I had the chance to sit down with one of the former VPs of Citigroup last night and talk about the bail-out. I must admit that I had almost no opinion on the bailout before our conversation, because there was far too much information floating around to form a cogent opinion. Now after my conversation, I understand the role of banks in society much better, and consequently why the bailout — at least in some form — must happen.

In our society, we ask banks to take a special role in our economy. They provide capital (money) for a wide variety of projects, such as granting business and farm loans, giving mortgages, and helping companies manage their payroll. They get paid for these activities in two ways: direct fees, such as the $35 fee they charge if you bounce a check; and interest. The amount of interest they charge depends upon the riskiness of the project. For low-risk projects, such as helping GE with short-term borrowing, they will charge a low rate of interest. For riskier projects, such as helping a “Amalgamated Widgets” build up its business, they will charge a correspondingly higher rate of interest. The interest is supposed to compensate for the risk.

Banks are therefore always taking on risk. We ask them to do this, and usually they are very good at assessing the risks of any individual project. When they are right, the banks make a good living, indeed, an excellent one. But, it is risky. And what’s worse, all the banks tend to have similar risks. So, if one of them is in trouble, it is likely that many of them are in similar straights.

Furthermore, banks are also very highly regulated. They must be, because if one fails the consequences can be profound. Business will find they cannot borrow money; depositors cannot get their money back, and so on. Our economy relies on the ability of the regulators and the banks themselves to monitor their risks and avoid the possibilities of a catastrophe.

As an aside, banks are highly profitable because they loan out more money than they actually have on hand. For example, a bank with $1 billion in deposits might have loans of as much as $12 billion outstanding. In good times, when most borrowers are repaying their loans, the bank makes 12 times as much money as you might naïvely have estimated. Of course, banks know that some borrowers will not repay the money they’ve borrowed, but usually that is a small fraction of the total number of borrowers. And anyway, the bank charges a higher interest rate for a riskier borrower, so they almost come out do fine.

In the past 14 to 18 months, the banks have entered a time of profound distress. The root cause is the collapse of the housing bubble in the US. And here’s where things get tricky.

• All the banks have similar risks, namely, they were all betting at least in part that housing prices would continue to rise, or maybe not fall too much. The banks assumed home owners wouldn’t default on their mortgages, or at most only a few would do so. Unfortunately, housing prices are down more than 15% from the peak and even more in Miami, Las Vegas, and LA. Several million homes are in default, and perhaps as many as 25% of all homes are “underwater,” meaning the value of their home is less than the amount of the mortgage.
• When a mortgage goes into default, the bank holding the mortgage takes the loss. Now, banks have tried to reduce their risk by packaging up huge batches of mortgages and selling off pieces of them to investors all throughout the world. The investors buy these securites because they offer a reasonable rate of interest and appear to be low risk. In retrospect, they aren’t low risk and the interest rates were far too low.
• As this wave of foreclosures hits, the banks (and other investors) have to reduce the value of these complicated securities.
• Unlike many other investors, banks are required to keep a certain amount of capital in reserve to offset losses and fund their business. The huge losses on the foreclosed mortgages wiped out this reserve at many banks, including Citigroup and UBS. A bank with insufficient capital MUST raise more immediately or close up shop. You might recall that earlier this year almost every bank raised capital by selling a piece of itself.
• But, these complex securities remain on their books. And continue to drop in value. And no one knows how many other non-performing loans the banks have tucked away on their balance sheet. Suddenly, no one wants to believe the values that banks give to these securities. When that happens, BOOM! Bear Stearns and Lehman Brothers go away. Again, that is because no one believes they have sufficient capital to continue in business, and that the as yet unrecognized losses will wipe them out.

So, now let’s look at the bailout itself. And to quote:

Key question to ask: SHOULD WE RESCUE THE BANKS?
Key answer: ABSO-FUCKING-LUTELY!!!!!!!!!!!!!

Reason: See above. We need the banks. It is a societal problem when banks go under. The banks are bigger than any one of us, indeed, than all of us. They are a crucial element of our economic structure, in someways, the key underpinning. Without them, all commerce stops.

