Mitt Romney Economics

It may seem amazing that the US Presidential Election could be a very close contest. It is between a President with more grasp of what is now being called "big data" on the economy versus an ex-governor who is personally rich despite a slew of business failures and debt increases in New Hampshire and a business record of vulture fund capitalism - buying companies, loading them with debt and selling out profitably before the firms went bust. Rommney's economic ideas are ideological and theoretical and not empirical. They are not based on macro-economic modelling of the US economy and its international context. Of the six distinguished Nobel prize winners in economics who support Romney only one (Edward C. Prescott) has an established understanding of national income accounting but this is over-ridden by his belief in smaller government and lower taxes and that growth is 70% dictated long term by technology change and productivety gains. Such views discount the short and medium term reality of economic and credit cycles and the need for government to lead an economy out of recession. We have no past experience or current evidence of the private sector by itself being willing and able to pull the economy out of recession or low growth. For that to happen the banks would have to change their fundamental strategy for doing business. Until then the job remains principally the government's financial responsibility and for that it must retain flexibility and sufficient financial firepower. Many talking heads and voters believe that US Federal Goivernment is financially bankrupt and has run out of effective ideas and tools. This is so far from the truth that such ideas are economic suicide. A third of the Federal debt belongs to government itself and could be cancelled. Budget deficits are no larger than they should be. The problem for government is how to include the banks in its efforts to boost economic growth. The Romney camp do not understand the economic role of government as a counter to wealth and income concentration serviced by banks that if unchecked would seize up circulation of money in the economy. Government's role is to recycle from wealthy and rich areas and people to porrer ones in order that the economic system continues to trade widely across the nation and provide growth opportunities and economic survival throughout. The presidential election is a battle between empirical realism based on understanding the acounting of the national economy and a contrary view that is philosophical and ideologically-formed, between a practical short and medium term view and an idealised long term view. This is not just left versus right, but between those who account for all the numbers and those who want to focus on some ideas only and assume all else will somehow stay the same?

OBAMANOMICS 101: REFRESHER COURSE

Political change is about shifts in voter opinion of the so-called 'floating voters'. In most of the USA in 2008, the Democrats gained such shifts, but not everywhere. Whether the White House will have a majority on 'the Hill' (both houses: Senate and Congress) after November is on a knife-edge of 'economic recovery' and voter confidence about how recovery is being managed by government.
The shifts that gained the White House for the Democrats looked very considerable, but in troubled stressful times voter opinion may be fickle, and perhaps not helped by 'no holds barred' decision of the Supreme Court over corporate spending on politicians! The outcome of the November election of legislators is probably as dependent on the performance of the domestic economy as at any time in USA history.Three months in the Obama presidency approval rating was high among Republican voters and not just among Democrats on key issues. Obama's rating then fell from over 60% to just over 40% - to some extent due to gathering anxieties about the economy as jobs were lost, also coloured by Main Street protest in an election year (Congress and Senate Mid-terms in November), and in part reflecting unemployment variance state by state, even county by county, as well as by economic class among registered voters.
The stimulus package/s are substantial but their effectiveness is interpreted as short term boost with a long tail work-through effect by which time when the benefits are becoming tangible they will coincide with wind-down of fiscal stimulus and thereby lose some edge. Like debates everywhere the issues concern how long should fiscal efforts to boost recovery continue befoe the private sector takes over?
Electioneering brings out ideological extreme views to sharply distinguish the two major parties. Post-cold war notwithstanding war in Afghanistan, and the continuing anger with banks and Wall Street, politicians inevitably seek to demonise domestic economy issues. It is traditional to fan the flames of anxiety about the national debt, and in so doing ignore its economic benefits and its actual affordability (most of it domestically owned and a third by owned by government and government controlled agencies).
Purchases of bonds issued by government-sponsored enterprises plus Treasuries swelled the Fed’s balance sheet from $900bn two years ago to $2,350bn today. The Fed’s buying of government agency paper has stabilised the market but selling soon might cause a price shock. Paring the amounts by repaying accruing principal and interest to the US Treasury seems more prudent (about $250bn a year). A very brave decision would be to cancel or recycle a lot of the national debt owned in government accounts and to recognise formally the amount of that debt which banks and other financial institutions must hold to invest pensions and insurance funds in and to improve the quality of the finance sector's capital reserves.
The Congressional Budget Office has a long history of ignoring the tax revenue feedback from deficit spending and thereby producing exaggerated forecasts of federal Debt.The USA has been, and will continue mainly to be, a credit-boom economy with a large trade deficit. This is maintained by a high proportion of bank lending to property, especially mortgage lending. Property exposure accounts for about70% of US domestic bank lending. Therefore, stimulating the housing sector has short term importance in restoring home-owner confidence, to lessen home-owner negative equity and mortgage defaults, to help restore banks' collateral and asset values, limit construction sector unemployment, and improve household credit and consumer spending generally. The American Recovery and Reinvestment Act, with a $700bn to $1,000bn gross spend ($500bn-$700bn net spend) has 40% going to small business and personal tax breaks, $77bn for unemployment benefits, and $400bn-$600bn remainder to maintain government consumption spending when tax revenues are down by 6% or more? Much depends on the multiplier feedback benefits of the fiscal boost.One of the criticisms of bank bail-outs is that funds given directly to support banks is into the wrong end of the economic food-chain - the mistake that Japan made following its 1989 asset bubble collapse that left most of its retail banking insolvent and that triggered low growth for most of two decades. The Japan government cut infrastructure spending and inflated the national debt to compensate banks directly for their loan loss provisions. While those loans were repaid government continued with deficits because consumers retrenched being forced to by multi-generational mortgages and low employment growth in domestic services.The above pictures are what the USA wishes to avoid, and China is afraid of similar happening to it in the next decades when its asset bubbles burst.
The Obama administration, with its economists led by Larry Summers, recognised that tax cuts for the wealthy and big business (the Bush response to the 2001 recession) resulted in a 'jobless recovery', relatively-speaking. This time the stimulus would be to 'middle America', to 'hard-working families', to 'blue-collar' as well as 'white-collar' and very much to small firms. But banks lend only 10% of customer loans to small firms despite these employing more than a third of all jobs in the whole economy. And, lending to business has shrunk by a third. Small firms are not an economy onto themselves however; they rely on the activity of large firms and on housing, construction, government and consumer spending. Everyone agrees that productive industry needs a lot of stimulus, especially in producing tradable and exportable goods and services, but how to do this, which means changing the size and stock of firms by sector, is not at all clear in a western democratic system that knows it has to trust the markets to make economic sense for the total economy.Tax breaks and other support to small firms (30 million small firms) helps their survival rates (lower firm death rates than otherwise it is hoped). But recession hits new firm birth rates through banks reluctance to lend and low confidence among start-up entrepreneurs, more than death rates caused by loss of trade credit between firms, late payments and, biggest factor of all, banks calling in loans or refusing to recycle loans and shrinking overdraft facilities - what is collectively called 'stricter credit standards'.
