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Schumer Is Way Off

by: Todd Sullivan October 15, 2008 | about stocks: BAC / BK / BRK.A / C / GS / JPM / MER / MS / STT / WFC    
Todd Sullivan

Todd Sullivan

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Dear Charles, this isn't the best answer, it was the easiest.

Here is Senator Charles Schumer's WSJ Op-Ed on Tuesday:

Here is the key point in it:

The administration's initial approach to the crisis was to propose buying troubled assets from banks. But direct capital injections into financial institutions - modeled on the Depression-era agency, the Reconstruction Finance Corporation [RFC] - always offered a far better prospect of success. The RFC provided fresh capital to banks and restored confidence (and lending) to the U.S. banking system, while making a small profit.

I pointed this out on the Senate floor a few days before Mr. Paulson came to Congress to ask for authority to spend as much as $700 billion to buy up troubled assets. Later, Democratic leaders Sen. Chris Dodd, Rep. Barney Frank and I made explicit our desire to make direct infusions of capital a part of the approach to solving the crisis during our negotiations with the Treasury.

The benefits of this approach are clear, which is why so many economists, both liberal and conservative, have embraced it. More than a liquidity problem, today we face a solvency problem. History has shown that under such conditions, the most effective means to restore health to the financial system is large injections of capital - which only the government has the wherewithal to make.

Capital infusions are also far more efficient than purchasing assets. Banks can lend much more if their capital bases are restored, and when they dispose of their troubled assets, private markets, not the government, will fix the price.

There is little question that making the government a major investor in American banks raises thorny questions, especially about the role of the public sector in private markets. So let me be clear - this is a temporary solution to an unprecedented crisis, and the government's role must be limited.

However, that does not mean the government should simply make investments with no or minimal restrictions. We must operate in the same way any significant investor operates in these situations - when Warren Buffett invested in Goldman Sachs and General Electric in recent weeks, he demanded strict, but not onerous terms. The government must be similarly protective of taxpayer interests, without involving itself in daily operational decision making. I believe there are a series of steps and principles, both carrots and sticks, that must be applied if Treasury embraces this approach.

The government should encourage widespread acceptance of capital injections, and mandate it where there are clear systemic risks.

Direct injections of capital will encourage all institutions to lend again. But because depositors and creditors may interpret an injection of government capital as a sign of weakness, we need to start by persuading a substantial cross section of major banks, even those in relatively good health, to accept capital. Widespread bank participation will reduce the risk that depositors may flee or that other institutions will refuse to do business with banks that accept or request public capital.

So, what about the ratio he talks about?

Here is a good definition of the "Tier 1 Ratio:

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank). Most central banks follow the Bank of International Settlements [BIS] guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.

A good definition of Tier I capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are, as they are held by the bank, by their nature not an amount of money on which anybody but the bank can have an influence on.

Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses.


In short, there are two ways to look at it. You either increase the equity portion of the ratio, or reduce the debt. Either improves the ratio. Now, I would argue that just raising the equity portion will not do the trick. Why? Many banks already have capital ratio's far above the legal limit yet still are not lending. Why? The bad debts they have that still cannot be fully valued are causing the debt portion of the ratio to rise and remain unacceptably unstable.

Adding capital to the banks now does NOT "encourage them to lend." It does assure they will not fail and does let management know it has ample capital to cover future expected losses. Neither of those "encourages lending." Rather they encourage management to "sit pat" until they have a handle on losses and things "work themselves out."

This is opposed to them running around searching for capital injections like they are now. Removing the debt would have stabilized (even diminished) loan losses AND freed up currently reserved capital being held to cover anticipated losses. Bank management, assured of its situation, would then have begun lending.

In short, removing the bad debt would have encouraged lending.

While Schumer does opportunistically mention the terms Bekshire's (BRK.A) Warren Buffett got from Goldman Sachs (GS), he also does, I think dishonestly omit that Buffett enthusiastically not only supported the original plan (buying of debt), but offered to take 1% of the assets ($7 billion dollars worth). Why? It kept the gov't out of private business and Warren was more than confident the transaction would be profitable for the tax payers and by default, Berkshire's shareholders.

Schumer also omits that this "capital infusion plan" is essentially what the Japanese did during the 1990's. What happened? A decade of economic malaise as banks simply sat on the money. Having the gov't as a partner only encourages the most benign of business practices. These are not conducive to economic growth.

