How to Resolve AIG & Citi; Walker Todd on Stress Testing the Banks
March 4, 2009
Greenberg: "There was a time when you could have saved AIG. I urged that. The first plan was a disaster -- $85 billion at 14.4% interest and 79% of the company. That was designed to liquidate the company. And to get $35 billion passing right through AIG to counterparties. That was Paulson's plan."
Eric Hovde: "Let me address that because on previous shows you have said that there should be an investigation about why the contracts on the CDS got bought out at par. That is an issue that I am outraged about. I think what the Treasury has done is to use AIG as a back door method to buy out all of these guys at par when they should have taken a hit. Goldman got bought out $20 billion worth. I don't understand why they were at the table with Paulson when they were cutting that deal. It's unprecedented. And a whole lot of other firms. I applaud your comments that there should be an investigation.
Greenberg: "Look, the time they had the meeting in September, the 15th of whatever it was, they made an announcement that there was going to be a meeting that night at the Fed. I called the New York Fed and called Tim Geithner and I said we are the largest shareholder, we ought to have a seat at the table. Never got an answer. But the only outsider at the meeting, as I understand it -- I wasn't there -- was the Chairman of Goldman Sachs."
"Greenberg Sues AIG "
March 2, 2009
First a housekeeping announcement for
users of professional version of The IRA Bank Monitor. We have added
a new metric for Tangible Common
Equity ("TCE") to the "bank only" profiles in the
system. Since bank units themselves are not allowed to have preferred
shares or unsecured debt, the ratios are slightly higher than the public company
ratios floating around Wall Street. But you will notice that for many
banks, the TCE ratios are well-below the leverage ratios for these
institutions. We have also changed the design of the QuickSheet display to
show the Bank Stress letter ratings for the past several quarters. Your
comments are welcome.
Stress Testing the Banks
Walker F. Todd
February 24, 2009
In the current public discussion of "stress testing the banks" for measures of their continued solvency, there has emerged a strange preference for examining only relevant foreign experiences (like Japan 1999), as well as a strange reluctance to examine relevant experiences in our own past (Reconstruction Finance Corporation, the RFC, 1933). It develops that the Japanese model was founded on our own RFC model.
The original stress test was developed during the bank holiday, March 4-12, 1933. It is described in Jones (1951, pp. 22-23, 27-30). Jesse Jones already was a director of the RFC and became its head with the coming of the Roosevelt Administration.
During the bank holiday, the RFC and other federal and state bank examining authorities simultaneously examined the nation's banks and divided them into three categories, A, B, and C. A banks were considered sound; B banks had lost most of their capital but still could pay off depositors in full; C banks had lost all their capital and also could not pay depositors in full at fair market value. A banks were reopened promptly; B banks were reopened as soon as they either raised new capital or made deals with the RFC; C banks were placed into conservatorship to be dealt with later. Banks in conservatorship, however, were allowed to receive new deposits as long as they were segregated from old deposits (Todd, 1993 and 2008).
Asset valuations were at fair market value. It was not until 1938 that the Federal Reserve forced the other regulators to accede to historic cost accounting for banks' assets. The 1938 examination and accounting change was made to encourage new lending and to enable private investors to acquire failed banks' assets from the federal authorities without immediate writedowns of their value (Simonson and Hempel, 1938).
By the end of the bank holiday week, the RFC's directors decided to pursue a policy of making loans (buying preferred stock with convertible warrants) in banks whose assets "appeared to equal 90 percent of their total deposits and other liabilities exclusive of capital" (Jones 1951, pp. 27-28). The RFC's aim was "to put pressure on the banks' stockholders and customers and the people in their vicinities to get them interested in putting capital in and owning their own banks" instead of having the RFC own them. Banks failing the 90 percent test were sent to the "hospital" (category C above).
By December 1933, Jones estimated that around 2,000 of the 12,000 remaining banks (there had been 17,000 before the March holiday) were below the RFC's 90 percent threshold, with average asset values in that pool not quite up to 75 percent. With the tacit approval of the Senate Banking Committee, one of whose members was Carter Glass of Virginia, an original House sponsor of the Federal Reserve Act of 1913, Jones made a bargain with Treasury Secretary Henry Morgenthau.