How much of that spending is on proven anti-poverty programmes? Setting aside the discussion on infrastructure and job creation, anti-poverty actions are more "benefits in-kind" rather than money i.e. food stamps, housing subsidies, and Medicaid. There is a cultural moralising presumption with a very long history, one that infects most Western aid to poor countries too, which is that the poor should be helped to benefit themselves and not given money directly except when absolutely necessary. 'The Projects' in the USA can be appallingly destitute places as all know, but whether anti-poverty actions will boost the economy short term or significantly in ways that feed through to the rest of the economy is a politically highly-charged set of questions. The data below is pre-credit crunch and pre-recession and must today be substantially worse.One extreme example of moral parsimony is the well-worn idea that all food-stamp, unemployment benefit and housing benefits to the poor living in 'the hoods', the slums, leaks out $ for $ in payments for illegal drugs, the 10% black 'black economy' etc. This is quite untrue, but a popular prejudice, like many among the better-off who need excuses for not being more charitable. The medicaid medicare debate over health insurance reform brought out many of the political issues but they were shunted into financial questions of budget deficits and national debt with the worst case scenarios absurdly produced by the Congressional Budget Office and believed despite caveats to say that the data is hypothetical and not to be relied upon.
The short social-democratic answer associated with European welfare states is to say "if the rich are not taxed to give money to the poor the rich will soon become a lot poorer because they can no longer trade profitably with the poor" but that is all about where money should be recycled into the economy's 'food chain' - at the top for 'trickle downwards' or at the bottom for 'sluicing upward'?
The question of criminal 'entrepreneurship', black market and prison population comes into this. At not far short of 1% of the population costing several times minimum standard of living cost, and the supposition that sounds like $1 trillion of crime and anti-crime; maybe a $1tn black market economy sector, which is equivalent to half the GDP of California or almost half of that of England?
Justice & Policing spend is about $200bn including state budgets. Cost of crime is estimated by academics at something like $800bn, of which half is considered to be white collar crime not counting up to about $500bn in tax evasion, according to some estimates. Total welfare state spending in food stamps ($75bn, with food stamp rolls growing by 5m people in 2009), medicare, unemployment benefit, totalling about $700bn, but with payments going to about one third (100m) of the total population including people with incomes at double the poverty minimum etc. is actually higher relative to the size of the economy in the USA than in many EU countries because poverty is a higher % of the population.
Total US welfare spending is about $1,600bn. More than one third of that returns to Treasury in taxes within a year.
Illicit drug spending is estimated by the UN at $240bn worldwide (other estimates of street value are $320bn-$400bn) with a quarter in the USA ($60bn-100bn). Ten years ago, US estimates were $36bn cocaine, $10bn heroin, $5.4bn methamphetamine, $11bn marijuana, and $2.4bn other substances (total $65bn). Perhaps it is $80bn today, but only 10-20% of that among the welfare-assisted poor?
However you look at this, it would be absurd to imagine that what welfare spends on helping poor people is matched or exceeded by spending on drugs, or in supporting crime? Officially about 1.5% (5m) of the total US population are in abject poverty, and 15% (40m) living on or below the poverty line.
In most countries the poor are the 'bottom' 20%, for a wide range of reasons. 10% (30m) are handicapped of which only half (15m) or less have jobs. Nationwide, 37m people, including 13m children, live below the official poverty line of $9,643 for one person and $19,311 for a family of four. Nearly one in five U.S. children is poor (meaning that they are a member of a poor family or no family?) .
One of the problems with anti-poverty policy is that the bulk of it is administered by the states, meaning the states set their own criteria and spend within balanced budget requirements, and most are currently 'under-water' financially. This leads to cuts to social programmes and the disparities between generous states like NY and punitive states like Louisiana.
In respect of unemployment benefits and "aid to states" figures, it seems $80bn-$100bn of the Obama stimulus will go to states for Medicaid coverage, not enough to compensate for cuts in most places, but it softens the blow for low-income households relying on state-healthcare. Food stamp use is at record high, yet there's no formal line item for food stamp provision in the stimulus plan. The presumption is that state aid covers food stamp programmes, in addition to job training programmes and infrastructure investments.
There is no evidence of Federal distribution being party-politically biased. Another important issue is states' rental assistance to households, for low-income, unemployed, and those at risk of foreclosure. Many progressives outlets and non-profit anti-poverty advocates want more spending on food stamps, rental assistance, and Medicaid coverage. The reality is that the number of Americans living in severe poverty - on less than $5,000 per annum for individuals or less than $10,000 for families rose 24% under Bush and must have remained high or even crept up in 2009 with rising jobless. It is doubted whether Congress will manage to push through an extension of benefits to part-time (underpaid) workers.
In the UK a counter-intuitive argument is developing within government that unemployment benefits need to rise (pensions and other welfare provision too) to force up wages and thereby improve the impetus to find a job rather than the previously prevailing view that sub-minimum benefits will force the jobless to seek employment, which seems to have failed as an intuitive concept.
The UK policy is often led by US examples where by international OECD standards welfare is minimal. It remains to be seen if such a gear-change is remotely possible in the USA?
Much depends on how the economy is boosted in relation to income distribution, which is not the same as wealth distribution, but the latter is sufficiently stark to make the point. Funding social programs beyond unemployment insurance is critical. The economic returns to food stamps compared to unemployment insurance and tax breaks need examination. The economy is not a homogeneous sponge, but it is highly interconnected in all directions including external trade and money flows. The logical argument is to say that as money flows inevitably towards the richest segments then the maximum multiplier effects, the widest benefits, are achieved by boosting the income and spending power of the poorest in the economy.
Robert Reich, Professor of Labor at Berkeley, defines the deficit hawks (cut sooner not later) as Herbert Hoover's disciples. The 2001 recession was responded to by the Bush administration with tax cuts for the richest.
President Obama, in a speech to the A.F.L.-C.I.O. executive committee, alluded to the issue in reviewing his administration’s efforts to emerge from what he called “the hole” Republicans dug in the Bush years. Advisers said he would engage more fully when Congress turns to the issue.
Now, Tim Geithner, Treasury Sec. has told New York Times all the Bush tax cuts will expire as scheduled. His reason: the nation's looming deficit requires it. "Permanently extending the tax cuts for the top 2% would require us to borrow $700bn more in the next decade, adding significantly to an already unsustainable level of debt,” Mr. Geithner said in remarks at an event jointly hosted by the Center for American Progress, a Democratic-leaning research and advocacy organization, and the American Action Forum, a Republican-oriented group.
