What is the Plan? A Discussion with Bill Dunkelberg
and David Kotok
Interview
Location: New York
Author: IRA Staff
Date: Monday, March 9, 2009
"I don't want to nationalize them, I think we need to close them... Close
them down, get them out of business. If they're dead, they ought to be
buried... We bury the small banks; we've got to bury some big ones and send
a strong message to the market. And I believe that people will start
investing [again] in banks."
Senator Richard Shelby (R-AL)
"This Week"
ABC News
In the wake of the decision last week by the FDIC to raise deposit insurance
premiums dramatically and market rumors regarding the possible resolution of
a large bank, over the weekend two leading Republican members of Senate
called for the government to take strong action to resolve insolvent mega
institutions once and for all. To better understand the perspective of the
smaller banks and the bond holders in this equation as the markets seemingly
head toward a decision point in New York, we turn to two friends and fishing
companions, David Kotok of Cumberland Advisers and Bill Dunkelberg, Chairman
of Liberty Bell Bank of Cherry Hill, NJ, and also Chief Economist of the
National Federation of Independent Business (NFIB).
The IRA: David, we have spoken a couple of times about the decision by the
FDIC to increase insurance premiums and the larger issue of how to fund the
bank resolution process now that the numbers are clearly too big for the
industry to absorb alone. Most people don't know that the banking industry
stands in front of the taxpayer in terms of absorbing losses to the FDIC due
to bank resolutions. But the negative macro wave washing over the global
economy is too big and will overwhelm private banking industry capital
globally, which is why the markets are panicked. We need a responsible adult
to stand up and tell us "what is the plan." Any ideas?
Kotok: There is a big issue here in terms of idiosyncratic risk analysis,
which is something we lived with for decades, and systemic risk, which we've
lived with since the Lehman Brothers failure and also the Washington Mutual
failures. These are cases where bondholders took large losses. Equally or
even more importantly, counterparties were in turmoil for weeks or more.
The IRA: We think the US Trustee, the DTCC and ISDA did a great job, but we
concede the cost is horrific. You mentioned that you've been arguing about
the systemic risk issue with people who do not want to see the world through
that lens. Here at IRA, we take the position that systemic risk starts with
the particular and is thus, at the aggregate or "systemic" level, a mostly
political concept. It's hard to measure, for one thing, like arguing about
"liquidity risk," but lay out your thesis.
Kotok: Chris we differ. We think that systemic risk is real and requires
serious consideration in times like these. Let me try to explain. The
idiosyncratic model is the traditional mechanism, the way we and generations
of analysts analyzed a structure or a company or a municipality or a sector.
We make determinations about risk and reward on a unique and case-by-case
basis. The process is that we measure, we estimate, we make determinations
in an idiosyncratic way, one element at a time. Lehman was the seminal event
of this generation. All the rules changed with the failure of a Federal
Reserve primary dealer, the ensuing meltdown in terms of counterparties, the
shock to the system as a whole, and the run-up to it. The world morphed into
systemic risk: it was no longer about Lehman, the problem became the entire
financial system.
The IRA: Yes. But was not that shock, that surprise due primarily to the
inconsistency of policy decisions taken by officials at the Fed and
Treasury? They saved Bear's creditors 100% and gave the equity $10 per
share, but then allowed the markets to believe, wrongly, that Lehman too
would be saved. As it turns out, noboby could buy it.
Kotok: It may be convenient to personalize to them. You and I have done that
along with others. But it is a waste of time now. The real focus must be on
the sequence with the primary dealers. That is how we can understand the
transition from idiosyncratic analysis to systemic risk analytics.
Countrywide as a primary dealer was absorbed into Bank of America, another
primary dealer. Result: shareholders suffered losses, that's idiosyncratic
risk biting a stock investor but the system was preserved because there was
no debt nor counterparty failure by a primary dealer. This was repeated when
Bear Stearns was preserved as a primary dealer and merged into JPMorgan
Chase (NYSE:JPM).
