrew G Haldane presented the paper Why Banks Failed the Stress Test at a recent conference on the topic.
First, argues Haldane, a multi-factor risk scenario that is sufficiently extreme to constitute a tail event must be devised.
Second, regular evaluation of common stress scenarios is needed. “Having banks conduct regular evaluations of their positions relative to a set of common scenarios (provided by the authorities) would be an improvement on current practices in several respects.”
Third, an assessment of the second-round effects of stress should be added. “The results of these common stress evaluations should be the starting point, not the end point. These common stress tests need to be made dynamic, so that the second and subsequent round interactions, and their consequences for system-wide risk, can be evaluated”
“This calls for an iterative approach to stress-testing in which banks’ first-round results and management actions influence second round stresses facing firms – for example, the effects of asset sales and liquidity hoarding.”
In effect, what we would then have is a hybrid stress test-cum-war game.
Fourth, results should be translated into firms’ liquidity and capital planning. “The results from these exercises need to influence management outcomes if they are to be useful; the internal incentive problem needs to be overcome. So there should be a presumption that the results of these dynamic stress tests are taken, for example, to banks’ risk committees. And banks’ executives should periodically be asked how they intend to respond to these findings, including how effective their defensive responses are likely to be when the stress is system-wide and how the results affect liquidity and capital planning decisions.”
Fifth, transparency to regulators and financial markets is required. “The bank-specific results ought to inform regulatory decisions about firms’ capital and liquidity buffers. Indeed, there is a case for having these results set out regularly in firms’ public reports.”
NERA Economic Consulting has published another useful primer, this time on the complexities of loan modification programs. It does not take a position, but clearly lays out the issues and the pros and cons of various alternatives.
NERA analyzes 5 complexities:
- The incentive to default to qualify
- Moral hazard and adverse selection
- The risk of redefault on modified loans
- Potential conflicts of interest between servicers of mortgage-backed securities and investors in these securities
- The reputational effect for lenders and servicers
The report includes an ominous chart illustrating the rising trend of redefaults. It shows that more than 50% of loans modified in the second quarter of 2008 had redefaulted after 5 months.
The concerns about redefault are frequently supported by statistics examining recent history.
“…of the loans modified in the first and second quarters of 2008, after three months, 36-39% of the borrowers had redefaulted by being more than 30 days past due. After six months, the rate was 51-53%, climbing to nearly 58% after eight months.”
For details see Understanding the Economic Complexities of Loan Modification Programs.
McKinsey offers its variant of how to solve the toxic assets problem and resuscitate the US banking industry in a new “Conversation Starter.”
“…. we propose that the government step in and establish a voluntary program to create a real market price and terms for the sale of bad assets. Rather than use modeling for valuation, the program would set discounts from either of the two basic approaches to accounting value, based on some recent past date (for instance, December 31, 2008). A reasonable level might be 10 percent off for securities already marked to fair value and 20 percent off for loans being held to maturity. Upon their sale to the government, existing shareholders would absorb the loss taken on the discount, and that loss of common stock value would be replaced by converting TARP1 preferred stock to nonvoting common (which would be vested with voting rights if sold to private parties).”
“The government would be partially protected from overpaying through this approach by its increased ownership of common stock in the bank, which means it would recover, as a shareholder, much of whatever it overpaid. If it underpaid, it would keep the gain. In addition, the government could provide an incentive for the banks, which should know these credit instruments best, to maximize the value of the assets they offload to it—say, by allowing them to earn a percentage of the subsequent asset recovery price as a servicing fee.”
By our rough figures, if the government purchased $1.5 trillion in assets with an average 20 percent discount from accounting value ($300 billion), it would end up acquiring an ownership stake of some 36 percent in the industry as a result of the conversion of preferred stock to common or the injection of new common stock to make up for the equity lost through its discounted purchases.
“While that is a significant stake in the banking industry, it remains considerably less than what would occur under full-blown nationalization.”
Meanwhile in a preview of an hour-long special on This American Life, MIT’s Simon Johnson and Deutschebank’s Joe Lavorgna debate this issue. While they disagree on much, they agree on one thing: the taxpayer will pay … and pay and pay.