Mr. Geithner described the Obama fiscal policies as seeking to balance short-term stimulus measures with moves toward long-term deficit reduction, calling this “pro-growth” — which used to be the Republicans’ favorite adjective for tax-cutting!
Former Treasury Secretary Robert Rubin, Reich's colleague for a time in the Clinton administration, appearing on CNN, says any further effort to stimulate the economy is "counter productive," and that policy makers instead should craft a deficit-reduction plan.
Reich is caustic about Rubin's view. He says the Bush tax cuts should expire for the top 2% (those earning over $250,000) because they save more than they spend, "and we need all the spending we can get. The cuts should be extended for everyone else because they'll spend them". The top 2% own a quarter of total national income i.e. the middle classes alone do not have sufficient purchasing power to lift the economy. Reich says "The best way to give them even more purchasing power would be to give the middle class a larger tax cut -- say, a payroll tax holiday on the first $20,000 of income." and that "Rubin is entirely wrong... the gap between total private spending (consumers plus business plus net exports), on the one side, and the nation's capacity to produce goods and services at or near full employment, on the other, is still a chasm. So government needs to do more spending now, in the short term, in order to get people back to work and the economy back on track."
In 1999, both Greenspan and Rubin, who were at the time said to be joined at the hip, urged Congress to repeal the Glass-Steagall Act that had separated commercial from investment banking since 1933. In 2000, they argued against allowing the Commodity Futures Trading Corporation to regulate derivatives. Until recently, Rubin ran the executive committee at Citigroup, where it was clear he had n problem with excessive risk taking and encouraged it. In 2001, Greenspan supported the Bush tax cuts that blew a gigantic hole in the federal deficit to mostly benefit the wealthiest. In 2002, Greenspan lowered interest rates to near zero but refused to oversee how banks were using their almost-free borrowings.
Reich says both Greenspan and Rubin are deficit hawks, like Herbert Hoover, and Hoover's Treasury Secretary Andrew Mellon. And look what Hoover and Mellon caused. Reich says "when we least need him, Hoover is being exhumed".

Citigroup Disposals and Regulation lessons: A question of Time.

You will remember that in December 2007, Vikram Pandit became the new CEO of Citigroup, replacing interim-CEO Sir Winfried Bischoff, who became chairman of the board as well as remaining CEO of Citigroup Europe before becoming Chairman of Lloyds Banking Group. Pandit succeeded Charles 'Chuck' Prince who resigned in November 2007 due to that year's poor performance due to CDO- and MBS-related writedown losses. By 2007, it was not totally clear that Citicorp's performance was unsurprising. It had suffered and survived other shocks.Prince was named by Fortune magazine as one of eight economic leaders "who didn't [see] the crisis coming", noting his overly optimistic statements in July 2007. Other journalists identified him as one of twenty five people who were at the heart of the financial meltdown. Before Prince left he started some retrenchment. It was Citicorp than by making margin calls on Bear Stearns that propelled Bear into crisis. In early 2007 Citi began eliminating about 5% of its quarter million global workforce, to cut costs (a year later more job losses and a year after that as much as a quarter of jobs would be in plan to go). Prince resigned in November 2007. When the bank warned it may write off $11bn of subprime mortgage loss (out of $55bn exposure) on top of a $6.5bn write-down the preceding quarter.
The factors that led to the housing mortgage and price boom and the 20% or so of 'sub-prime' mortgage lending were various. It was the job of banks to see through the 'smoke 'n mirrors' and assess the fundamental realities. The delegation of a lengthening food chain that supplied mortgages and the risk packaging that appeared to disperse the risks blinded almost everyone as much by their 'I'm only a cog in the bigger machine' type thinking.There has been blame heaped on regulations, regulators and central banks. But it is not their job to order decisions that the boards of banks only had responsibility and authority to do on behalf of shareholders. Authorities can only be blamed if they withheld big picture information from the banks that if revealed would have triggered better decisions earlier. The balance of argument should be that the information was made public; it was out there for those with the eyes to see it. Bankers are mortal and like salesmen anywhere they can be chumps for their own sales patter and that of others.
If the property price fall and mortgage default linked to a follow-on recession was the only problem, then no problem; banks are experienced, and capital equipped to take that in their stride over the medium term. What made the crisis worse was the scale of structured products and derivatives that had built on top of this fast-growing mortgage business that had crowded-out other bank lending to industry and which postponed the onset of recession making it worse than would have happened if securitised loanbooks had not played such a large role in financing the USA's external trade deficit.
Arguably, however, that was a great boon to emerging markets of long term benefit to the world economy. When the property market turned south in mid-2005 and banks took little action before the end of 2006, it was already too late to avoid the Credit Crunch. It was especially too late as banks had responded to underlying business weakness and the last gasps of competitive market-share grabbing by upping their funding gap financing and making themselves vulnerable to a large chunk of the liabilities side of their balance sheets suddenly unsticking and not returning. When prince resigned the length and depth of the crisis was becoming apparent only over the previous 4 months as ratings agencies downgraded more and more collateralized mortgages. What market players forgot however is that the liquidity and collateral supporting credit risks is not what ratings agencies rate; they only rate the gross credit risk in the underlying loans, and not market prices of the bonds. The structuring of these bonds made them vulnerable to threshold triggers and insurers and standby liquidity providers took fright, panicked. Investors could not see who was liable to whom, the whole had become hopelessly tangled spaghetti, and certainly far beyond the central banks to unravel, not least because these were over-the-counter deals without a secondary market or an exchange or clearing house. The only Cassandras were a bunch of economists using the Levy Economics Institute Model that at that time no one else paid any attention to.What anyone could also have seen, however, was the unsustainable share of corporate profits in the USA taken by the finance sector, growing to an unsustainable 45% of the total. Bankers even today do not appreciate how untenable and absurd that was, and how their bonus levels established in those years can never be returned to, at least not for nearly as many 'rainmakers' as before, at best only for very few. Similarly, fees and margins on lending have to narrow. Banks should not return to the rich seams of earnings relative to the 'real economy' as before the crisis. But that is a question like weaning addicts off heroin or methadone in a rehab.When Prince saw the game was up for him, former U.S. Treasury Secretary, Robert Rubin, no stranger to the bonus culture, who had chaired Citigroup's executive committee, but who had also had a role in pushing structured product investments that were the bank's downfall, was named chairman, while Sir Win Bischoff, head of Citigroup's European operations, was named acting chief executive. Prince's memo to staff said, "I am responsible for the conduct of our businesses. The size of these charges makes stepping down the only honorable course for me to take as chief executive officer. This is what I advised the board." Getting out was honourable and his package reflected that, but the speedy exit was probably not unconnected to CEO Stan O'Neal's ousting 5 days earlier at Merrill Lynch & Co following a $8.4bn write-down that was more than 50% higher than forecast. It was a long haul ahead before the bank could sight dry land. At the time, it was thought capital levels needed supplementing and that could be achieved by June 2008, partly by a 54c lower dividend. All banks were losing credibility. They were incapable of getting together collectively to help each other and the only safe harbour was government support. By Nov.'08, the crisis hit Citigroup hard again despite TARP bailout money and Citi made further cuts. Its worst stock value hit was in March '09 the month that many claim was the final nadir of the Credit Crunch. Its stock market value dropped far below book value to $6bn down from $244bn in '06! It is now back up to $119bn and "hair-shirt" Pandit is safe, a story that Eric Daniels at LBG (also with Bischoff's oversight) is emulating in many respects (except the hair-shirt).