The IRA: Yes, there was no failure of the counterparty exposures
particularly. As we like to constantly remind, the counterparty exposures of
the bank subsidiary of a holding company are senior to the debt holders of
the parent.
Kotok: Precisely, the counterparty exposures are preserved, the shareholders
get wiped out in the case of Countrywide and get a damaging haircut in Bear,
but the debt markets and the derivatives markets don't get shocked; hence,
the counterparty structure does not fail and the system continues to
function albeit with a rising risk premium creeping into the pricing.
The IRA: But don't the bond holders and counterparties of the money centers
and the GSEs deserve to take a loss? We watch creditors of small banking
holding companies getting shot every week, but somehow this ill-defined
concept called systemic risk gives the creditors of the biggest, ugliest
banks a free pass? Something does not compute here David. The community
bankers are going to be seeking the overthrow of the US government by June
if something does not give. Do you know, for example, that the State of
Washington just assessed a special premium on all banks because a pooled
state money market fund took a loss in an FDIC resolution? We cannot
continue to stick the cost of this mess to the low risk, small banks and
leave the large bank creditors whole, can we?
Kotok: Whether the creditors of the larger banks deserve to fail is a
question we can debate for generations, but the reality is that with
Countywide to BAC, with Bear to JPM, we did not witness a failure by a
primary dealer and we were still in the idiosyncratic mode. Look at IndyMac.
It failed as a $32 billion bank that you wrote about last year. Several
billion in deposits were not covered, but it was viewed as a bank failure
and thus we were still operating in the idiosyncratic mode. But with Lehman
Brothers, the unthinkable happened. At least one rating agency still had
them at a "AA" corporate rating.
The IRA: The CDS was trading 700 over the curve plus upfront the day before
Lehman failed, according to Bloomberg. Yet more evidence of the huge
psychological risk pricing head fake the Fed and Treasury's decision to fail
Lehman represented to the market. Spreads did not even blow out at the end
of the day.
Kotok: Spreads are forward looking and are attempting to adjust rapidly to
risk. But idiosyncratic risk is different from an event in which you fail
and you trigger systemic risk. Your pre-failure CDS pricing description just
proved it. Lehman triggered systemic risk and we have been living with it
ever since.
The IRA: Agreed, but could you not say too that the tangible factor we can
identify, that fueled the contagion, was the surprise, not the resolution of
Lehman itself? As we have said before, had Jimmy Cayne been led out of
Bear's HQ in handcuffs several months before, carried live on CNBC, and the
Bear equity holders were wiped out in a Fed-managed merger with JPM, the
markets would not have been surprised and the dealer would have been
conserved. But we regress. So what now?
Kotok: If we apply solutions in a systemic risk concept they must be very
broad and consistent. For example, the Fed's Term Auction Facility (TAF),
now that is had grown to a sufficient size, has been successful in shrinking
credit spreads. The commercial paper facility has likewise done the job in
that sector. The international TAF has started to narrow the LIBOR spreads.
When you think in those systemic, macro terms, there are tools and they can
help, not all of them, not quickly, but they can help. It is important that
they be applied in systemic terms. When the TAF was started it was small and
way oversubscribed. The Fed was timid and took the size up slowly. Finally
they grasped the need to think in systemic terms. But now we are in a
situation where some of the tools we use for resolving banking problems for
the largest banks are still idiosyncratic. And these tools do not recognize
the systemic nature of this global financial crisis.
The IRA: Fair enough. As we said before, the industry and the FDIC cannot
shoulder the load. And we do need a broad plan, a rule, that is consistent
and that people can get easily to turn around confidence. How does it go?
Kotok: That is the way it looks to me. In that context, here we are with a
growing conflict between the big banks and the community banks. We punish
one side while bailing out the other. This is another example of
idiosyncratic thinking. We bailout of General Motors (NYSE:GM) and GMAC,
making them able to compete against Ford (NYSE:F) who is not subsidized. As
I said: this is a transfer from the strong to the weak. GM gets subsidy,
changes its marketing and undercuts the stronger Ford. The government is
creating the next problem instead of trying to avoid it. The government is
acting in an idiosyncratic model and damaging the entire system by doing so.