Why wasn't the debt purchase plan done? Timing. It would have been very difficult and time was a factor. The setting up of auctions and the implementation of it would have been a bureaucratic nightmare. Paulson and Bernanke took the capital infusion option not because it was "the best idea," but because it was the "best idea we can do today."

If you read the Treasury's term sheet and watch the Paulson video here, it is clear that Paulson does not think this idea is the best one, just the one we can do this minute.

Had the market not cratered last week, this plan would not have been unveiled.

The following banks have already agreed to the program: Goldman Sachs Group Inc., Morgan Stanley (MS), J.P. Morgan Chase & Co. (JPM), Bank of America Corp. (BAC), Merrill Lynch (MER), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Bank of New York Mellon (BK), and State Street Corp. (STT).

None of these banks were in danger of being below required capital ratios, and all have uncertain loan losses coming up.

What this plan did is diminish irrational fear in the market as the banks were going to fail. You saw that relief in yesterday's rally. What it will not do is lead them to increase lending dramatically and that will hamper any economic recovery. That is where we sit now.

I hope Schumer is as willing in the future to step up and take credit for the economic flaccidity this plan will induce just as eagerly as he was Tuesday in standing up to take credit for its implementation.

Disclosure ("none" means no position):Long WFC, C, GS none.

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This article has 14 comments:

  •  
    Oct 15 06:30 AM
    Chuck Schumer is like the houseguest who comes over to dinner and starts hovering around you in the kitchen, making suggestions as to your ingredients and methods, getting in your way and then announcing at dinner that you are a terrible cook.
    Reply
  •  
    Oct 15 07:02 AM
    lets see if the 8 banks you mention will lend this out... I think not because no one will borrow money when LIBOR still stuck above 4% while a month ago it was 2.82%... This despite lack of deals...

    What will do with all this capital?

    usually traders use 3mths libor + 1-2% as a bench mark for transactions which is not a bad return but where are those deals?

    if banks were scared to lend each other what makes you think they will be less scared to lend to businesses... There is no lack of money around the corporate world, it is the consumers who are drowning...

    The real issue is demand and the consumers. They seem to have just disappeared in this crisis. What triggers their return is confidence in the economy and their perception of their wealth. This means you MUST reverse the upside down situation of many homeowners. It will take a gigantic "stimulus" package to save this consumer - possible the same amount as the banks! maybe considerably more...
    Reply
  •  
    Oct 15 08:29 AM
    You write as if you think this capital infusion is the sum total of what's happening. Did you even listen to Neel Kashkari Monday morning?
    Reply
  •  
    Oct 15 09:02 AM
    Paulson is an investment banker, and in a crisis reverted to what he knows - the mortgage-based financial engineering and those institutions that were involved at its core. It took Sheila Bair at the FDIC to get on guaranteeing deposits for the folks and small businesses, and the Europeans to get on bank capitalization and short term lending to each other. And where was the contingency planning?
    Reply
  •  
    Oct 15 09:08 AM
    Just like the American people thought, this is a bailout for the biggest on wall street. Look at the list of who is going to get the money. It is a who's who list of the companies which caused this mess and they are being rewarded! There should be jail time not bonus time for these companies. This money should have been used in better ways. The fact of the matter is that the banking sector will be reduced by twenty to forty percent weather the government wastes the taxpayer money. Goldman Sachs is a $50.00 stock masquerading as a $115.00 stock. Until this changes the market will continue to suspect the valuations of the financials. The government just threw our money down a deep dark hold and it will not help Main Street.