Whoever is in charge of our banks has to navigate through choppy waters around a lot of rocky outcrops and submerged reefs. What happened to Citi - its timeline lessons?
Early in '08, Citigroup was on the floor for the count, winded by subprime mortgage financing. Since mid-'07 to mid-'08, Citi lost $17.4bn from over $58bn write-downs apart from increased funding costs hitting net interest income. Citi's credit derivatives was its Damocles Sword, a $3.6tn portfolio, 2nd-biggest CDO player.
From Aug.'08, it revamped its capital markets within the investment banking division. It raised $2.92bn by selling three-year samurai bonds in Japanese market in Sept.'08, which as a sum was not confidence-building, but the opposite. To enhance liquidity, a group of ten US banks unveiled a $70bn collateralized borrowing facility just as Lehman Brothers Holdings Inc. filed for bankruptcy protection and Merrill Lynch offered itself to be acquired by Bank of America followed by Citi failing to buy Wachovia cheap for $2.1bn in stock (+ $53bn in Wachovia debt, facilitated by FDIC, the Fed, Treasury and The White House) just as too Congress was debating and voting the TARP $700bn rescue plan to buy retail mortgage securities and with $250bn to buy stock in major banks.
The deal collapsed when Wells Fargo bought Wachovia for $15.1bn in a stock-for-stock deal. Citigroup shares lost $2.99 and traded at $19.51 and it resorted to litigation. These issues would have informed the echoing deal in the UK where Lloyds TSB bought HBoS. In consultation with Federal Reserve, agreed for a litigation standstill after which Citigroup decided not to continue its legal challenge and the stock was further battered down to $11.67 (market cap. now below $70bn).
Citi soon reported another bleak quarterly performance (3Q '08 net loss of $2.82bn or $0.60 per share, compared to $2.21bn profit or $0.44 per share in the same quarter a year earlier). By early Nov.'08, the stock was at its lowest level since May '96 at $9.64. In Oct.'08, Citigroup decided to exit its wholesale mortgage business and shrink its network of external mortgage brokers to 1,000 from 9,500.
Rumours emerged of Citigroup looking to sell parts of the company or outright sales. Citigroup's shares plunged below $5 (back to 1993 values pre-buying Salomon Smith Barney and Traveller's). Investors were doom-laden about further credit losses and write-downs in '09. That Vikram Pandit survived all this is remarkable. It helped that Saudi Prince Alwaleed bin Talal bin Abdulaziz Al Saud increased his holding back up to 5% and expressed support for management, but Citi shares did not respond positively. The share price continued down as hedge funds were forced to unload holdings to meet requirements of not holding shares trading below $5. The bank announced plans to cut 52,000 jobs and reduce expenses by 20% below peak.
Investors remained gloomy even after the U.S. Treasury's infusion of $25bn from TARP. The bank had posted four consecutive quarterly losses totaling over $20bn (write-downs of bad debts) while rivals JPMorgan Chase & Co. and Bank of America Corp. turned in profits.
It was a blessing for Citigroup that Vikram is so much better looking than 'Chuckie' who had the same Hollywood Casting's bad guy looks as Dick 'Fooled' Fuld. Chuck 'the share' Price did not oversee such a loss of shareholder value as Vikram Pandit, but he looked like he could care less:The bank in its Q1 '09 reported using $45bn of TARP to infuse $36.5bn to boost customer lending. In February, Fitch, whose model must have been oblivious to government support, downgraded Citigroup's individual and preferred ratings to junk, predicting Citigroup would face huge credit losses in a deteriorating economy. One has to severely question the ratings agencies models for ideological bias! The February '09 balance sheet with idea of good bank/ bad bank split: In Feb. '09 Fed Chairman Ben Bernanke said there is no plan to nationalise Citigroup. This followed FDIC advice concerning legal obstacles. Stocks temporarily rebounded. The bank and government made a deal to increase the government's stake. The Treasury's Tim Geithner said big banks that are found to require capital would have 6 months to raise private capital or resort to government funds under TARP, which had onerous conditions that banks were very loathe to accede to such as bonus caps.
Federal supervisors conducted stress-test assessments to evaluate the capital needs of major U.S. banking institutions under a more challenging economic environment for the period to the end of the current budget (Sept.30). Citicorp was severely examined and its shares fell marginally to $2.46.At the end of Feb. before the stress tests, Citi agreed a deal to let the government to exchange up to $25bn fee money from asset swaps for a bigger stake (36% of Citi's outstanding common stock) leaving others 26%. In Q2 '08, Citigroup reported net loss of $2.50bn or $0.54 per share compared to net income of $6.23bn or $1.24 per share in the same quarter of '08. The sock fell further until in March it (alongside other troubled banks on both sides of the Atlantic) bottomed at $1.02.
Chuck Prince had to go as all leaders of major troubled banks have had to go, especially the ugly-looking ones (sorry to emphasise such cosmetic aspects) - CEOs only serve the equivalent of political terms anyway. But Vikram Pandit survived worse news over the coming two years. Could Prince have had the foresight earlier to recognise publicly how much value the bank had at its disposal? Could Pandit have steered a better course and made more positive news in his first 18 months? The fact is that the rubic cube problem of re-aligning a hugely complex bank was beyond anyone's skill in such a short period. The lesson is that big complex financial institutions are businesses that need all of a medium term (1-5 years) to turn around and restructure. Just designing and implementing a new computer system takes 2-3 years!
Legacy assets are long-held or even sleeping assets - including businesses - that have been accumulated by the group over time, but are now considered non-core.
As part of Pandit's plan, Citi intended to return to annual net revenue growth of 10% from core operations, including credit cards, consumer banking, securities, corporate, investment banking, and wealth management. It announced job cuts at start of '08 of 13,200 to be made during 2008.
In May, Pandit, in his biggest positive news, said Citi will sell $400bn of assets (out of $500bn it could sell) within 2-3 years to return to profit. This was not received with all the confidence-building it deserved - why, because the market was deluged with short term profit-takers and stock-shorters - it amazed many who could only see an insolvent bank that should be broken up and sold off to others, or taken into state ownership. More than two years on these $400bn sales are almost complete, and at $118bn the share capital value is back to half of what it was at its peak, which is probably not far below where it should be in normal conditions (my guess: $150bn) and when it gets back to safe & solid normal return banking, Pandit no doubt can take all his forsworn back-pay and feel justified!