Jones promised that, if Morgenthau would certify the 2,000 unresolved banks as solvent on January 1, 1934, when the new federal deposit insurance system was to take effect, Jones and the RFC would see to it that the banks in fact would be solvent within six months. Essentially, Jones contemplated making larger loans to those banks, filling in the gaps that remained between the 75 percent and 90 percent valuation thresholds. Over the next six months, the RFC recruited $180 million more of private capital investments in those banks to reduce the valuation gap of up to 15 percent gap that it was financing. The new private investments were subordinated to the RFC's claims in the capital structures of the banks receiving that assistance (Jones 1951, pp. 28-30).
The Japanese approach to eventual resolution, after nearly a decade of delay, of the large-scale bank insolvency of the 1990s is described in Koo (2008, pp. 69-73). By 1999, the Japanese authorities were willing to apply a stress test to the banking system and to inject any necessary capital. Koo makes it clear that the U.S. government's 1933 stress test was the model for Japan's actions (2008, p. 73), as follows:
In the end , the [Japanese] government dropped the conditions [on which it had been insisting] and after much arm-twisting reminiscent of the capital injection implemented by President Franklin Roosevelt in 1933 on which the Japanese scheme was modeled, the banks finally accepted the capital and the credit crunch was ended.
But there was no other 1933 United States government stress test or capital injection. There was only the Jesse Jones stress test described above.
Sources and References for Further Reading :
Jesse H. Jones, with Edward Angly. Fifty Billion Dollars: My Thirteen Years with the RFC (1932-1945). New York, NY: Macmillan, 1951.
Richard C. Koo. "Lessons from Japan's Lost Decade," The International Economy, Fall 2008, pp. 69-73.
Donald G. Simonson and George H. Hempel. "Banking Lessons from the Past: The 1938 Regulatory Agreement Interpreted," Journal of Financial Services Research (1993), pp. 249-267.
Walker F. Todd. "Receivership and Conservatorship for Fannie Mae, Freddie Mac, and Failing Banks," Commentary posted on AIER website, July 23, 2008.
Walker F. Todd. "Bank Receivership and Conservatorship," Economic Commentary, October 1, 1994. Federal Reserve Bank of Cleveland.
Walker F. Todd. "History of and Rationales for the Reconstruction Finance Corporation," Economic Review, 4Q1992, pp. 22-36. Federal Reserve Bank of Cleveland.
Kenneth Gould then adds the following comments to Todd's article and on Fed Chairman Ben Bernake's comments on mark-to-market accounting:
1. In 1933, banks were using mark-to-market accounting. The Fed convinced all the other banking regulators to switch to historical cost accounting in 1938, in an effort to reduce the fear that results from the volatility of mark-to-market accounting. I watched Mr. Bernanke testify to Congress yesterday and today. No one asked him about this when they were questioning mark-to-market accounting and he did not bring it up. Had he done so, it would have torpedoed his ability to side-step the issue by saying mark-to-market accounting is the SEC's subject, not his. The SEC existed in 1938, but the Fed in 1938 understood its responsibility to provide stability for the banking system. You ought not to be fooled by Mr. Bernanke's tactics. He knows the Fed's history better than anyone else, so he knows what the Fed did in 1938.
2. The "stress test" used in 1933 was very simple, unlike modern stress tests, which take months or years to develop, if done correctly. It took only a week for the 1933 stress test to be done for 12,000 banks. You can bet it will take months for the modern stress tests to be done for the 19 banks to be tested. So it is clear that we will get a "stress test" that is so complex it cannot be questioned by the average person, but still so hurried that it will not be mathematically valid. That means it is a LIE, which is being used to give regulators freedom of action.
3. In 1933, the RFC and Treasury heads, with the "tacit approval" of a key senator, did something substantially different than Congress had authorized in the law. It happened to work out in 1933. You can bet our modern regulators will act in the same way, especially given their behavior with TARP. There is no guarantee that their creativity will be successful, but there is a guarantee that it will take years for it to be admitted. I support the 1933 actions, both those within the law and in defiance of it, but I have no naive illusions about them. They put the taxpayers at risk.
Until there is forthright action as simple to understand as the 1933 action, the markets will not improve. This is the standard by which the new administration's actions should be judged.
And the Todd article is one more bit of proof that
the claim that "we didn't know what was being done" is simply bogus. If you want
to know what is happening and NOT happening, the information is available. You
just have to look for it.
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