Last week, the US treasury altered its bailout plan to resemble the ones being implemented across the Atlantic, but with subtle differences.
Under the new plan, instead of buying troubled assets from banks, the first $250 billion (Rs12.3 trillion) tranche of the Troubled Asset Relief Program will be used to buy preferred stock equivalent to between 1%?and?3%?of the risk-weighted assets of financial institutions.
The preferred shares will pay a 5% dividend for the first three years, and 9% thereafter. The treasury will also receive warrants equal to 15% of the value of the preferred shares. Nine large institutions have been selected to receive the first $125 billion.
Gone are the days for punitive capital injections—the preferred equity is clearly cheaper for banks than private capital currently would be. Also the inclination to wipe out existing shareholders—aka Fannie Mae, Freddie Mac and American International Group Inc.—isn’t there to encourage further private capital to grace the area. Also, the Federal Deposit Insurance Corporation is insuring all new unsecured bank debt for three years—all checking accounts and savings accounts up to $250,000, up from $100,000.
The apparent size of the recapitalization isn’t large— around 2% of gross domestic product—compared with either the European effort or past crises recapitalizations such as Sweden’s, but let’s not forget this capital injection is a whopping 25% of the banking industry’s tangible equity.
The difference between Europe and the US is an aversion in the latter to take large, controlling stakes, and the blanket guarantees in Europe and the UK on all bank debt. The US treasury until now seemed ideologically averse to taking equity stakes in banks. We believe the treasury’s hand was forced, not out of wanting to protect the competitiveness of US banks as the Europeans and the British pumped capital into their banks, but by the ever worsening credit market and the drumbeat of weak economic data.
The markets have cheered the plan—the London interbank offered rate spread has narrowed, US treasurys have sold off and equity markets globally have rallied—recognizing that this is a quicker fix than taking toxic assets off the banks’ balance sheets.
Capital adequacy was anyway not an issue—average tier I ratios were in excess of 8%, while the regulatory minimum is 6%. Most analysts, and even the International Monetary Fund, are estimating that US financial institutions will have to take $250 billion more in credit losses, implying we have just crossed the halfway mark. Capital raises have been adequate, roughly equalling credit losses.
We, however, reckon that future credit losses are going to surprise most to the upside. There is concern whether the banks that go for the capital injection will actually start lending the money. Many believe the capital might be spent in acquiring other banks on the cheap. But we think future credit losses will cause the banks to hoard the capital.
The future credit loss estimates are being worked off either far too rosy an economic outlook or a housing market outlook that does not worsen much from here. On the housing market, we will continue working off multi-decade excesses, which means further price erosion.
At the risk of digressing, some of these excesses are startling. The number of people per household has only gone down in the last 20 years, even as the size of the home has kept creeping up, inspiring the term McMansions! Over the last 15 years, the home ownership rate has gone up at least 15 percentage points, even as the homeowners’ equity has only gone down.?Median household income has grown by 18% in 30 years and in the same time, home prices have more than quadrupled. This housing market correction will see these excesses normalize to an extent.
Weak home prices combined with a severely weakening labour market will mean that especially second lien mortgages will go bad at a much faster rate than expected. Credit card balances tend to grow well into a recession as consumers seek the last resort to fund spending and are extremely susceptible to weakening credit. American Express’ charge-offs, by some calculations, have already exceeded 7%. If American Express, one of the most conservative credit card firms, can see such credit deterioration, losses for this area could eventually spike to low double digits. The commercial realty slowdown is also under way, with retail, office and residential vacancy rates rising. Credit losses from this area, too, are being underestimated.
All told, the after-tax credit losses are likely to be at least $400 billion, not $250 billion, which would imply that banks need almost $150 billion more just to keep their tier I ratios where they are currently.
Economic cycles, however painful, are the best cleansers of past excesses, which is just what we are going to see this time as well. Asset prices have to correct themselves and consumers have to start saving more, but a financial system that’s more sound as a result of these capital injections will eventually be a good backbone for a sounder recovery.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They will write every other Thursday.
Send your comments to firstname.lastname@example.org