Back in the winter of '08/'09 FDIC cautioned The Fed and Treasury that a break-up faced legal obstacles across many foreign jurisdictions (operating in 140 countries, but 40 of materially legal significance) and so that option died. It was this problem more than the example of Lehmans or Fortis that inspired the 'living will' idea that is now core to new global regulations for all large complex financial institutions. New regulations also emphasise liquidity reserves and making it easier to break up and sell off or close down big banks. But the real lessons may be that the complexity of banking is such that time is the necessary healer and this is what most government interventions essentially have done, which is to save banks by buying them time to unravel their book - many banks have been doing what Citi announced earlier than others; selling off non-core operating units and investment assets.
A time-winning formula should probably have been consciously applied to Fortis and Dexia that were broken up by three governments acting in concert, perhaps to HBoS too, and is exactly that which has been applied to RBS and LBG, the Irish banks, and to AIG, Fannie Mae and Freddy Mac?
But, in the Autumn of 2008, in the wake of Lehman Bros. left with no option but to declare bankruptcy, the high drama of 15th Sept.'08 and its immediate aftermath that included AIG's implosion, concentrated authorities on instant decisions (even if some disaster-planning had already been worked on). The dark clouds were worst-case disaster scenarios and therefore decisions necessarily, so it seemed, had to not shirk dramatic solutions; "hard choices", "resolute action to save our financial system" etc., what politicians actually enjoy, being Churchillian, the 'Dunkirk Spirit', followed by the 'Battle of Britain', though arguably in the Credit Crunch the line might be "never in the field of human finance has so much been owed by so few to so many".
But, the reality of the crisis moment caused by Lehmans' collapse, the Credit Crunch's Dunkirk, was that politicians, Treasury, Fed, SEC, and FDIC could not bring themselves to 'save' a bank headed by the ugly visage and arrogant demeanour of Dick Fuld of Lehmans (an investment bank with a turbulent history) should have counselled the idea that perhaps there was too large a dollop of subjective politics involved. Nearly three years on the resolution of Lehmans may be turning a profit.
Citigroup was hit by Sept.'08 but not in direct line of fire and further government help was not hugely embarrassing politically. Government in Nov.'08 took a 36% stake by converting $25bn of fees charged to Citi into common stock. This % holding fell to 27% when Citi subsequently sold $21bn common stock (largest share sale in US history, surpassing Bank of America's $19bn in Oct.'08).Stepping hopefully clear of the Autumn wreckage that included failure to buy Wachovia cheap, in Jan.'09, Citi announced its plan to reshape itself as two operating units: Citicorp for retail & investment banking business, and Citi Holdings for brokerage & asset management, but would continue operating as a single company while Citi Holdings is tasked to seek "value-enhancing disposition and combination opportunities as they emerge", and spin-offs or mergers involving either operating unit were not ruled out. In Feb.'09 Citi announced that government would take a 36% stake by converting state-aid into equity. The bank's shares dropped 40% on the news. It was only now becoming clear that while bank funding had eased in price it remained high and government aid had not yet lanced the boil. The darkest hour, though less noticed by the public, there was one more major pothole on the road to restructured recovery, in March. Government state aid conditions included equity-raising, but shareholders felt angry, duped and battered, and so banks' share tumbled in early March. Bank shares only rebounded after the middle of the month when the Fed announced its $800bn Quantitative Easing inspired by the Bank of England's example of buying in $300bn of government bonds over the winter. The dollar fell but bond prices bounced up.
Ben Bernanke had previously insisted that the scheme would be buying mortgage-backed securities and other assets to unblock credit markets, "credit easing" not "quantitative easing" as per Japan as well as UK central banks. The idea was that if banks loan out the cash they raise from selling treasuries and households and businesses spend, rather than save, then the economy will be given a floor to bounce off, increasing the chances of a stronger recovery in 2009. This was reinforced at the G20 meeting in England when the world's leading central bankers promised to do whatever it takes to get growth back on track.
But, yet again, it was up to the politicians to take action. What they could see was traditional banks on which economic growth depends suffering from asset write-downs in their investment banking sides. What they did not fully appreciate is that these depreciating assets were regular traditional banking loan-books where the trade price had become divorced from underlying cash-flows. Nevertheless, the idea grew that splitting the banks between retail and investment banking would quarantine that side of banking that really matters (the side that does not pay massive bonuses) and thereby also quarantine government from having to risk its budget balances and break-up or nationalise banks!
Splitting of banks was politically and technically weighed in 2010 in re-framing the Dodd-Frank Bill leading to compromises, and may weigh similarly with the UK Banking Commission considering breaking up 'universal banks' to split Investment from Retail banking (or as others might term it "Wall St. from Main St. banking as was required in the USA by the 1933 Glass-Steagal Act repealed in 1999 as one of President Clinton's last acts since vilified as a direct cause of the Credit Crunch?)
Citi, like UBS and Bear Stearns less so, was arguably a little lucky its crisis became public before the melodrama of September 2008 when it might have been sucked into the most dramatic end of the vortex of that Autumn. Citi (Vikram Pandit) had already stated it had $500bn of "legacy assets" to sell, though clearly not at fire-sale prices that were panic responses by many in late '07 and most of '08 of at worst 20c in the $, or the minimum of 50-60% discount that hedge funds and vulture funds were seeking.
With government support sell-offs rarely fell below 30% discounts to book, except when whole banks were sold and merged when half of book value discounts prevailed. Citicorp 9and many other banks) have since March '09 shown reassuringly stable share values. In my view this has much to do with shorting speculators recognising that they could not stage a replay of 2008 plus other factors such as signs of solidifying recovery, and not least a shift in volatility to Europe and the sovereign debt crisis. Citi said it wanted to reduce its 'legacy' or 'non-core' assets by sales to $100bn over the medium term, and by today it has almost achieved all of that, but getting there has been a bumpy ride or hard lessons learned that all need to consider.
From late '07, Citigroup raised over $36bn in capital to fund losses and write-downs from sub-prime mortgages and other assets. It sold $3bn worth of new shares after issuing $6bn of preferred shares that diluted shareholders who may or may not have been made aware of further losses (almost $15bn for the six months to the end of March 2008, second only to UBS).
Some analysts said there was more bad news to come and they were right. Deutsche Bank estimated in early '08 that Citi's $29bn mortgage structured products could suffer another $15bn write-down, which seemed excessive discounting and was simply reflecting the terms of the asset repo-swap with the Fed (FDIC) covering $360bn-worth of assets. But it still had $460bn in businesses and assets at 'real economic' (medium term cash-flow based valuation) book value to sell.
