Well, Are the Banks Weak or Strong?

Good question. Many have received injections of capital (purchases of preferred stock) through the Troubled Asset Relief Program (TARP), yet many large banks announced large profits this week. If this week's announcements were all I knew about it, I'd be very confused.

But, my answer is…

…that many of our banks that have engaged in significant real estate lending or have mortgage-backed securities in their portfolios have weak asset and capital positions because of large reserves for loan losses and write-downs of securities. Their capital is very thin, which is what TARP is designed to remedy.

On the other hand, some of their ongoing businesses have generated profits recently while other lines of businesses are incurring losses. Sustained net profits would enable weak banks to rebuild capital in time, but write-downs from past loans and investments continue to erode capital and pro-cyclical regulatory responses make a bad situation worse.

In addition, some of the recent profit announcements have benefited from some unusual accounting treatments. Goldman Sachs, for example, changed its fiscal year from one that ended in November to one that started in January, which caused a heavy-loss month in December to disappear from the radar screen. (This is hearsay on my part.) A couple of the banks, whose own bonds had declined in market value, marked them to market, thus reducing the value of their liabilities. I'd never thought of marking your own debt to market.

In the case of Bank of America, their net earnings of over $4 billion consisted largely of the trading profits of Merrill Lynch. The fact that BOA's stock declined sharply on its announcement of a large profit suggested that the market understood the negative aspects and probably the nonrecurring nature of its first quarter performance.

So, do the banks need to keep their TARP funds or not? Some have offered to give them back?

Most of the 400 plus banks receiving TARP funds probably need to keep them until this crisis is over. The government is worried that if a few high profile banks return them it will put pressure on others to do so and create a distinction in peoples' minds about bank safety. They are all safe within the limits of their deposit insurance.

People don't like the idea of giving the banks money, especially when the banks do things they don't approve of, such as give retention bonuses or raise credit card interest. Do you agree?

Yes, but we shouldn't use the term "give" too loosely. Let's not forget that the government didn't "give" them any money. The banks have to pay a higher than market interest rate for those "borrowed" funds and had to give warrants to the government which are convertible into common stock. For example, Bank of America, in its quarterly report, showed $400 million dollars going to the government as interest last quarter.

Even so, I think the government should allow banks to pay back the money as soon as they are able to.

What about the idea of the government converting the preferred stock to common stock? Is this the government's way of taking over or "nationalizing" the banking system?

It could be, but I doubt it. Government officials don't want to run banks, especially since they know they don't know how and would only earn their government paycheck anyway. I think the idea is simply a way of giving the banks more support (to the extent that common stock is superior to preferred) without having to go to Congress for more money. If the government did such a thing, I think it should be voluntary on the part of the banks since that wasn't part of the original deal.

What about these "stress tests" that the regulators are performing on the 19 largest banks?

I think announcing such a thing was a huge mistake. Bank regulators routinely perform stress tests and require the banks to do so; so they won't learn anything new. But now they have put themselves in a position of having to announce something about the results of the stress tests, which is a no-win situation. I think it was a gimmick to buy time that wasn't thought through. Anything they announce will have a downside with no upside that I can think of.

What about banks raising interest rates on credit cards? Isn't this a bad time to do such a thing, especially banks that have accepted TARP money?

Yes, it's very bad PR. However, the financial crisis has created a severe recession which has raised credit card delinquencies. The banks need to recover their costs.

The consumer response should be to pay off their cards as soon as possible and never again carry a balance on them. They are a terrible deal for consumers.

Should Congress put a limit-a usury limit-on what banks can charge?

The last time Congress did that was in 1980 and it caused, or helped cause, a severe recession. Any kind of price fixing is bad.

In 1980 or 1981, I testified before the Maryland Legislature urging them not to impose usury limits on bank credit cards in Maryland. The Maryland banks said they would have to move their credit card operations out of state if limits were imposed.

The legislature imposed the limits, and the Maryland banks moved their credit card operations and many, many jobs to Delaware where they remain today.

What about TARP II, the private-public partnership designed to buy illiquid assets from banks? Will it work?

I don't know. Most people don't realize it hasn't even started yet. They have incentives for private sector capital to come in as buyers. I'm not sure there is an equal incentive for the banks to sell, if selling causes them to take a big loss on their capital.

Also, Congress and others are already complaining that the terms aren't tough enough on banks. This is just one more instance where Congress sets out to help the banks and ends up trying to penalize them. The government has the private sector afraid to do business with it. They keep changing the rules.

Do you blame the private sector for feeling distrustful of the government?

No, not at all.

Comments (8)

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  1. Tim says:

    Bob, I’m no accountant, but I’ve never heard of writing down the value of your liabilities. Is that really allowed? I could understand that if they plan to repurchase those bonds at market prices, but I suspect that isn’t case.

    I think that it was Ben Graham who said something like, “Remember, the value of the assets is questionable, but the value of the liabilities is real.” I guess that doesn’t apply anymore.

  2. Nemo says:

    The banks have to pay a higher than market interest rate for those "borrowed" funds

    Why would any bank pay a "higher than market" rate for anything, instead of simply going to the market?

    Could you explain what you mean here? Because I honestly have no idea what you are talking about…

  3. Bob McTeer says:

    Response to Nemo:

    I'm referring to the interest rate the government is charging banks for the preferred stock it purchased. This is probably above what the banks would pay for deposits, but may be in line with or less than they might pay for new capital, if they can get it. Some of the big banks had the new capital "crammed down" and received it involuntarily. You are obviously correct in saying that banks would not choose to pay high rates on the type of money they could get more cheaply. I would just add to your statement "under normal circumstances," but these aren't normal circumstances.

  4. Bob McTeer says:

    To Tim:

    I’d never heard of writing down the value of liabilities either, but apparently mark to market applies to both sides of the balance sheet. Their debt was trading below par so they adjusted it to market value rather than historical value. It is indeed strange to benefit from doubts about your ability to repay your debt in full.

  5. Bob McTeer says:

    A Footnote to the Post:

    I mentioned the lost December when Goldman changed its accounting year. This morning's papers (Apr. 23) indicated that Morgan Stanley did the same thing. It turns out that both cases were based on their becoming bank holding companies, which apparently have to report on a calendar basis. So, while they may have benefited, apparently the change was on the up and up.

  6. […] publicize the results was “a huge mistake,” former Dallas Fed president Bob McTeer writes on his […]

  7. Beau says:

    I enjoyed meeting you yesterday in Dallas, Bob. Great speech. In response to Tim’s comment, I will add that when banks moved to Fair Value accounting (FAS 157) they became obligated to mark to market both assets and liabilities. This has the perverse effect of generating “earnings” for companies when the credit spreads on their debt widens in the face of eroding confidence in the credit worthiness of the borrower. Mark to market accounting not only distorts the value of assets in illiquid markets but also liabilities. The law of unintended consequences needs no better poster child.

  8. […] merits of running stress tests and releasing the results. Former Dallas Fed president Bob McTeer certainly isn’t a fan, but Justin Fox at Time’s Curious Capitalist blog says trying to determine which banks need […]