Pass a Test, Get Government Money

The Obama administration appears to favor administering tests.  The plan that Geithner outlined earlier in the week to save our banking system involved a "stress test" for the largest banking institutions that would separate the wheat from the chaff.  Banks that passed the test were free to continue with business as usual.  Those that scored a C- would garner additional capital injections with stringent new terms.  Finally, those receiving an F- would be nationalized.  Bank regulators are busy investigating our country's biggest banks and the results will be revealed, hopefully soon.  The market hates uncertainty and the future of the free market remains in the hands of a few bank regulators.  Frankly, this is disconcerting news, although the market seems to have already designated which banks will fail the test.  If the bank's stock is trading in the single digits, the future is not looking particularly promising for equity and preferred shareholders.

   

Although the market hated Geithner's plan for testing the banks, it loved the new home loan subsidy plan leaked to the press yesterday afternoon.  Although details remain fuzzy at best, the plan involves a standardized reappraisal of homes of troubled borrowers and a test for homeowners to determine if they qualify for subsidized help from the government.  The principal on the mortgage would be written down by the lender and the government would subsidize the new mortgage payments.  When news of this new proposal hit the tape yesterday afternoon, the indexes rallied back from steep declines, as if this plan is somehow going to help save some of our insolvent banking institutions and add back those 3.5 million jobs the country has lost in the past year.  Although it may help some homeowners, it still fails to address many issues, including what to do with all of the vacant houses, the mass of REO inventory, or investor-owned properties where the investor just wishes to walk away.  I'm not even going to get into the condo overhang or impending commercial real estate defaults on deals struck at the peak of the frothy market.  

What to make of the mandatory testing by the government?  Is bank nationalization of the weakest banks really the answer?  Those that are the most bearish on the economic outlook argue for bank nationalization, while those that see glimmers of a rebound on the horizon believe it's foolish to think that the government can do a better job running our banks than the private sector.  Frankly, what concerns me about an aggressive and perhaps premature nationalization of our largest banks is the cost.  

Every Friday when the FDIC seizes insolvent banks, it announces the estimated cost of the clean-up.  I am often amazed at how high the estimated cost is relative to the size of the failed institution.  For example, on Friday Feb 6, 2009, the FDIC closed three banks, one of which was FirstBank Financial Services of McDonough, Georgia.  According to the FDIC's press release, the bank had total assets of $337 million and total liabilities of $279 million.  The FDIC found another bank to assume all of the deposits and purchase $17 million in assets.  The FDIC is stuck with the remaining assets and is estimating that it will cost the insurance fund $111 million.  The FDIC also seized Alliance Bank in Culver City, California.  The bank had assets of $1.15 billion and deposits of $951 million.  California Bank & Trust acquired all of the deposits and some assets at a discount.  This one will cost the fund $206 million, but the FDIC has a loss sharing agreement, so technically it could go higher.  The case with County Bank of Merced is similar.  County bank has $1.7 billion in assets and deposits of $1.3 billion.  The FDIC found a buyer in Westamerica Bank but also had to enter into a loss sharing agreement.  The FDIC estimates that the cost will be $135 million.

These banks are fairly small and yet the FDIC is still shelling out big bucks when they are taken over.  Particularly in the case of the banks where the FDIC could find no takers for the assets, the cost of the bailout is fairly large relative to the size of the assets.  In the case of FirstBank Financial, the cost amounts to roughly one third of the assets of the institution.  So what happens when the government nationalizes a bank with assets of $2 trillion?  Is it possible that it may cost the taxpayers $500 billion or more?  Sort of makes the stimulus package look like peanuts if we do this with more than one institution.  My guess is that this is what makes the administration hesitant about an all-out nationalization of several large banks.  Maybe if the $800 billion stimulus actually works and the economy turns, some of the institutions on the brink of insolvency today may turn the corner at some point in the future.  While hope is never a good strategy, sometimes too much preemptive meddling is not the appropriate solution either.

On a positive note, the credit markets have improved fairly dramatically in the past few weeks.  This explains why the stocks of Goldman Sachs and Morgan Stanley have rallied, while the commercial banks' stocks have stagnated.  Goldman and Morgan have sizable portfolios of fixed income assets, much like the commercial banks, without significant exposure to the consumer through pedestrian mortgage and credit card lending.  In the past few weeks, executives within these investment banking firms have come out and made bold pronouncements about wanting to pay back the TARP funds immediately because they don't need them and don't appreciate the government's attempts to tell them how to run their businesses (read: distribute bonuses.)  So why don't they just give the money back?  The answer is fairly simple:  They may not need the TARP, but they need the cheap money they garner from the FDIC's bank debt guarantees, and the special access to the Fed's fancy financing programs that didn't exist a year ago.  Give away that extra capital cushion AND lose the ability to issue government guaranteed debt equals a possible run on the bank again ala September 2008.  The risk is too great.  Plus, when you're in the business of making a spread, cheap money is a necessity.  It's much easier to talk a big game than to actually follow through.  The market has bought into the posturing, of course, because the market is susceptible to the BS that flows freely from the mouths of these "financial geniuses."  The market seems to have forgotten that these are the same geniuses that said the worst was over a year ago.