The IRA: I think the short selling pressure on F, GM, General Electric (NYSE:GE)
and other names with financial exposure is more of a menace than
competition. So long as dealers particularly can write exposure with
substandard margins and without having to borrow the underlying stock to run
the position, then short pressure is unlimited. The shorts don't make
companies bad, but they drive questionable names into the dirt with
overwhelming leverage vs. shares outstanding, short interest or other
measures. On exchange short interest in meaningless in the age of credit
default swaps.
Kotok: Chris, what you described is an asymmetry with the short sellers.
They are able to take advantage of systemic risk because many agents,
including government, are still thinking in idiosyncratic terms which
permits the short to have a one way bet. Level that playing field and you
will add risk to short sellers. Reach asymmetry and short sellers will lose
their power.
The IRA: Agreed. When we see everybody playing with uniform margin and
collateral, we will get to that place you describe. Marty Mayer always said
that OTC derivatives are about shifting the risk to the dumbest guy in the
room. All our channel sources say that Sell Side banks in New York and
London stuffed AIG and the Euroland banks to a degree heretofore
unthinkable. Again, cash settlement derivative contracts multiply the risk
and make these losses possible. Don't you agree that the primary dealer
failure issue you describe is now even broader?
Kotok: Yes at this point it is no longer about dealer failure but about a
more broad based fear of default, of not getting paid as the Corrigan group
defined it. That is systemic risk. Sentiment indicators are showing 95%
bearish sentiment, as Jim Bianco's measurement work shows today. We have
terrorized an investor class. There is a pile of cash equal to the current
value of half the stock market now sitting in money market funds at zero
interest. That is an absurdity. It has never been that high.
The IRA: We agree on the problem. Bill what is your view of the market
situation and how the FDIC and the Obama Administration seem to be intent
upon confiscating the capital of the industry. We hear that the GA governor
and congressional delegation went to see Sheila and there's a line out the
door. The new FDIC premium will cost GA banks $400 million in assessments
but all the banks in the state earned $200 million in the period used for
the assessment calculation.
Dunkelberg: We have a number of asymmetries in the marketplace right now.
Bank of America only finances half of its assets with deposits. The other
half BAC finances from the markets with debt. There is no tax, no FDIC
premium on bank holding company debt, but there is clearly more risk there.
So these large banks are out there taking unreasonable risks and they are
not even going to contribute their fair share to the resolution on a dollar
of assets basis. The huge reduction in the prime rate is another disaster. A
third of our balance sheet is tied to prime so we and the other community
banks get screwed there too. Then the FDIC comes in and says you got to
reserve a lot more money for loan losses even if you don't have any bad
debts. And then they raise the insurance so it goes from seven cents to
fourteen cents per hundred of deposits, then sixteen cents. Then they say
that they want another twenty cents. For our bank, that is going to be a
horrendous number, far larger than we thought would be the case.
The IRA: It's even worse than that. Half of C's deposit's are foreign, which
are not insured or assessed for premiums, so really only one quarter of C's
liability structure is supporting the Deposit Insurance Fund. Is the FDIC
confiscating your capital or just income for the period via the new
assessments?
Dunkelberg: Well, the dynamics are such that they are confiscating small
bank capital. If you are an organic grower as a bank, you add to capital by
making money. If you take our income, then our balance sheet does not grow
and our share price falls. Raising capital becomes more difficult and
expensive as a result. Our returns are lower and the market can see this. So
a hike in the FDIC insurance premium has the effect of shrinking bank
balance sheets. Just the natural runoff of the portfolio will cause you to
shrink if you are not making new loans. It becomes harder to raise private
capital, so this situation is a really bad deal for the smaller banks that
did the right thing and are now paying the full boat to bail out the money
centers. The net effect will be a crippling blow to the small business
sector, which is largely ignored in the stimulus package, accounts for 50%
of private GDP and private employment, and depends critically on community
banks. The small banks are getting hammered and it will trickle down to the
Main Street economy that is dominated by small business.
