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Memo to the President-Elect; How Much Capital Does a Bank Need?
August 21, 2008

Memo to the President-Elect; How Much Capital Does a Bank Need? "There ain't no point in having a leader if he's… just simply going where people take him," remarked [Tommy] Corcoran to Harold Ickes in the summer of 1946. "A democracy can't function except under leadership," Ickes replied, "and we haven't got any here."

The Fall of the House of Roosevelt
Michael Janeway
Columbia University Press (2004)

If you still have not picked a book for the final week of summer, Michael Janeway's The Fall of the House of Roosevelt is a fine choice, especially with the nationalization of the GSEs looming. It's kind of surreal, don't you think, for the Democrats to be holding a nominating convention as two monuments to FDR's government intervention in the financial markets totter on the brink of failure?

We're not sure who's going to win the presidency in November, but we are very sure that the safety and soundness of the nation's banking system is going to be an issue in this election - perhaps as prominent an issue as energy prices. Indeed, we think that the president-elect will be forced to meet with President George Bush and both men will ask the Congress to move on providing funding and new legal authority to backstop the FDIC.

In this regard, the other book people need to read, as we've said before, is Fifty Billion Dollars: My Thirteen Years With the RFC by Jesse H. Jones, the colossus who managed the recapitalization of the American banking system and economy in the 1930s and then led war mobilization in WWII. With respect to the banks and the GSEs (including the Federal Home Loan Banks), at least, in the near-term Uncle Sam is going to be forced to get even more involved to head off a catastrophic contraction in the availability of credit to the private economy, thus a reading of Jones' autobiography is essential.

Here's what we would tell the next president-elect today about the credit crisis, the danger to the banking system and possible solutions.

Nationalize the GSEs

We're glad to see the Treasury making progress on the GSEs. Secretary Hank Paulson eventually will accept reality and move to take over Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). That will be the good news.

Since last summer, the various parts of the securitization market have been slowly imploding, right on up the food chain from subprime CDOs to the AAA-rated GSEs. The only way to staunch the bleeding and begin the process of restoring confidence in all manner of securitzations is to take the GSEs off the table as a concern for investors. When and only when the GSEs are affirmed as affiliates of the US Treasury will yield spreads on GSE debt start to fall, ending the immediate crisis.

Once the GSEs are safely under a conservatorship, with a program in place to slowly run-off the retained portfolios as the debt supporting them matures, then we can start focusing on the next task, namely fixing the securitization markets and recapitalizing the commercial banks. As you've read in this space previously, banks are GSEs too, just more competitive and focused on providing primary market finance to the private economy as opposed to the secondary, after-market function performed by FNM and FRE.

Securitization and Bank Recaps

When the presidential transition team meets to go over the issues, the need to provide massive new financial support for the FDIC will be among the chief topics of discussion. Add a zero to the $50 billion in spending by the RFC under Jesse Jones, which resulted in a profit to the government, and you get an idea of the magnitude of liquidity that may be required in the near term to make good the FDIC promise to insured depositors. Since the banking industry is in no position to replenish the deposit insurance fund, it is left to the US Treasury to pick up the slack.

As with nationalizing the GSEs, the short-term issue with FDIC is reassuring investors that the government's guarantee is money good. This includes providing funds for immediate resolutions and providing a separate, RFC-type vehicle for owning failed institutions that cannot be immediately sold. Once this is done, the FDIC and the private banks and investment community can focus on triaging institutions between the merely wounded and the dying, and bank failures will cease to be so remarkable. The public will stop worrying about "How's My Bank?"

Simultaneous with this action, the Treasury needs to convene a meeting of the top Buy and Sell Side firms to reach a consensus on changes needed to the OTC securitization and derivatives markets to restore function, in the case of the former, and safeguard against any mishaps, in the case of the latter. A big part of the reason that the LIBOR rate is askew and retail credit availability is plummeting is the greatly reduced ability of banks to adjust or even maintain their liabilities.

Note to the Big Media: The credit crisis story is as much about assets, namely investments, as liabilities, namely funding. Everyone has the same problem, namely shrinking availability of credit. That's why re-liquefying the banks is the first priority to stabilize the economy. The crisis in the financial sector is as much about the ability of banks to fund their operations as it is about losses on assets such as loans and CDOs.

As colleagues like Josh Rosner and Joe Mason have repeatedly warned, the collapse of the market for securitizations is resulting in a growing shortfall in terms of overall financing available to the private sector. This shortfall makes it increasingly difficult for banks to make loans, especially when banks are already in a defensive posture in terms of their deposits and other funding sources due to investor concerns about safety and soundness. Only by helping to restore some level of function to the securitization market can banks regain flexibility when it comes to liability management.

It will take time to restore investor confidence in securitizations and in US banks. The key to success, in our view, is for the Treasury to act promptly and with purpose regarding the GSEs and providing the FDIC the support it requires to do the job with respect to failed banks. Once these two key tasks are complete, then we can proceed to work towards fixing the flaws in the OTC market structure that helped us arrive at this unhappy circumstance in the first place.

How Much Capital Does a Bank Need?

"His servant picked up the spade and dug a grave long enough for Pahom to lie in,
and buried him in it. Six feet from his head to his heels was all he needed."

"How Much Land Does a Man Need?"
Leo Tolstoy

As we prepare to get the Q2 data from FDIC next week, below we reveal the Q1 Economic Capital numbers for the top-10 US bank holding companies based upon bank assets.

Click here to see the margin of safety for the ten largest banks vs. their OTC derivatives exposure in this table from The IRA Bank Monitor, including Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase (NYSE:JPM).

The spread vs. Risk Based Capital in the far right column is the amount of change in valuation in the bank's OBS derivatives book to wipe out the Tier One Risk Based Capital for the subsidiary banks.

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