In Dec.'09 the Treasury's holdings in Citigroup were valued at $26.5bn and it announced it would sell these shares in an orderly fashion within six to 12 months (subject to an initial 90-day 'lock-up' period after the secondary offering).
In Jan.'09 Citi announced hiving off Smith Barney to be merged into Morgan Stanley, a move many shareholders disliked causing a 22% drop in share value.
In Mar.'10 government shares showed a $9bn profit. But actually the profit was far more than that because the shareholdings had not been bought (at $3.25 a share) with actual taxpayers' fund but in lieu of fees for the repo asset swap. Taxpayer profit (from selling 7.7.bn shares at $4.39 a share) was really all of the $33.8bn, though at a cost to other shareholders whose shares dipped instantly 26% that also wiped $250m off the government's gain, but that was nothing compared to $36bn temporarily wiped off other shareholders' holdings. It bounced back to $5 in April but since subsided to $4.10 or $118bn.
The latest asset sales by Citi are its private equity unit for $900m and EGG internet bank in the UK for perhaps $0.5bn. Another asset that could be for sale is Citi's over 80% stake in Student Loan Corp (STU).
Government still owns 18% of the Citigroup, down by half at its peak.
It is expected that the remaining stake (about $22bn) will be sold by the government as soon as it can be done profitably and without upsetting the market. Total government profit from saving Citigroup may be in the region of $40bn, but for now that's just a conservative guess.

Big Banks, Capital, Overleverage, and Living Wills

Just like the question of whether BP's cap on its oil leak will hold, and whether the oil slick can be cleaned up at an economic cost affordable by BP and its cohorts, we still have similar anxieties about our banks. Credit Crunch writedown losses have recovered by 75% over nearly 3 years. BP's oil slick has been reduced by 75% by burning off, hoovering up, and break-up by sea action - but with another problem emerging that of the toxins in the enormous volume of dispersants used! It is three years since ratings agency Moody's announced that their securitized bond valuation models were buggy with bugs that meant the system was preposterously indifferent to defaults rates - and hadn't been updated for over 2 years for changes in mortgage obligor defaults until January 2007! That said, even Ben Bernanke got his mortgage default data spectacularly wrong in a speech in January 2007.
After six months to figure out how to deal with the errant valuation system, Moody's announced a replacement almost exactly three years ago, after which they and other ratings agencies and underwriters had to re-value all $2.7 trillions of securitised bonds in a batch process that inevitably took many months. This was like BP leaking oil well, operating at a depth that people and equipment had difficulties operating at. It was like Chinese Torture on the stock markets, on banks' share prices, or like the months of the Gulf of Mexico pollution crisis and the question day after day how can these streaming losses be contained?
Governments stepped in to try to quarantine the debt markets and banking systems. But these were long since not geographically containable like an oil slick, but global.
Note that BP's oil slick, to take the analogy further, has escaped the gulf and is threatening the USA East coast and spreading into mid-Atlantic (see graphic below of 10th June). The Credit crunch slick spread across The Atlantic not in nano-seconds as some may imagine the analytic speed of finance, but taking months to spread, speeding over some spectacular events such as the problems of Bear Stearns, Citi, UBS, NR, Dresdner, Hypo-real, Soc Gen, WaMu, Commerz, Fortis, Dexia, HBoS, Bayerische LB, until culminating in September 2008 with the implosion of Lehman brothers and AIG resulting in fire-sales of Merril-Lynch and HBoS and then nationalisations of RBS, Anglo-Irish, and partial state ownership of LBG, AIB, BoI, and so on. All happening as RMBS and other ABCP covered bonds were downgraded, subject to sometimes desperate sales or central bank asset-swaps, and on and on being reprocessed through the revised or 'new' ratings models when the graded assets fell sometimes spectacularly by as many as 17 risk notches, straight from triple-A to 'junk', thus dramatically and progressively shaking, and sometimes shocking, the confidence of 'wholesale' funding sources (including money-market funds and banks who would lend cross-border to each other) who lent to banks by buying banks' Medium Term Notes, on whom the banks were typically reliant for 20% to 30% of their liabilities. The long period over which this shock reverberated without any obvious end in sight was longer than a typical recession.
It is surely remarkable that bankers like Sir Fred Goodwin of RBS witnessing the growing slick of asset write-downs could think this is a temporary problem and the values would bounce bank to return to 'normal' sometime soon? Did he, and others like him, have any inkling, based on any analysis, of the likely balance sheet clean-up time and costs? That we still don't know, just as we do not know how many group risk officers or chief economists issued severe warnings to their boards or whether central banks did so other than buried in their stability reviews? There were warnings, lots of them, but whether they were sufficiently strongly worded or taken full account of by banks, or whether the banks thought it was too late anyway to avoid the storms ahead, we don't know. It is three years since the run on Northern Rock, the UK bank most reliant on short to medium term borrowings to fund its very large gap between deposits and loans. It could not book its next quarter's borrowings and could not envisage paying the higher spread demanded and temporarily losing its profit or changing its business model. Over the year that followed, US banks and EU banks were dragged into a vortex led by those most exposed to refinancing their own maturing securities. Then, when Lehman Brothers was allowed to collapse funding margins spiked and interbank money market deals failed to complete on a massive scale. Governments had no choice but to intervene on an equally massive scale, essentially by stepping into the vacuum wherever the private sector failed to fill the gaps in balancing both sides of banks' balance sheets, the gaps on the liabilities side of the balance sheets, that side that banking regulation had been least diligently concerned about!
What has changed in the interim 2-3 years to make the global financial system safer, better risk diversified, and prepared to change culture? The answer is not a whole lot so far. Why, because the general idea that everyone seems to have is to get back to normal, to how it was before the credit crunch and recession. But that 'normality' is not available and cannot be for some more years; the macro-economy balances of the world and in each country has changed. Therefore, banks have to change their lending profiles and their risk diversification - are they on the job of figuring that out? Banks are still in a stunned reaction, recoiling from lending like anyone would recoil from a fire after getting their fingers burned, or maybe like a seabird still dripping in oil. They are desperately cutting costs before looking for new business, defending deleveraging on the basis that they have a fiduciary responsibility to lend only to borrowers who they can be sure will pay back. What they cannot face is the accusation that if the banks all do this it is a systemic risk to all of them via the underlying macro-economy. How many SME firms on whom economies rely for most job-creation see banks collectively as their biggest single risk factors? The regulators want more detergent, fire-retardant hoses and fire-guards installed and bankers to wear oven gloves - but above all they want well-head caps on risk-taking, on leverage and on 'own portfolio' speculative trading that is seen as detracting from and displacing banks' proper focus on traditional 'transmission mechanism' banking, that of converting deposits into loans.