The IRA: David, what principles do you want to see included in a systemic
rule? Can we come up with a plan that could possibly move the ball forward
so that we could deal with some of the idiosyncratic situations starting
with C?
Kotok: Well, the first rule should be for the industrial nations to stand
behind bank deposits in their respective banking systems, at least
temporarily, and say that they are good. We stop the games with respect to
the most senior liabilities in a bank, liabilities that are senior to the
debt. Let's just take this off the table. We basically guarantee anybody who
puts a dollar in a bank. You have a situation where you are dealing with
systemic risk. You have behaviors engaged in by depositors, for example, to
place funds for safety, not for any other purpose, at times for little or no
return.
The IRA: So why don't you call our friends at Promontory Interfinancial
Network, who are users of The IRA Bank Monitor? They will help you place
deposits for your clients in good banks and that pay competitive rates of
return. And deposits placed by their network are viewed as "core" by
regulators, so users can feel satisfied that they are part of the solution
and not contributing to bank industry stress.
Kotok: But nobody believes the "A" or "A+" ratings. Chris, this is true even
if it is yours. That's what this is about. The systemic crisis is about all
of the idiosyncratic rules being placed into doubt. Bill, do you differ?
Dunkelberg: Savers and investors don't believe it is safe at the moment.
Companies and institutions that we thought were totally safe are now in
doubt, so the market is about the return of capital instead of return on
capital. We see that at the street level in South Jersey today.
The IRA: OK, so let's take as a given enhanced backing for deposits. How
about the bonds? If the G-10 nations agree on "national treatment" to clean
up the mess and the larger nations agree to help their smaller neighbors,
what rule do we take in US regarding the bond holders of insolvent banks? If
we agree that the equity is wiped in the case of C, for example, and the
half of the consolidated balance sheet in deposits is off the table, what
about the $600 billion in debt?
Kotok: Well, I have a bias here. I represent bond holders and my clients are
bond holders. They have a promise that is different from the promise made to
equity holders. We have defaults, of course, but we don't encourage
defaults. I think there is a distinction between the debt side of the
balance sheet and the equity side of the balance sheet and as much as
possible I don't want to see the debt side of the balance sheet eroded. That
gets us back to systemic risk.
The IRA: The Corrigan group distinguishes between market disruptions and
systemic events, with the latter including the quality of surprise a la
Lehman, WaMu. Bond holders are represented by agents. These professionals
have watched as regulators encouraged the growth of OTC derivatives and
structured assets. These banks publish VaR numbers in their EDGAR filings
that disclose above average aggregate risk. Is the bogey man of systemic
risk so dreadful that we subsidize the asset allocation choices of
professional advisors but put the local bond holder of a community bank to
the sword? Are you are telling me to "Kill Bill" Dunkelberg and other small
bankers, to borrow the film title, but not C's bond holders?
Dunkelberg: Let me make two points on that before David. First, we should
have a progressive tax on deposits or even the entire liability structure of
banks based on risk. This way everybody at the party is contributing to the
pool and those incorporating more risk to grow will pay more. The idea that
only one quarter of C's liabilities pay into the DIP yet the bank's maximum
probable loss could be a multiple of capital, according to your model at
IRA, raises basic issues of fairness. The bigger these banks are the harder
they are to manage and understand. The tax ought to be applied to the
liability side of the entire institution across the board and then we start
to have equity in the industry again. The growth of non-deposit funding for
banks and securitizations is the untold story of the current mess.
Kotok: OK, so we now have these FDIC bonds. We have a model for an
alternative form of credit enhancement going back to the Muni model in a
way. With the onset of systemic risk we don't have any reliable credit
enhancers any more. Even the ones that are not in trouble are not trusted
anyway. If we go back to Lombard Street and Walter Bagehot, the modern form
should be a penalty rate which is this: we'll do FDIC insured bonds with a
cost attached, which is that a premium to the DIF must be built into the
cost of the bonds. This means that this FDIC bond vehicle will be a way for
any bank to raise new funds on a term basis and also increase the resources
available to fund resolutions by the FDIC.
