Fixing the Banks

Timothy Geithner’s policy to fix the banks is destroying private equity and simply inadequate.

Outstanding mortgages total $11 trillion plus. Half were financed through Fannie Mae and other government banks. The balance were written by commercial banks, held as straight mortgages or bundled into collateralized-debt-obligations (CDOs) held by banks and fixed-income investors.

As housing prices fall, mortgage losses mount and will likely reach another $1 trillion. Banks take charges against capital to cover losses and could deplete capital and become insolvent. Through TARP, Treasury is boosting bank capital by buying dividend paying preferred shares, and is financing these purchases by selling $750 billion in bonds.

As housing prices fall, loan defaults and losses rise, and the CDOs held by banks fall in value. Housing prices are down by 27 percent since August 2006, and could easily fall another 15 or 25 percent.

About $400 billion in TARP funds are committed, and with housing prices dropping faster than Galileo’s rock, the remaining $350 billion will not be enough.

The Treasury is performing stress tests on the 19 largest banks to determine whether their common share equity could cover prospective losses. Citigroup and others will come up short if Treasury is honest about how much housing prices could fall.

Bankers usually include preferred shares and other assets when measuring capital adequacy to cover prospective losses, and by those measures, Citigroup and others remain well capitalized for now.

Treasury has offered banks the option of converting its preferred shares to common stock, eliminating the dividend on those shares but diluting private shareholder equity.

At Citigroup, Treasury is offering to convert $25 billion of preferred shares to common stock, if Citigroup suspends dividends to most private preferred shareholders and significant numbers convert to common shares.

Choosing between preferred shares paying nothing and high risk common shares worth just a bit, most will likely take the plunge.

These tactics essentially confiscate private equity—a government taking.

Washington’s stress tests and sacking of Citigroup motivate general fear among investors and are driving down most bank common stock prices. Coupled with the need for more government funds as housing prices fall, these make the government the inevitable controlling shareholder of the largest banks.

Comrade Stalin was not as stealth.

No solution to preserve private banking can be found without halting the freefall in housing prices. That will require an aggregator or bad bank to purchase about $2 trillion in mortgage-backed securities from banks.

Leaving alone mortgages that will be repaid, reworking those that could be repaid with some adjustments in principal and interest, and foreclosing on the rest, the aggregator banks could fix the number of foreclosures and limit the fall in housing prices. As many mortgages would be saved, and the aggregator bank, like the Savings and Loan Crisis Resolution Trust, would likely earn a profit. Hence, it could be financed with TARP funds and private investments.

The banks, though not free of other problems, would be strong enough to raise new capital, buy back the government’s preferred shares, and contribute to economic recovery.

Secretary Geithner has other plans whose motivations only the Gods above Mount Olympus can divine.

PETER MORICI is a professor at the University of Maryland Smith School of Business

PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.