So, let’s deal with this head on. The banks act as intermediaries between two sides of a deal, they move money (capital) around the world, and they are paid to manage risk. They allow other parts of the world to function by lessening our overall risks and smoothing the wheels of commerce. They are not like, say, Enron or WorldCom. If you go bankrupt, that is a personal tragedy. We should help you get back on your feet, and that is something people in other societies do. (We are much more cut-throat). But if a bank goes under, it is a social tragedy that affects every corner of the society. That is why we have FDIC insurance on your accounts, so that you are protected up to at least $100 thousand.

What is happening now is that because banks can no longer properly assess the risks of doing business with each other, so they’ve stopped lending. When that happens, everyone gets hit. And hit hard. Small business owners cant’ get money to run their business. And they need cash because they get paid on one time cycle, but have to pay bills on another one. They need cash from the bank to tide them over. The cash crunch is worst for fastgrowing firms because they have to buy lots of goods now and only get paid later. So, if they can’t get capital, they stop growing or go under. Jobs disappear, and it is the small, most productive firms which get hit first.

And to quote further:

We also know the consequences of letting the banks fail. We tried that experiment in 1929-31. How do you think it worked? Unless and until we find a replacement for banks, we need them to keep the world’s economy going. I might add that in more than 2,000 years of history, we have never found an adequate replacement for banks.

The key idea of the bailout to take the garbage off the banks’ balance sheets, give them money, and restart the game. No-one argues about the necessity for each step, the devil is in the details. The banks desperately need more capital and they need to staunch the bleeding. Buying the garbage off their balance sheet is a reasonable idea. The Treasury would absorb any further bleeding, the banks would have “clean” balance sheets and lots of newly minted dollar bills to lend. But how can we buy it? If we buy it at the price the banks have it marked on their balance sheet, then we are almost certainly overpaying. That’s because the banks are very reluctant to price this garbage at its true value.

An example: a fictitious Bank of the Banana Republic (BBR) originally paid $100 for some Assorted Stinky Garbage (ASG) bonds. These bonds have lost value, but since they aren’t actively traded, the bank assigns them a value of $80, which is $20 less than they paid for them. No-one believes that figure, it is an accounting fiction created by wonks in the finance department. Suppose the “true” value is $25, meaning the bank has really lost $75 on its ASG bonds, but only recognized $20 of that. If the Treasury buys the bonds at $25, then BBR will have to recognize another $55 of loss ($75-$20) and wipe out even more capital! But if the Treasury buys the bonds at $80, we are vastly overpaying, and there is no way we will ever get back any more than a small fraction of that number.

The proposed solution is to buy the bonds at $25 and give BBR another $55 of cash. In exchange, they give the Treasury a piece of their company equal to $55, i.e., we pay a fair price, they get their money, and the Treasury owns a chunk of them. If the ASG bonds go up in value, the Treasury will keep the profit. And if BBR stock goes up in value, the Treasury can cash out and take their profit, too.

Sounds simple, but is enormously complicated to run. And the Treasury will be left with somewhere between $400 billion and $1.5 trillion of stinky garbage they have to manage.

All the rest — limits on compensation, etc, is window dressing for the underlying problem.
That’s the short term fix. Longer term, we will almost certainly have to force banks to manage their risks more carefully. Risk managers will be assigned from the Treasury, and all new “deals” will probably have to be vetted by an independent team of risk managers.

Oh, and — there were supposed to be independent risk managers, namely the rating agencies such as Moody’s, S&P, and Fitch. They are allowed to see inside information on all the securities they rate. They use that information to assign “risk” ratings to bonds, like AAA, AA+, etc. AAA is the highest and means the bond has a less than 1% chance of defaulting in the next 10 years. But, the rating agencies weren’t truly independent, as they earned fees from the banks for providing the ratings. If the bank wanted a particular rating, and the rating agencies wouldn’t provide it, then the banks wouldn’t pay the fee. That is a bad business model and they should all go bust. They are a disgrace!

But, there is a wrinkle in all this bank stuff, and it has to do with the banks and the rating agencies. Banks have to set aside “capital” to cover the risk on a security. The riskier the security, the more money they have to set aside. The banks set aside money to guard against losses on securities they hold. The rating agencies determine the “riskiness” of any particular security. Very low risk securities need about 10% of the value set aside. Very risky securities need up to 100% of the value set aside. But, starting in October and November 2007, the rating agencies started to downgrade many securities from AAA (very low risk) to BBB (very high risk). Banks were forced to set aside tons of extra money as the securities got downgraded (rerated to a higher risk category). These moves have contributed to the massive losses.