The IRA: I think we are all coming to the same place here, but we want to
bring the discussion back to the bigger issue of funding resolutions,
because the industry cannot shoulder the burden IOHO. Even if the money
centers had been paying a full tax on their liabilities, which would have
far exceeded the funding goals as set during the past few years, the
prospective losses would still dwarf the resources available. Specifically,
what is the systemic rule for insolvent money centers that need to be
resolved quickly but where we need to be creative about how we deal with
bond holders?
Kotok: It sounds to me like what we are saying is level the playing field on
FDIC enhancement and assess universally. But what is the quid pro quo for
bond holders to go along, to play advocate for a minute? What do I take to
my constituents? As a practical matter, if we are going to say that the
deposits are safe globally, then there must be a cost otherwise you don't
get the safety.
The IRA: But, again, we are asking more basically about C and perhaps
several other money centers and even industrials like GE that may face a
restructuring. Is there a formula whereby we could offer bond holders a deal
to put part of their money down lower into the capital structure as new
equity with warrants to provide upside leverage for the risk? Perhaps Uncle
Sam matches the new bond holder equity in C to ensure no loss to the
FDIC-backed bonds. We take the other part of the bond holders principal and
roll into an FDIC insured security, say 3, 5, and 7 year maturities? If you
think of it for C, you increase TCE at the bank level by $300 billion and
stabilize the rest of the liability side by locking the bond holders in for
a term. We give them certainty regarding 50% of their principal. With other
banks, the haircut to bond holders may be smaller or none at all. They may
just roll their securities into FDIC insured paper and keep on going.
Kotok: Yes, again let's use the Muni model. Bondholders can take their bonds
to the FDIC and pay a premium for the credit enhancement. The FDIC gets the
revenue for its fund. The bondholder gets the guarantee and accepts a lower
yield. The system starts to clear as uncertainty is replaced with clarity.
We already see signs of it when Morgan Stanley (NYSE:MS) gets to issue FDIC
bonds and the non-FDIC debt spreads narrow. Why shouldn't the bondholder pay
for the safety? Either the FDIC is a guarantor or it is not. If yes, then
its role should be covering liability funding of various types with it s
guarantee and, hence, it should get paid by all types of claimants that
benefit from that guarantee. It is outrageous that an FDIC bond doesn't have
a premium paid to the DIF at a market based price. Here is a sample of an
idiosyncratic solution applied in a systemic risk framework; it amounts to a
transfer payment. Get the policy to the broad and macro level; diminish
systemic risk. That is how you extend a systemic risk solution and return
the system to functionality.
The IRA: Bill, do you think that the equal playing field would be a natural
limiter of size in the US banking market? If all banks had to pay a tax on
liabilities and their capital requirements were risk weighted, being too big
would be a death sentence, don't you think? Again, to cite Mayer, there are
no economies of scale in banking - except in multiplying risk via OTC
structures!
Dunkelberg. I was hoping that would be an outcome of the incentives in a
leveled playing field. We have confirmed that too big to manage and too big
too fail is very expensive. We need to discourage these maniacally big,
ego-based banking structures that nobody understands and we can't run
correctly.
The IRA: Well, to extend the concept, would you almost require bank
securitizations to pay into the kitty as well? We now know that there is no
good sale so maybe we need to evolve the thinking of a level load premium
for bank liabilities to include securitizations, which would have to be made
more transparent and standardized as the quid pro quo.
Kotok: But you are not going to extend the federal guarantee to the private
label securitizations!
The IRA: Well, bank securitizations are about funding. I think if Rosner or
Joe Mason were on the line they would at least concede that a bank
securitization has to be part of the risk profile of the institution because
of lingering control and liability issues. In terms of market share
analysis, would not the total footprint of the bank be the real measure? C
and the busted SIVs are certainly one bucket of risk, are they not?
Dunkelberg: Well then they must have all of that stuff on the balance sheet.
The banks will have to bring the risk back onto the balance sheet and
account for it as we have discussed. To the extent that a securitization
leaves a tail of risk at the bank, it must be accounted for. Covered bonds
or FDIC enhanced, it should all be on balance sheet and just end the issue.
