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How to Resolve AIG & Citi; Walker Todd on Stress Testing the Banks
March 4, 2009

How to Resolve AIG & Citi; Walker Todd on Stress Testing the Banks
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.

To the issue of TCE, keep in mind that the equity and debt holders of a bank holding company have only a conditional claim on the net assets of the subsidiary banks, basically the common equity and dividends, and cannot "claw back" equity to the BHC once the proceeds of common, preferred and debt are downstreamed to the subsidiary banks as common equity. Indeed, if you as an investor in a BHC want to understand just what you really "own" when it comes to bank equity and debt, you must first look at the "parent only" profile of the BHC, excluding the subsidiary banks.

Click here to view the form Y-9P for Citigroup (NYSE:C) from the Fed. Notice that in Schedule PC -- Parent Only Balance Sheet, that C's assets ex-bank are only $379 billion. Of that, $342 billion represents investments in and payments due from affiliates, in this case other BHCs. Add the $1.3 trillion of bank assets at the end of 2008 and you have the consolidated C entity familiar to investors. So as and when the FDIC is forced to resolve C, the parent would immediately see more than two-thirds of its investments in bank affiliates disappear, which is why we believe that C must eventually be restructured once the FDIC takes over the subsidiary banks.

C is actually not a direct owner of any of its subsidiary banks and non-bank companies, meaning that you can restructure the BHC w/o affecting the operations of the banks and non-bank affiliates, or the subsidiary holding companies. In the case of Lehman Brothers, only the parent company filed bankruptcy and the operating units did not. Most of these assets were sold to new investors.

So BHCs are really SIVs in disguise. Yet another wonderful achievement by our friends at the Federal Reserve Board. Just remember that the Bank Holding Company Act is the last remnant of Glass-Steagall. Indeed, we suspect that post bust, you may see many commercial banks go back to a unitary legal format to give investors greater comfort. Just as investors don't care for the highly leveraged, opaque legal configurations in structured finance, the tiered BHC structure may also go away -- assuming that our talented fellow citizens at the Fed take notice of investor preferences.

Stress Testing the Banks

In this issue of The IRA, we feature a guest comment from Walker F. Todd of the American Institute for Economic Research. The topic? Stress testing the banks, of course. You can listen to Todd's comments on the bailout to date from the January 28, 2009 conference at American Enterprise Institute by clicking here.

Before were get to our featured comment, we wanted to remind one and all to take a look at the interview on CNBC yesterday with former AIG CEO Hank Greenberg regarding American International Group (NYSEAIG) and Goldman Sachs (NYSE:GS). Greenberg, who is suing AIG, came as close as we've ever seen to denouncing Treasury Secretary Tim Geithner, GS and its management team, for engineering one of the greatest acts of fraud ever perpetrated against the US taxpayer. He also reminded us that Martin Feldstein was on the board of AIG Financial products.

Meanwhile, Andrew Ross Sorkin at the New York Times seems to be toeing the line from GS about how we must spend tens if not hundreds of billions of additional tax dollars to bail out AIG and how the cripped insurance company cannot be resolved in receivership. As we told Sorkin in a comment, this is nonsense. (And BTW, all of the comments on Sorkin's article seem to have disappeared from the NYT web site.)

Not only is the State of New York and the other jurisdictions where AIG operates ready and able to deal with an insolvency, but we should not miss the opportunity to put the entire CDS market to the sword as well. Remember, once we begin the inevitable unwind of AIG and Citigroup (NYSE:C), the beginning of the end of CDS and the derivative nightmare on Wall Street will have begun.

More, the US government cannot fund the operating losses of Fannie, Freddie, AIG and C. We do not have the money. Between now and the end of March, IOHO, the markets are going to force a resolution of AIG and C. We may never even see the much discussed stress tests promised for April by Secretary Geithner.

As we discussed with Josh Rosner and will be writing about same next week, Treasury Secretary Tim Geithner and Fed Chairman Bernanke think they are driving this process, but in fact the markets are setting the agenda. Either we act now to deal with AIG and C and take these names off the table before the other zombies arrive for the dance party, or we risk being overwhelmed. If we have a choice between preserving the credit standing of the US Treasury and flushing AIG, C and every other CDS counterparty on the planet, we'll take the latter every time.

Indeed, yesterday we were slumming at the Four Seasons in New York. Among the dinosaurs we observed grazing in the tall grass of this Midtown Manhattan refuge for the transactional class was former C director Robert Rubin, former New York Fed Chairman Pete Peterson and Treasury Secretary Geithner, who apparently was there to get new instructions from his sponsors.

Before Geithner arrived for lunch, Peterson reportedly asked one NY real estate mogul: "How much of that toxic paper is there?" Now we may know where Geithner gathers his market intelligence -- over a luncheon table in New York with his owners. Next time we are going to bring the flip-cam.

BTW, we hear that a meeting of the Financial Standards Accounting Board's Crisis Advisory Group will be held in New York tomorrow at Baruch College. We've got several pairs of eyes and ears in the room and will report back afterward if anything interesting occurs.

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 [1999], 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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