From the perspective of the banks they are being burdened with requirements that their systems have great difficulty processing. As I often repeat, most if not all banks need new general ledger systems with full risk accounting and have great problems obtaining solutions that work accurately and cleanly. The system suppliers are over-stretched and the banks are over-stretched - intellectually and technically. regulatory standards are one thing, but technical standards expressed in reliable templates and detailed blueprints that can be safely implemented are quite another. I doubt any major bank can say hand on heart that either their credit risk or market risk accounting and analytics grown from the bottom up, deal by deal, account by account, are totally fit for purpose.
Banks have increased their capital reserves and economic capital buffers and liquidity reserves. Before the credit crunch minimum regulatory capital reserve (Tier 1 common capital to risk-weighted assets ratio historically stood at 7¼% over 1997–2007 for all FDIC banks in the U.S.) compared to a requirement of 8%. You can monitor this by looking at total US banks reserve capital, which should be no less than $1 trillion where banks' domestic assets are roughly 100% of GDP, and about $2tn in the EU where banks' domestic assets are 100-200% of GDP.
In Q2 2009, the U.S. Supervisory Capital Assessment Program (SCAP) performed the stress tests to assess risks faced by banks, assumed a target of 4% Tier 1 common capital (before supplementary capital) to total loan assets ratio, which is lower than the historical standard but should be equivalent roughly to an 8% ratio to risk-weighted assets. The SCAP also assessed the capital needs of the largest 19 Bank Holding Companies (BHCs) under pessimistic scenarios. To achieve a 4% ratio, it found that the banks needed $185bn in additional capital and estimated that all U.S. banks would need $275bn of additional capital to maintain a 4% ratio (tangible common equity or 'own capital' to tangible assets) or $500bn to maintain a 6% ratio, over the same period. Now, a year on, the IMF says small US banks needs another $76bn in reserves. But FDIC has this surely under close monitoring control? Europe's banks have been subjected to a similar stress test that, however mild it might be at least comes on top of a crisis stressful period and shows us that even given sovereign debt issues, the exposures to loss in further adverse scenarios (double-dip so-called) should in net terms be relatively mild, or actually trivial, because banks are more risk-diverse than before. How they have achieved this is arguably economically damaging because the banks shrank their loan-books to all classes of borrowers (except Government) and run off amortising loans, cancelled undrawn overdrafts, sold operating units and other assets, and shrunk their 'own portfolio' trading exposures.
Regulators are concerned to improve banks' safety margins, like asking them to install two-stage airbags to cope with head-on collisions.This week, regulators set new standards for bank capital and liquidity, except that the Bank for International Settlements (the global authority in these matters) has, according to most of the media commentary, diluted earlier proposals and gave banks eight years to comply. This is not so. BIS has insisted on a longer parallel working period of reporting both old and new reserve ratios, before the new ones are the only only ratios. The time frame of 8 years will take us into the next cyclical downturns and recessions if the past is any guide.
The idea expostulated by politicians is that the new safety standards will mean that the governments' ambulance services and fire brigades (central banks and treasuries) will not be required to save anyone next time. No one who know anything should truly believe that, nor should they want that to be true, in my opinion. Why would bankers listen to central banks and regulators if they are no longer to act as lenders of last resort, ready, willing and able to intervene to save the banks.
This is where the moral hazard argument falls down. The moral hazard argument supposes that if important banks know they will be saved from insolvency they then indulge in excessive risk-taking. But, against this, is the argument that there remain plenty of disincentives against excessive foolishness and furthermore, regulatory and government authorities exert a full market price for saving banks and without this role of final guarantor of banks, which includes rights to exert penalties, why should banks be motivated to listen to central banks and regulators and to follow their advice about systemic risks?
What were the leverage ratios before the credit crunch?The fact is that leverage is not a precise science and has many issues below the simple ratios taken straight from the balance sheet.
Governments are in the business of protecting vital interests and these include major banks. Who can envisage an economy where major banks are not vital economic interests? There are restrictions on them in the Frank-Dodd US Banking Bill, in various measures being worked on in the EU, and in the UK the government has formed a commission under Sir John Vickers (Martin Wolf, the FT economics columnist, is among its members and I'm providing briefing papers) to consider whether big high street banks should be split? The impressive but Future of Banking Commission that involved many politicians, experts and submissions from bankers advocated splitting investment from traditional banking. Vince Cable, the business secretary, supports the idea but is at present most concerned to persuade banks to lend more not less to small businesses. Such issues may be re-manufactured as tradable levers? Arguably such policy issues were traded in the compromises in the Frank-Dodd bill over the Volcker Rule. All this is about seeing in the iceberg above the waves, in what is in public view, the true scale and structure of what lies below. Regulation is also about making such matters more transparent and there is inevitably a conflict between what is systemically important to show, what is necessary for shareholders to know, and what is commercially sensitive or only for the regulators to see, and therefore not even subject to Freedom of Information Acts?BIS is above such things, one imagines, but it does see the technical and timing issues of enforcing major changes all at once on the whole banking sector. Some of the reform issues are significant but relatively minor or merely technical such as reducing hybrid instruments in Tier 1 capital. The FT says "It is extremely hard to understand what “mortgage servicing rights” and “deferred tax assets” are, let alone what use they will be to any bank when the next crisis blows up, as it inevitably will." But, these are straightforward matters of what counts as usable revenue sources to predict net cash-flow and internally-generated capital. The FT says, "Yet the BIS succumbed to pressure from Germany and France not to be too hard on their banks by allowing both these oddities to count towards core capital." I don't see that - the matters are simple ones of what is operating revenue? In the case of deferred tax, obviously this is available capital if it reduces with bookable losses.
Regulatory changes (up to about 100 by my reckoning) to respond to banks’ misjudgments and deceptions (including self-deceptions) are still in process, inviting comment and further analysis. Many legal actions are in train that will take years to process through the courts and court judgements will add to regulatory law.
As the FT rightly comments, "By and large, however, as they break for the summer with their bonuses and jobs intact, bankers can reflect that it could have been a great deal worse. Conversely, the rest of us are left to wonder how all that regulatory resolve slipped away?"
The Ft says, "reforms are not only inconsistent but – particularly in the case of the BIS – have a lowest common denominator feel. Taken as a whole, they only go a small way towards addressing the two problems made obvious by the 2008 crisis: that global banks are too big and too interconnected to be allowed to fail." I disagree; they are not inconsistent. There are inevitably some national and even regional variations, but most reforms are merely fleshing out what is already in Pillar II of Basel II. The above graphic of the supervisory process that is Pillar II typically underplays the key element that is the biggest challenge which is how to macro-economically model and forecast under different scenarios the banks exposures and performance relative to economic factors.Modelling all the above and a lot more is technically daunting and stretches banks' intellectual resources to the maximum. The more regulators agree with that view the more they will think simplifying banks is a very good idea. And maybe they are right, maybe large banks have not just become too big to fail but too complex to manage? John Gapper of the FT, reflecting the views of many writes, "The most disappointing aspect of the reforms is how easily these banks have brushed aside the obvious solution – to break them up into retail and investment banking operations. That would help to curb excessive risk-taking subsidised by retail deposits and taxpayer guarantees – what Martin Taylor, former chief executive of Barclays, calls investment banking divisions’ “parasitic” nature." 'Parasitic nature' maybe, but this is not obviously a solution - we do not yet know enough about it. Paul Volcker, the former chairman of the Federal Reserve, did include his 'rule' in US financial reforms provisions to ban proprietary trading at large banks and force them to limit exposure to 'alternative investments', hedge funds and private equity. But, we have yet to see a full analysis of what this means.