There’s something about the “Royal” moniker that implies solidity in an institution. No more. The Royal Bank of Scotland Group’s (NYSE: RBS) record loss of £24 billion marks a new low in the demise of this once widely respected bank. As Credit Writedowns points out “That’s about £400 for every living sole in the country.”
Likewise a knighthood is supposed to reward outstanding contributions to the nation. Maybe the current financial reforms should include a mechanism for rescinding the honor to people such as RBS’s deposed “Sir” Fred Goodwin, who now suffers the misfortune of retiring at 50 with an annual pension of a mere 650,000 quid.
Despite the miserable performance, RBS seems safe for now, given the UK Treasury’s massive support, analysts tracked by Alacra Street Pulse say. Under the latest terms of the bailout, the government’s stake is set to rise to 80% or more.
Sandy Chen, the bearish banking analyst at Panmure Gordon, remained cautious, saying that while the favourable pricing of the scheme, along with the additional capital injection from the Government, will remove the immediate capital concerns around the bank, his team still had “concerns about further losses and capital strains, particularly in the £991bn of derivatives”. “We expect these concerns will crystallise over the next 6 months; for now, the markets will probably focus on the favourable terms of the bailout.”
The FT’s Lex says “the reality remains that this is another big step along the road to state control. Assuming all B-shares convert, the government ends up with over 84 per cent of RBS. Even though its voting rights are limited to 75 per cent, this is a Potemkin-like pretence at private sector capitalism.” ”
It might forestall outright nationalisation, unless economic disaster strikes, but this will be a public sector company in mind, body and spirit for years to come.
Also at FT.com, Willem Buiter says “the Treasury’s deal with RBS under the Asset Protection Scheme is even more disadvantageous to the tax payer than I had feared.”
It isn’t even a dead bank walking any longer – more a dead bank stumbling and fumbling around.
Oxford Analytica warns that the threat of financial protectionism is real, despite exhortations from politicians to avoid it.
Banks are likely to return to more proximate lending relationships both at home and abroad, where due diligence is taken very seriously, as they attempt to limit their exposure to potentially non-commercial foreign lending, OxAn says.
Despite these considerations, the spectre of financial protectionism is still real.
“It seems likely that, whether explicitly or implicitly, national governments will pressure banks to lend to particular firms and sectors. However, this does not mean that such pressure to lend will be under completely non-commercial circumstances, which is implicitly implied by those fearful of financial protectionism.”
“The difficulty is that uncertainty makes it difficult to model future economic conditions and thus the credit quality of borrowers, even for low-risk borrowers. Yet ensuring an open credit channel for firms is essential to returning to growth. As such, if banks alone are unwilling to extend credit, especially when credit quality is sound, there is a rationale for some form of government intervention. Where such financial protectionism becomes problematic is when it becomes overly mercantilist in nature. It is still uncertain whether a return to blatant mercantilism will occur.”
For details see: Prudence drives retreat of finance.
CreditSights says common equity will play an important role in determining capital adequacy under the the government’s new stress tests for US banks.
“The Treasury did not define what constitutes an acceptable “capital buffer,” but did refer to both the amount and “quality” of capital as a factor in its analysis. So, we sense this could indicate a regulatory preference for common equity to a higher portion of Tier 1 than is the case for some banks.”
Therefore, it seems that tangible common equity (TCE) has gotten increased regulatory prominence as a capital measure important to market participants.
Under this measure, Citigroup (NYSE: C) is in the weakest position among the large banks, with TCE of 1.51%, compared with 4.67% for Goldman Sachs (NYSE: GS) at the top of this group. Smaller banks such as First Horizon (NYSE: FHN) and Comerica (NYSE: CMA) have still higher TCE’s at over 7% each.
Meanwhile reports persist of an imminent deal for the government to increase its support for the struggling Citigroup, as documented at Alacra StreetPulse.
For details see Banks: Geithner Gets Going, But Do SA’s Get It?
Most countries would be delighted with a 6.5% rate of economic growth this year, but in the case of China, that figure is seen as a disappointment. Still, Standard & Poor’s believes that China’s ambitious stimulus plans will bring about a rebound in the second half of this year.
“In third quarter 2008, real GDP growth for the world’s third-biggest economy, after the U.S. and Japan, slipped below 10% for the first time since 2006, to 9.0%. It slowed further to 6.8% in the final three months of 2008 to bring the full-year growth figure to 9.0%.”
