Kotok introductory note: During the weekend, we participated in a colloquy with Bill Dunkelberg and Chris Whalen. Our purpose was to examine the banking crisis, the risk in banking liabilities (deposits and debt), and systemic cures. The full text of the interview follows.
What is the Plan? A Discussion With Bill Dunkelberg and David Kotok 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, nobody 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.
Questions? Comments? firstname.lastname@example.org
Christopher Whalen is the co-founder of Institutional Risk Analytics, the Los Angeles based publisher of bank risk ratings and provider of risk management tools and consulting services for auditors, regulators and financial professionals. He edits The Institutional Risk Analyst, a news report and commentary on developments in and around the global financial markets.
We thank Chris Whalen for organizing this colloquy.