The Importance of Battlefield Nuclear Weapons
By James Kwak on April 30, 2009
I've been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.
The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it's a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury's fear of a bankruptcy to extract better terms at the last minute. (And it's even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.
But there's a much bigger, slower game going on at the same time, and the administration's basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how "a growing number of banks are resisting the Obama administration's proposals for fixing the financial system." It didn't have a lot of new information, but it summarized the outlines of the game.
The administration has created three main tools to help the banks – and it really, genuinely wants to help them:
The Capital Assistance Program (CAP) to give new capital to banks that need it (based on the stress tests).
The Public-Private Investment Program (PPIP) to encourage the private sector to buy troubled assets from banks.
The Term Asset-Backed Securities Loan Facility (TALF) to provide funding to the asset-backed securities market, which is being expanded to mortgage-backed securities.
According to the Times article, the banks want none of it – even though, as many people (including us) have argued, the terms of these programs are clearly favorable to the banks.
Instead, banks such as Bank of America and Citigroup are arguing that they are more sound than the stress tests indicate. This claim is almost not worth debunking, but I'll give it a few words anyway. First, the "more adverse" macroeconomic scenario used in the stress tests is already more optimistic than the forecasts of respected bodies, such as the OECD. Second, the IMF recently estimated total losses on financial institution balance sheets at $4.1 trillion, future writedowns by U.S. banks at $550 billion, and U.S. bank capital needs at $275-500 billion. If B of A and Citi don't need the capital, who does?
In addition, according to the Times, "Several big banks have declared they have no intention of participating in the [PPIP]. . . . Many banks are reluctant to sell their nonperforming loans because they could suffer big losses, forcing them to raise more capital." Finally, only $6.4 billion in loans have been given out under the TALF – a program currently sized at $200 billion, and projected to grow to $1 trillion.
Why are the banks turning their banks on this government largesse? I think there are two reasons.
First, taking capital under the CAP or selling assets into the PPIP involves some hardship, despite the taxpayer subsidies involved. Raising capital dilutes existing shareholders, and selling assets (at prices where someone will buy them) will require writedowns from their current, unrealistic book values. Treasury really wants the banks to participate, because it will increase confidence in the banks, and that's why Treasury is offering to share the pain, via underpriced capital and low-risk loans.
But even though Treasury is so generously offering to share the pain, what's the incentive for the banks to suffer any pain at all? We know the government won't use the strategic nuclear weapon and let them go bankrupt or pull their banking licenses (which amount to the same thing). And Tim Geithner's request for a battlefield nuclear weapon – resolution authority for systemically important financial institutions, including bank holding companies – seems to be going nowhere in Congress. This is not surprising, since the banks have already demonstrated that they can count on most or all Republicans and at least a few Democrats in the Senate. With the administration's hands tied and the banks' political power intact, the banks are in the same position they always were: if things go well, they will make money; if things go badly, the government will always bail them out later, on terms they are willing to accept.
On the one hand, the banks are complaining about unprecedented government interference and pressure, and to some extent that is happening. But on the other hand, the banks are ultimately calling the shots, because they know Tim Geithner can't use his only real weapon.
Second, the incentives of managers and shareholders are not aligned. A major factor in the banks' reluctance to participate in their own rescue seems to be fear of government interference, which is code for executive compensation restrictions.
Executives worry that whatever assurances the White House gives them, an angry Congress might impose new rules on banks that participate, particularly on pay. . . "We're certainly not going to borrow from the federal government, because we've learned our lesson about that," [Jamie Dimon] said earlier this month in a conference about earnings.
Now, while I think some of the compensation caps discussed in Congress (but not passed by the Senate, as far as I know) were silly, I haven't heard a lot of shareholders complaining about them; it's the managers who don't want them. So the situation is very simple. Participating in PPIP, for example, might be a net positive for shareholders, because even though it forces short-term writedowns, it also reduces the risk of larger writedowns in the future. But if managers think that it will lead to compensation limits, then it is a net negative for managers. I think our readers can fill in the rest of this thought.
Originally published at the Baseline Scenario and reproduced here with the author's permission.
The Importance of Battlefield Nuclear Weapons added by James Kwak on April 30, 2009
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One Response to "The Importance of Battlefield Nuclear Weapons"
george harter May 1, 2009 at 9:44 pm
DO the Chickens ever come home to roost? Or will it be Vultures?GHNYC, USA