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Industry News  Crisis Management Capital of Last Resort:Confronting The Prospect |
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Capital of Last Resort:Confronting The Prospect
Print - FPinfomart - American Banker - Monday July 7th, 2008
First of two parts
If you think conditions in the financial sector are stabilizing or improving, you can stop reading now.
With the optimists weeded out, it is time to address the prospect that the banking industry is in an accelerating downward spiral that could spur government-led recapitalizations of private-sector companies.
Implied in this view is that the Federal Reserve Board's crisis management to this point - admired by some observers for its creativity and vilified by others as overstepping - ultimately will not prove sufficient to stem the tide of writedowns and credit losses caused by poorly structured products, falling house prices, and a stagnating economy.
With global estimates of losses now reaching as high as $1.2 trillion, a growing constituency is convinced that the industry's capital-raising efforts to this point are merely tentative and inadequate first steps. And these people are asking where precisely all that money is going to come from.
It is not clear whether public markets will perceive additional investments in struggling banking companies as bargains or as good money thrown after bad. There is no guarantee that the Fed will hit upon a way to ease regulatory burdens associated with controlling stakes in financial companies - and even if it does, there is no guarantee that private-equity and sovereign wealth funds will commit patient capital to the sector, given their disastrous experiences thus far.
The foreign banking companies that have traditionally been interested in the U.S. market are suffering from the exposure they already have, and they are conserving capital.
Some regulators continue to disavow a policy of bailing out systemically important companies - a disavowal that to some observers looks increasingly silly in a world where the Fed has rescued creditors and counterparties of Bear Stearns Cos. Nevertheless, it is clear that some companies are too big, too complex, too entangled, or too politically connected to fail.
The problem, according to some observers, is that the Fed's idea of throwing liquidity at financial companies is the wrong tool to restore balance sheets, not to mention a bad deal for the government.
"What is distressing to me about the discount-window approach is that it is providing liquidity to the very neediest firms in an unaccountable way, subsidizing them for the troubles they got into - and we're not getting anything back for rescuing them," said Edward J. Kane, a finance professor at Boston College and a senior fellow in the Federal Deposit Insurance Corp.'s research center. "As a firm approaches insolvency, it needs more risk capital, and the question is where does it get it? During this turmoil it has been coming from the Fed, and it has not been priced properly or fairly to the taxpayer."
Joseph Mason, a finance professor at Louisiana State University, said equity recapitalizations are "part of the discussion, certainly," as academics, economists, regulators, and market observers debate how and whether to prepare for widespread insolvency in banking. "It is a commonly used tool worldwide. I don't think we can dismiss it out of hand."
Such recapitalizations are no doubt a blunt instrument that would raise philosophical questions about the propriety of socializing loss in an ostensibly capitalist economy.
Government recapitalizations have been tried with varying success in European countries, including Sweden, and perhaps more notoriously in Japan, where an initial recapitalization effort failed - in the minds of some, because the government failed to restrict use of that capital, which in some cases was pushed in through the front door and flowed out the back door in form of dividends to equity holders.
The question is whether a more elegantly tailored program could succeed here.
"As is clear now, this is a broad, Main Street banking story, not just a Wall Street banking story, and these ideas naturally come out," said Alex Pollock, a resident fellow at the American Enterprise Institute and a former chief executive of the Federal Home Loan Bank of Chicago. "Whether it is severe enough to warrant it, we don't know yet, but conceptually, these are the issues one deals with."
Mr. Pollock has dealt with these issues before. He was a senior vice president at Continental Illinois National Bank and Trust Co. when it was circling the drain in May 1984. Its demise was by some estimates the first application of the "too big to fail" doctrine in this country, when the Office of the Comptroller of the Currency, the FDIC, the Fed, and the Treasury secretary agreed that the bank must not fail, for fear that its failure would trigger a systemic crisis that would drag down much of the banking sector with it.
The policy prescriptions for Continental Illinois, which got itself in trouble with speculative and fraudulent loans to the energy sector, including oil and gas companies, were extensive.
The Fed allowed it to borrow $3.6 billion from the discount window, and 16 banks teamed up to create a $4.5 billion loan package. When that did not work, the Fed assured creditors that it would meet any of Continental Illinois' liquidity needs. The FDIC stepped in with a $2 billion package and offered a guarantee to depositors, including those holding more than the $100,000 insurance limit. The FDIC took a large preferred stock investment in the bank, and cashiered its management.
The experience with Continental Illinois proved so wrenching and lasting that even today - in a banking industry where naming conventions are so traditional that "People" appears in the name of 164 banks - only seven have "Continental," and each has less than $1 billion of assets.
That was not the government's only experience with equity investments in the banking sector. The Reconstruction Finance Corp., chartered by the Hoover administration in 1932 to forestall a collapse of the sector, eventually made such extensive investments that virtually every large bank that survived the Great Depression emerged with the government as a shareholder.
The agency's initial mission was to extend loans to banks and companies in other industries threatened by insolvency, but the depth of the problems revealed the limitations of a lending program.
"If the problem is one of undercapitalization or insolvency, no matter how much money I lend you, I can't change the fact that you don't have enough equity. That's why the RFC came around to providing equity," said Mr. Pollock, who researched the agency after his experience at Continental Illinois. "The RFC is a useful thing to study, because it marked the key shift from being a provider of credit or liquidity to a provider of equity capital."
Tomorrow: What are the lessons of the RFC and other public recapitalizations of banking companies? What should a recapitalization program look like, and who should administer it?
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