Kotok: Do we need the Congress here? If we need legislation that is a big
issue. If we want universal enhancement and a level playing field as our
systemic rule, this needs to be done quickly. Are the community bankers
strong enough to advance this idea in the Congress? Bill?
Dunkelberg: I don't know. They are certainly trying. We have already gotten
a story from the FDIC that maybe they can cut the twenty cents to just ten
if we get a bigger line from the Treasury. I am not sure that Congress has
to act on that. We could reduce the tax on the banks in the name of
supporting growth and the economy. We need to treat banks as being important
and special to the economy - as they are - and not implement policies that
are going to further contract credit. The FDIC is attacking its
constituents, not helping them get their job done. These policies will hurt
Americans more, not help.
The IRA: Correct. There is no point in having the TARP banks recycle
government money back to Treasury through higher FDIC premiums, is there?
Can we outline some summary points?
Kotok: The key is to address the systemic so we can then address the
idiosyncratic risk. That is the key. If we then start to resolve some of
these situations, then the markets will react positively. Certainty is what
is missing. A plan is what is missing. The Obama Administration is
floundering. There seems to be no plan, no design. This is scaring people.
The key to any workable plant is to have the systemic elements under control
before we try to deal with particular situations. So what points shall we
make?
The IRA: How about this as the four action items for President Obama:
1) President Obama, flanked by Fed Chairman Ben Bernanke and FDIC Chairman
Sheila Bair, to lead G-10 to announce a temporary sovereign guarantee of all
bank deposits, foreign and domestic, and agree to national treatment of bank
bond holders and OTC counterparties on a case-by-case basis, using actual
realized and probable losses as the decision point for resolution.
2) FDIC suspends all bank insurance premiums for 2009 and directs all
depositories to suspend dividends and retain capital to help stabilize the
aggregate capital of the industry and thereby the lending base. This would
be coupled with access to the Treasury and all the dollars we are pouring
into sick institutions in order to finance FDIC activities. Starting in
2010, FDIC insurance premiums are tied to all bank liabilities, not just
deposits, and increase with bank size and complexity. Need legislation for
this.
3) Operating under open bank assistance, the equity holders of C are wiped
out. The Fed, FDIC and OCC begin to make board changes and the Treasury
invites bond holders of C to form a creditor committee. The new C board
recruits new management that knows how to do basic banking. C creditors and
FDIC negotiate a 50/50 debt for equity and FDIC insured bond swap.
Resolution remains the ultimate threat by FDIC, so the creditors will
probably play ball after some yowling. Once C is in hand, Treasury and Fed
begin the resolution of AIG and managed "blow up" of the CDS market as now
called for by Myron Scholes, among others, and then accelerate active stress
assessment of remaining money centers.
4) Treasury then begins to bid selectively for toxic securitizations,
contributes these assets to the DIP. FDIC uses its receivership powers to
dissolve the DE trusts that are the issuers of the toxic waste, gain control
over the underlying loans, and sell this collateral back into the market. As
the quid pro quo for the deposit insurance premium relief, the banking
industry must be ready to buy these loans from FDIC with financing from the
Fed and service/work out same. The community bankers get an asset they can
work and shelter from the immediate cost of the large bank cleanup. We help
homeowners without further government subsidy.
Kotok: You are heading in the correct direction. In my view a universal
guarantee of bank liabilities will stop the bleeding in the system. It must
have a clearly defined premium or cost. The shareholders are already wiped
out so they have little remaining to lose. The debt markets will pay a price
and obtain safety and certainty. The cost or premium can be high but must be
transparent. Transparency and clarity are key. Playing fields need to be
level and broad to avoid one class subsidizing another. We must get rid of
these transfer payments whether community banks subsidizing big banks or
Ford having to subsidize GM.
The IRA: Or the US taxpayer subsidizing the counterparties of AIG, as
Gretchen Morgenson
writes in the NY Times yesterday. Thanks gentlemen.
This
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