What’s The Endgame For The Big Banks?

U.S. officials are wary about taking the most extreme step — nationalizing banks altogether…

But as the market value of many firms evaporates, they may be left with no other alternatives to raise cash.  From a political standpoint, there’s not much support for protecting shareholders of banks when the government is pouring billions of dollars into the institutions and in some cases guaranteeing their debt.

– “Banks Hit By Nationalization Fears” (subscription required), The Wall Street Journal, January 21, A1

I’ve found that credit losses could peak at a level of $3.6 billion for US institutions, half of them by banks and broker dealers.  If that’s true, it means the US banking system is effectively insolvent because it starts with a capital of $1.4 trillion.  This is a systemic banking crisis.

The problems of Citi, Bank of America and others suggest the system is bankrupt.  In Europe, it’s the same thing.

– Nouriel Roubini, NYU Economist, on Tuesday at a conference in Dubai

The bottom line is that, given declining assets and increasing liabilities, many – perhaps most – big banks are essentially insolvent and have been for a long time.

– Frank Partnoy, Professor of Law and Finance at the University of San Diego, “Prepare to bury the fatally wounded big banks”, Financial Times, January 18

[State Street’s announcement was a] blockbuster…. People had been seeing State Street a little differently, as a little safer.

– Kevin Kruszenski (subscription required), Director of Equity Trading, KeyBanc

I almost bought some big bank stocks late last week.  I calculated the number of shares I wanted to buy for all the individual accounts.  But I couldn’t pull the trigger.  The reason is that I just don’t have a good sense of if these banks equity have any intrinsic value and, second, what the political endgame is for them.

The news from Bank of America last Friday and then State Street yesterday on top of the continuing debacle at Citigroup has raised the issue of whether the endgame for the big banks might actually be nationalization.  That’s because, as Nouriel Roubini and Frank Portnoy argue, many of these big banks might actually be effectively insolvent.  That is, their liabilities are greater than their assets and therefore their equity has no value.

If that’s right, then private investors have no incentive to invest in these businesses – at least not in the common stock.  But because these banks need capital and their collapse would be catastrophic for the financial system, the government is likely going to keep propping them up and injecting capital into them.  The issue then becomes how they do this.

In today’s New York Times, Edmund Andrews does a good job of surveying the options for government bailouts:

(1) One option is to revert to the original Paulson plan of buying up the toxic assets on bank balance sheets that are leading to all these writedowns and destroying their capital.  The thorny issue, which is what stopped this plan from being put into effect, is how to value these assets.  If you value them at fair value, the banks get money but they have to take such massive writedowns that it could crush them.  If you value them too high, the government is essentially subsidizing the banks.  This is unpopular from a political perspective and is a socialization of private loss.  The new “good bank, bad bank” idea seems to be an iteration of this option.

(2) Another option is to backstop losses on asset pools, which is what has recently been done with Citi and B of A.  This plan has a number of virtues including being cheap for both sides upfront.  The bank has to pay a moderate fee to have a huge pool of assets backstop and the government doesn’t have to put up any money right away.  Ultimately, though, this puts the government on the line for a huge amount of losses that they will likely have to make good to the banks.  Again, this is a transfer of wealth from the taxpayers to private companies.

(3) A third option is to just straight up nationalize the big banks that need it: “When we did things like this, we took the banks over.  This is a huge, undeserved gift to the present shareholders,” William Seidman, former FDIC Chair, told the New York times.  The problem is that if you do this, you wipe out the equity for these banks and that will terrify other bank stockholders.  They will sell their shares, resulting in a stock market crash.  Ultimately, there will be no private capital for the financial system and the government will have to get even more heavily involved.

In my estimation, nationalization is highly unlikely.  Not because the politicians give a crap about shareholders but because the result would likely be a stock market crash as financial stocks got torched across the board.  That would look really bad and politicians would likely want to avoid that outcome.

Therefore, the most likely outcome is subsidization either via asset purchases or asset guarantees.  If this is correct, the big banks will be a recipient of a massive windfall, they will survive, their equity will have value, and this could be a good buying opportunity.  (For an excellent account of this point of view, also see “Banks May Be a Buy – If You Can Stand the Risk” (subscription required), James Stewart, The Wall Street Journal, January 21).

Disclosure: Top Gun has no position in Citigroup (C) or Bank of America (BAC) shares.