BIS in its report this week says other structural reforms are needed to curb incentives for banks to keep on getting bigger, more complex and more macro-economically powerful. My view is that the banks need to be guided by regulators forcefully to risk diversify better across the whole of the economies they serve. This idea is currently drowned out by the idea that banks are too burdensome on taxpayers, while in my opinion this view has failed to see how well taxpayers have been protected in the nature of the measures that governments and central banks have taken, and can repeat again in the future.
It is relatively easy for banks to define organigrams to cope with all operating lines of business and risk factors, but a totally different task to combine all of that into a holistic view and then take decisions based on how 'the risk appetite' (a much over-used yet vital term about which bankers have very poor understanding) is an altogether different problem. here is the risk organigram of troubled Commerzbank, which is not especially different from any other large bank. The US is looking for new legal powers including to be agreed internationally to regulators to collaborate to be able to seize and break up very large financial institutions (as they contemplated doing with Citigroup until the FDIC pointed to the many cross-border legal problems of a bank with half its assets abroad) that they deem to be in severe solvency trouble, as well as insisting on banks preparing their own “living wills” to simplify how their internal group structures so that financial restructuring or breaking up is easier Nearly two years since Lehmans went bust and the shell broken up between Barclays and Nomura, we now hear that its financial balance sheet may be unravelling profitably? hence, it is clear that insolvency can be a difficult matter to judge. What was true however was that Lehmans' net cash-flow had petered out and in the short term it was technically bust. Some US politicians suppose that new laws will end the “too big to fail” problem but that is surely a naive and vain hope.
The US problem banks appear to be currently concentrated among small banks with assets of under $1bn, many small local banks with less than $0.5bn. Private equity and vulture funds looked at buying these as entry into banking, but now that looks less attractive, an entry cost problem new entrants find everywhere, the cost of capital adequacy, and yet the set up cost of a bank from scratch is also daunting. But when all banks need new core banking systems to accommodate risk accounting and transition from US GAAP to IFRS accounting standards, and when most banks have zero or very little brand value, building a new bank from scratch looks relatively sensible. essentially a traditional bank should have a balance sheet that may be viewed succinctly and where connection between different lines and sides of the balance sheet may be known and the factors driving the performance (the net interest and other income) should be easy to model for different scenario forecasts. But, of course, even that is quite a complicated task, even for such a simple bank as the balance sheet below: In the UK, some networks are for sale, but new 'green field' banks formed by JS Flowers, Virgin, Tesco, Blackstone and other groupings that may or may not buy existing networks as well. In the USA, Apollo is taking advantage of a change that allows banks to operate in multiple US states without a national charter. It has $55bn under management, and hired a team from Countrywide Financial, and is awaiting regulatory approval. It is asking its investors to put money in the new bank, which will have a separate board and operate independently of Apollo. Like others keen to own banks who believe they can set up a new more attractive customer service model, Apollo has a back-to-basics model based on the belief that bank lending will become more important as capital markets lessen in importance and so long as the securitisation market remains frozen.
Most private equity groups appear to have abandoned plans to create banks based on buying FDIC 'saved' banks that were thought could be lucrative 'fire-sale' deals. In FDIC auctions, it became clear FDIC preferred strategic banking sector buyers over private equity groups, probably because the former offered better prices.
Blackstone last week said it had “changed focus from assisted bank deals”. Others ar looking at buying minority stake in banks for sale.
If the biggest banks are too big to be allowed to fail that is certainly not the case for small banks. And yet their failure can be traumatic for local communities and need protection of regulatory oversight that the FDIC provides. Regulators can impose limits through capital, leverage and liquidity rules, and by refusing to accept banks' risk accounting. Auditors do not audit banks' risk accounting - only regulators do this. In my view banks' quarterly and annual reports should be signed off by both regulators as well as auditors. But, until now, regulators lack sufficient resources to risk-audit all banks. they should however be able to audit the biggest banks and to provide published opinion in the banks' financial reports. That would go far in ensuring banks listen carefully to the regulators.
All this is a lot more than just about over-leveraging by banks, so called exuberant risk-taking. Over-leveraging is a blanket concern but it remains a subjective judgement until precise studies are published that look at all major risk factors and can size and sequence them. The regulators have to equip themselves with precise analytical tools and make these work in the wider context of systemic risk.
Over-leveraging is a factor "among other things" as th e FT's John Gapper rightly caveats. The links between investment banking, especially 'own portfolio' trading, and traditional retail and commercial banking, how these worked, have yet to be rigorously examined. It is generally adjudged so far on the basis that the higher the leverage the bigger trading books are in banks' assets - hence, less own portfolio trading means lower leverage means safer banks - if matters were so simple. Insolvency risks in a systemic risk crises hit all banks, small as well as big. Property bubbles bursting can hit small retail banks and building societies or mortgage banks most, as we saw spectacularly in Japan in the early '90s and asian banks in the late '90s and western banks in recent years. Credit crunch hit those banks with maturing debt that had grown recently fastest and had to refresh their borrowing in the middle of the credit crunch. Arbitraging between what is in trading books or banking books given the much lower capital reserve required to support trading book value at risk compared to banking book credits is being squeezed by new regulations that should triple the capital reserve for banks' trading books and arguably by other regulatory requirements and accounting treatments that are still feeding through into banks' implementations. We should see a reversal therefore of the growth in trading books versus banking books in banks' total assets.The above factors may appear more important than national leverage and sovereign risk, but while this is less obvious to track and more a problem after the fact of the credit crunch, it is an area into which funders' risk assessments now appear to be focused, even if, as I believe, the sovereign risk crisis is hysterically over-blown, not least because of the opportunities that debt-shorters see in the turbulence of the sovereign debt markets. It may be that the bigger issues are really to be found in the area of management systems and management skill, in insufficient macroeconomics education as well as lack of in-depth regulatory risk training of senior bankers, especially of those in the boardrooms. Attendant on that is the question of not just whether boardrooms can steer the risk appetite of large banks in and across all their constituent business units and franchises, but how is it that they actually do this?
Are executive boards and supervisory boards truly in masterful control of large banks or are they dogs wagged by their tails instead of being led by their heads?