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Can We Use the Threat of Insolvency to Goad Banks into Making Their Own Deals?

Jimmie | September 30, 2008 | Comments (0)

Rich Lowry posted an e-mail he got from a financially-savvy reader who favors the bailout plan. Though he didn’t intend it, I think his e-mail revealed a big part of the problem and a possible solution. Here’s the excerpt.

The problem is that while there would be a tremendous public benefit if financial institutions would collectively sell their bad assets and rid the system of the uncertainty currently plagueing it, they individually lack the incentive to do so at such a down point in the market. It’s perfectly rational for a CEO to look at his solvency ratios, determine they’re stretched but basically fine, and opt to ride his bad securities until the market recovers and he can get $0.65 on the dollar, rather than sell now and get $0.20, especially when selling at such a huge loss would seriously cut into a bank’s equity. Unfortunately it’s a bit of a catch-22. Banks won’t want to sell until the market recovers, but the market won’t recover until the banks start selling and we get more clarity on their exposure.

Okay, fair enough. But who says the government must provide that incentive? Right now, it looks to me like these institutions are waiting on the government for a better deal. Sure, they could get 22 cents on the dollar now, or they can wait for Congress to give them 40 cents, or 50. So why not wait?

I say if our financial institutions are looking for incentive, they have all they need right now. It’s called “investor confidence” and the e-mail explains why that’s critical.

…[T]he solvency of financial institutions, unlike that of industrial companies, doesn’t depend merely on their being able to generate cash flows sufficient to service their debt. Their solvency requires that they maintain enough confidence among lenders, depositors and counterparties that these parties don’t lose faith, suddenly pull their money out all at once, and initiate a Lehman-style run. Thus, in jittery markets where nearly everyone has bad assets, even parties whose ratios look fine on paper are at risk. Since everyone is at risk and lenders have no way of predicting who will be the next victim of a Lehman-style run, they’ll simply stop lending altogether (it’s happening already). This uncertainty can be largely eliminated if all the assets were to be removed from the system, allowing lenders to lend confidently once again.

So, okay. The banks need to make sure that we are confident in them to remain solvent. On the other hand, they’re putting their solvency directly at risk by sitting on a ton of bad paper that they could sell but won’t because they think they can get a better deal later. Except that later might not come for them because the longer they wait, the lower confidence in them falls and the more likely it is that there’s a run.

That’s not responsible stewardship of our trust. That’s gambling with the future of an entire financial system. That’s something we should not countenance. If banks want an incentive to sell their bad debt, they have it. It’s called insolvency and so long as it’s a very real threat, the institutions should be doing everything they can to avoid it. Selling off their bad debt is a very good way of getting out from under that threat.

Now, that doesn’t mean that they have to accept a 22 cent on the dollar deal from a private buyer. There is a good chance that those securities, which still have very real value because they are backed by tangible assets, will increase substantially in value once things have calmed down. There are lots and lots of creative deals that can be made that can get these toxic assets off of the banks’ balance sheets and still generate appreciable income for them. Here’s an example.

Professional sports teams routines make trades where the final compensation to one of the teams is contingent on the performance of the person traded. Let’s say that the Washington Redskins trade Ladell Betts to the Baltimore Ravens for two draft picks because Betts has gotten very unhappy and his attitude is having a bad effect on the team. The Redskins would get a second round pick and a contingency pick in exchange for their discontented running back. The second draft pick, the contingency pick, could be worth more or less depending on how Betts performs during the year. If he gains 1,000 yards, let’s say, the Ravens give up another second-round pick. If he only gains 500, it’s a fourth-rounder. The upshot is that both teams get something of value now and the Redskins stand to get more based on the future performance of an asset they need to move now.

Now let’s translate that to banks. Bank A has a truckload of steaming, fetid securities that its CEO thinks he can get 35 cents on the dollar for if he waits a year instead of the 22 cents he can get right now. Except that doesn’t necessarily have a year. He needs to make a deal now to put cash in the coffers, instill confidence, and straighten out the balance sheet. Investor Team B would love to buy that pile of securities because there’s a real chance that they could make at least 50 cents on the dollar, but they’re not willing to pay the price he really wants. But they’re willing to make a contingency deal to pay 22 cents now and more based on the value of the securities in three years. Let’s say that the deal says, at the top end, that if the securities hit 50 cents or more, the investors pay 15 cents back to the bank. That gives the bank an additional income stream farther down the road plus it means that the securities basically sold for 37 cents. Not too shabby. Meanwhile, the investors are making at least a 13 cent profit or more if the value goes higher.

The numbers here are purely hypothetical, so don’t get too wrapped up in them. The thing to remember here is that there are options. The upshot is that the bank gets a cash infusion and gets the bad securities off its balance sheet. It’s still taking a bit of a gamble, but it’s a much smaller gamble than holding the bad debts and risking an immediate insolvency. The bonus is that the deal sends a signal to the bank’s customers that it’s taking real action which boosts confidence. If the government really, really wants to get involved, it can bring the SEC in to monitor these deals to make sure everything’s on the up and up.

Unfortunately, I don’t see such deals in the immediate future because the Federal government is still throwing out mixed signals about its involvement in this situation. It seems to me that the answer lies in our reminding banks that they still have things they can do and that we’re waiting for them to show some responsibility instead of waiting on the Federal government to use our tax money to let them off the hook.