“Standard & Poor’s Ratings Services expects further economic weakness for China in early 2009 but sees a rebound within the year to bring the annual growth rate to 6.5%–significantly slower than 2008’s 9.0%.”
And we believe China is likely to weather the downturn better than most others, in large part through its ambitious stimulus plans.
S&P expects the yuan-dollar exchange rate to remain broadly stable in 2009. Nevertheless, the effective exchange rate has appreciated significantly with the U.S. dollar. “China’s current export slowdown, however, is due more to the global economic crisis than to the strength of the yuan. So engineering a yuan depreciation would be likely to increase tension with major trade partners and yet deliver very little boost to exports.”
U.S. regulators are beginning “stress tests” on the top 19 U.S. banks and investors are braced to see what happens.
Appearing before the House Financial Services Committee today, Fed Chairman Ben Bernanke would not comment directly on the financial health of Citigroup, saying in essence that regulators are waiting to see how their stress test “works out.”
In testimony before the Senate Banking Committee Tuesday, Bernanke reassured lawmakers that regulators were not eager to nationalize troubled banks.
How much more we’ll have to do depends on the state of the banks, it depends on how the economy evolves and it depends on the margin of safety we think we want to have.
Though JP Morgan Chase said it wasn’t pressured by regulators to cut its dividend to 5 cents per share from 38 cents per share, Gimme Credit’s Kathleen Shanley posits that the move on Monday was well-timed:
Overall, the bank’s move appears well-timed to ensure that the company passes its stress tests with flying colors despite deteriorating trends in products such as credit cards.
CreditSights illustrates what government help might look like in both the conservative and worst-case scenarios under the Obama Administration’s newest bank bail-out proposal in “Supervisory Sphinx Spits out More Solutions”:
Meanwhile, PIMCO’s Bill Gross said in a new commentary that he would not dispute the need to “further capitalize systemically important banks via convertible bonds held by the government,” even though it would dilute existing shareholders.
But to those proponents of nationalizing the U.S. banks as Sweden did during the 1990s, such as NYU Professor Nouriel Roubini and former Fed Chairman Alan Greenspan, Gross says:
The U.S. isn’t Sweden, and not just because our blondes aren’t au naturel. Their successful approach revolved around a handful of banks but we have 7,500…if you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B of A would do.
Gross predicts it will take “trillions” of dollars in the U.S. alone to make up for the loss of private credit, as well as a high degree of policy coordination among nations.
All of the angst and market volatility over the bank stress testing might have been prevented, to some degree anyway, had the U.S. Treasury said from the beginning what it finally announced this afternoon.
According to Bloomberg, the stress tests will be completed by the end of March and banks will then have six months to come up with the required additional capital needed.
Fannie Mae and Freddie Mac debt obligations still lack an explicit guarantee from the U.S. government, but Fitch Ratings says that’s a technicality, and it predicts the government sponsored enterprises’ senior and subordinated debt obligations “will be fully supported.”
How does Fitch come to this conclusion? The ratings agency points out that U.S. policymakers have put Fannie (NYSE: FNM) and Freddie (NYSE: FRE) at the center of their plans to come to the rescue of the mortgage market.
[Fannie Mae] and [Freddie Mac] will play instrumental roles in evaluating and approving loan modifications and restructurings over the next few years…The Housing Affordability and Stability Plan ensures a role for the GSEs until the housing market recovers.
The long-term risk has to do with what happens after the housing market is stabilized, according to Fitch. The ratings agency outlines several possible outcomes:
- Nationalize the two entities, creating organizations similar to the Federal Housing Authority. This would eradicate the inherent conflict between the mission of homeownership and maximizing shareholder value.
- Consolidate all of the GSEs, including the Federal Home Loan Bank, onto one government balance sheet.
- Hybrid approach: Provide a partial government guarantee or establish highly regulated private entities similar to a public utility, and appoint a commission to provide oversight.
- Fully privatize Fannie and Freddie, potentially guaranteeing all senior and subordinated obligations for an extended period of time, similar to what was done with the student loan GSE Sallie Mae.
For details, see “U.S. Government Places GSEs at Heart of Mortgage Plans.”