Thursday, April 15, 2010

Last week, the Senate Banking Committee approved Sen. Christopher J.

Dodd’s financial reform bill on a party-line vote, moving the bill to the full Senate. Without a doubt, the most important question about the bill is whether it will end massive Wall Street bailouts. Republicans such as Sen. Richard C. Shelby of Alabama want to change the bill to guarantee that it really does end “too big to fail.” That’s just what he and his colleagues should be doing:Bank of America, Chase, Citigroup and Wells Fargo - the four largest bank holding companies in America - required massive government aid in late 2008. They barely survived into 2009. Now, somehow, these banks have reported upbeat results in the fourth quarter of 2009 - a shocking turnaround. Or was it?

Can these bank forecasts possibly be accurate, or have the banks hired Bernie Madoff to perform their forecasts? Sadly, it looks as if Bernie is hard at work, predicting an unrealistically bright future for these banks.

If we’re right, some of our biggest banks will be asking U.S. taxpayers for yet another bailout in the near future.

Consider, for example, Wells Fargo, which reported that its bad loans increased at an annualized rate of more than 70 percent during the fourth quarter, with bad commercial-mortgage loans increasing at a 160 percent annualized rate.

Not a very comforting statistic.

Looking deeper into the data provides even less comfort: One of us (Rebel Cole) with experience in measuring bank health for both the Federal Reserve Board and the International Monetary Fund ran a credit-risk stress test on Bank of America, CitiBank, JP Morgan and Wells Fargo. This was a rigorous test similar to those used by the International Monetary Fund, quite different from the sham stress tests run by U.S. banking regulators last year. Also, the new test took into account some economic facts that U.S. regulators didn’t know about last year: 9.7 percent unemployment rate, the more than 10 million discouraged and underemployed workers, the 15 percent combined delinquency and foreclosure rates on residential mortgages and the continuing deterioration in the commercial real estate market.

Together, these four banks hold $408 billion in tangible common equity and an additional $129 billion in allowances for loan losses. In their loan portfolios, they hold $445 billion in home-equity loans, $136 billion in pay-option adjustable rate mortgages and $44 billion in construction loans on which I estimate mark-to-market loss rates at 50 percent, $628 billion in residential mortgages, $238 billion in commercial real estate loans, $255 billion in consumer credit card loans and $351 billion in other consumer loans on which I estimate mark-to-market loss rates at 15 percent. Other loans total to $861 billion, for which I set aside 1 percent for general reserves, or $9 billion.

Estimated writedowns total $542 billion as compared with $537 billion in tangible common equity plus reserves for loan losses. Certainly, these assumed loss rates are open to discussion, but most knowledgeable real estate and banking analysts would agree that they are in the ballpark, given current economic conditions in the real estate and consumer sectors of the economy.

If we’re right about these losses, three of the four biggest banks have such bad loan portfolios that they would be deemed insolvent under mark-to-market accounting rules. Only Citi would be marginally solvent, but it has serious problems outside of its loans portfolio that drag it into insolvency as well. One can safely predict that these four megabanks, as well as most other lenders, will lose much, much more on mortgage-related loans than rosy-eyed regulators or the banks themselves are publicly acknowledging.

After looking at these numbers, one naturally asks, “Why did these banks repay the tens of billion of dollars in Troubled Asset Relief Program (TARP) funds invested by the U.S. taxpayer when they are in such horrendous financial condition?” One logical answer is that their management teams wanted to free themselves from the oversight of the government’s “pay czar” and other forms of government interference in their business. Another is that they wanted to escape, at least temporarily, from the stigma associated with taking the TARP investment.

But it doesn’t have to be that way: Instead, Uncle Sam can turn them away next time they come, hat in hand, asking for a bailout. Next time, we can tell these banks to bail themselves out. How? By forcing the bondholders of these banks to become the new shareholders: Each of these banks owes $100 billion or more to bondholders - bonds uninsured by the FDIC or the government, bonds that represent real investments in these megabanks.

If these were normal times, businesses with balance sheets as crippled as those of Bank of America, Wells Fargo or the rest would go to a bankruptcy judge, and the judge would take years deciding which bonds would be converted to voting shares, which would be repaid at 60 cents on the dollar and which would be repaid dollar for dollar. In the end, the business would continue - and just as bankrupt airlines keep flying planes and just as the bankrupt Six Flags keeps running roller coasters, so would these bankrupt banks keep most all of their branches open, cashing checks, taking deposits and making loans.

But these aren’t normal times, and these megabanks aren’t normal financial institutions. We’ve been told relentlessly over the past two years that these banks are “too big to fail,” that the government must buy shares in them when a crisis hits. But instead, Congress can force bondholders to become the new shareholders, a bankruptcy procedure known as a debt-to-equity conversion. With just minor changes in current law, this can be done in a matter of days.

When bank debt is converted to bank equity, people who have already freely chosen to invest in the banks can face the consequences of their decisions, and these new shareholders will have every incentive to turn a profit. In fact, turning a profit will be easier after the debt-to-equity conversion: Once hundreds of billions of dollars of big-bank bonds are converted to shares, interest and principal payments at these banks will plummet by tens of billions of dollars per year. With less money going out the door, these banks will find it easier to get free-market financing and won’t need to rely on government bailouts.

The next wave of bank bailouts is surely coming - there are just too many bad loans already on the books and too many unemployed workers who won’t repay their loans. Only one question remains: Who will pay for the next big bank bailout - you and me or bank bondholders?

Garett Jones is professor for the study of capitalism at George Mason University’s Mercatus Center, and Rebel A. Cole is associate professor of real estate and finance at DePaul University.

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