Making Sense of the Citigroup Deal
Earlier this week, Paul Krugman said:
But what [the Obama administration is] actually doing is underestimating the problem, doing too little too late, and not being open and honest in trying to assess the true cost. The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up. It’s Japan all over again.
And the result will probably be a deeper, long-lasting crisis.
Krugman is largely correct and the actions of the Obama Treasury team on the banking crisis have largely been depressing. My sense is that a fear of the "N" word, i.e., nationalization, has been driving their weak response to date. That said, I wonder if the Citi deal announced yesterday marks the first meaningful sign that things might be changing for the better - although, at a glacial pace that is still unacceptable.
Let's look at what happened here from the standpoint of a poor man's "economist". A basic question revolving around the state of the big U.S. banks has been whether they have adequate capital (equity) to service their liabilities given the collapse of the values of the assets they own - i.e., are the banks solvent or insolvent? For some time, the answer to this question has been delayed or obscured by the propagation of the following notions - one each on either side of the major banks' balance sheets.
- First, the pretense, at least in part, that the value of the imploded assets on the banks' balance sheets is mostly down temporarily and if we just give it enough time, many of those assets' values will recover reasonably, although not fully
- Second, the pretense, that the banks have adequate capital to service their liabilities until the asset values bounce back up, especially given the government's injection of funds through ownership of preferred shares
Now, the Obama administration's position is a bit nuanced and doesn't quite fall in line entirely with the above notions. However, the effect of their actions (or lack thereof) until yesterday certainly made me skeptical about whether they were serious enough to acknowledge reality, as Krugman has noted. For example, we heard about the good/bad bank idea - which makes it clear that the government does believe that some of the assets are permanently damaged. However, their fear of crafting a plan that attacks the asset price collapse while protecting taxpayers and not merely bailing out the creditors and shareholders of the big banks using preferred shares has been suggestive that they are afraid of going down the route of temporary nationalization followed by re-privatization.
One of the developments over the last several months is that honest financial analysts have been calling for a re-appraisal of what constitutes real capital in the banks' balance sheets. As this Reuters article notes, banks and financial experts have, until recently, been largely using the notion of "Tier 1 Capital" to assess the bank's capital adequacy ratio. This includes not just common shareholders' equity but also elements such as preferred shares and other intangible items. More rigorous financial analysts, such as those at Friedman, Billings and Ramsey have argued that Tier 1 capital is very misleading and that the only way to get an accurate picture of a bank's capital adequacy ratio is to rely on common equity - or tangible common equity (TCE), which excludes preferred shares. The difference is not just a matter of arcane financial mumbo jumbo. As Paul Kedrosky observed, the difference is enormous when it comes to evaluating the balance sheet of a bank. Kedrosky has a chart comparing the Tier 1 Capital ratio and TCE ratio for each of the major banks and you will notice, for instance, that Citi's Tier 1 Capital ratio was nearly 12% at the end of last year whereas its TCE ratio was just ~ 1.5% - which is terrible.
Originally, the U.S. government had made a conscious decision NOT to take common equity in Citi and used preferred shares as the vehicle for injecting cash. But the terms of that deal made it very clear that the preferred shares were effectively an instrument of debt rather than a capital injection . As Baseline Scenario explained:
That preferred stock was designed to be much closer to debt than to equity: it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years. In fact, it is hard to distinguish from debt, except perhaps for the fact that, if Citi defaults on it (cannot buy the shares back) we don’t need to worry about systemic instability, because the government can absorb the loss. As preferred stock, these bailouts boosted Citi’s Tier 1 capital, but not its TCE.
Therefore, the notion that the preferred shares constituted capital injection was in many ways a pretense that only prolonged the problem and the solution. It is in that light that we should view the Obama administration's change of heart yesterday, as well as Treasury Secretary Timothy Geithner's position that the stress tests on the banks will use TCE as the relevant metric. Although we have a long way to go, the action yesterday suggests to me that the Obama team is beginning to heed some of the critics and is willing to at least partly acknowledge that it is no longer acceptable to keep up pretenses. Granted, the partial conversion of preferred shares to common equity adds risk to taxpayers without giving the government majority control - i.e., the fear of the "N" word continues to dictate these actions unfortunately - but I can't help but think this is a small step in the right direction.
P.S. I've been reading a bit about the Swedish experience in the 1990s. Here are some worthwhile readings on that:
Stopping a Financial Crisis, the Swedish Way (Carter Dougherty, New York Times)
Effective Practices in Crisis Resolution and the Case of Sweden (O. Emre Ergungor and Kent Cherny, Federal Reserve Bank of Cleveland)
On the Resolution of Financial Crises: The Swedish Experience (O. Emre Ergungor, Federal Reserve Bank of Cleveland)