    msgtb
    Reply
  •  
    Oct 15 09:43 AM
    Schumer is pretty much right on. The most important aspect of this bailout at this time is the LIBOR spread. Buying mortgage securities would take forever - and possibly longer - to bring those down. However, direct capitalization will remove the solvency fears that have caused the spread. The news on hedge funds that purchased the securities "distressed" at .85 to the $ is that they're holding .65 now. There is no way that a price can be put on those securities without many man hours of unraveling. Give it up - you have no idea what the problem is.
    Reply
  •  
    Oct 15 09:52 AM
    More of the same useless diarrhea that is expelled on a consistent basis by Schumer. I am surprised that he has been so quiet on the trade and currency imbalances with China. Oh wait, we need them to purchase more debt to fund the bailout proposal.
    Reply
  •  
    Oct 15 09:52 AM
    Yogidad:
    And Schumer doesn't either. He is nothing more than an egotistical ham. He makes my skin crawl he is such a shill.
    Reply
  •  
    Oct 15 09:56 AM
    paper is paper no matter what initials or pictures you put on it. the liars & scoundrels that caused this mess are unfortunately still in charge.its not going to change.our system is no longer adequate for the world as it is today.think for yourself.dont trust the talking heads as all have an agenda.
    Reply
  •  
    Oct 15 11:00 AM
    Infusion of capital is superior to buying unmarketable paper in the following aspects:

    1. The recipient of the equity makes interest payments until the equity is repaid.

    2. Repayment prospects are more narrowly defined compared to that of toxic paper.

    3. The taxpayer money is put into something that can be regulated.

    4. The workout from the pyramid of debt and its costs are born by the perpetrators rather than the U.S. taxpayer. In otherwords, the perpetrators (banks) face more pain than if they were simply relieved of some of their mistakes.

    The buying of unmarketable debt by the the government has the following advantages:

    1. Banks immediately improve their balance sheets without having to do as much deleveraging because they have unloaded some of their first leverage problems. Therefore, more credit liquidity is available in the near term than with the equity infusion. In the equity infusion, much of the money may be used for increasing reserves and deleveraging.

    2. The potential exists for a higher ultimate return for the taxpayer. Unfortunately, there is also the potential for significant loss. The outcome depends on the intitial purchase prices and the ultimate default rates.

    3. The government will have less direct control over how the banks operate. Some might argue that this is not a good thing.

    Reply
  •  
    Oct 15 06:11 PM
    I was reading in another column that Libor is a theoretical rate, a rate that would be if banks were lending to each other. It's obtained by gathering a theoretical rate from a number of U.K. banks, throwing out the highest and lowest sets of rates, and averaging out the rest. These banks don't actually lend to each other at the Libor rate. It's more like an opinion poll. However, there are a lot of financial arrangements that are tied to the Libor rate, for better or worse.
    Reply
  •  
    Oct 15 10:22 PM
    Basically it encourages the defunct banks to loan more $ because they must pay 5% on more $ that they can not loan to credit worthy companies and invividuals. Let the asset bebble begin anew. Maybe give $100,000 credit cards to kids under 15 years old.
    Reply
  •  
    Oct 15 11:50 PM
    Thanks for the good article and explanation of why this new plan faces the same problems as any other. Schmucker is certainly one of the worst. A dagger at the throat of the economy.

    The idea that the banks will run out and lend money is a bit odd. What growing business will be able to pay it back in a shrinking economy? Don't you have to laugh when you hear about the problems at the auto dealers? Hell, they aren't selling any cars. Over leveraged in the first place, low volume for 18 months, finally facing financial reality. Many are just broke in a bad business. So this plan is hurried through to save them.
    Reply
  •  
    Oct 16 12:58 AM
    HELLO EAST COAST AND WASHINGTON DC: WAKE UP.. PUT SCHUMER,FRANK, DODD, REID , PELOSI IN JAIL.

    HERE ARE SOME IDEAS
    1. ELIMINATE MARK TO MARKET
    2. DO NOT COPY EU
    3.GIVE EVERY USA MORTGAGE HOLDER A REPAYABLE $90,000 DOLLAR LOAN TO PROTECT THEIR MORTGAGE.
    4. GIVE BAIL OUT LOANS TO TOP 100 INDUSTRIAL COMPANIES IN USA(since banks are cowardly holding our cash)
    5.STOP PORK TO OIL COMPANIES AND RICH FARMERS.
    6.CAP FED MONEY TO EDUCATION AND DUMP THE EDUCATION DEPARTMENT.
    7. NO FEDERAL MONEY FOR ABORTIONS. GIVE birth control tablets and PLAN B at discounts
    8.mandatory development and MARKETING OF hybrid vehicles from USA auto companies
    9.50 new nuclear power generators linked to a TGV train system and wind and solar power stations
    10. CNG cars fueled by PHILL by FuelMaker

    DIEGOJAMES
    PORTER RANCH, CALIFORNIA
    waiting for leadership and a new president
    Reply
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