Capital Losses
| Sun Nov. 23, 2008 11:39 AM PST
CAPITAL LOSSES.....This post is a couple of months old, but John Hempton says that our ongoing financial crisis is not a problem of bank capitalization:
Nobody I know calculates the total system losses plausibly above 2 trillion dollars....If I add the private equity disasters, GSE losses and things like car loans to [all the mortgage losses] I still can't get end credit losses above 1.5 trillion.
That is a vast amount of money — enough for instance to solve most of Africa's education and water problems. But in the context of the huge industry that is America's finance system it is just not that big.
So far financial institutions have raised (well) above 400 billion in fresh capital – its probably nearing 500 billion. The Federal Government has absorbed losses through the takeover of Fannie, Freddie, contingent liabilities on Wachovia, AIG and others of maybe 50-200 billion (lets use the low number).
The pre-tax, pre-provision operating profit of S&P financials used to be above 400 billion and is probably still above 350 billion. Two years of that and there is another 700 billion.
The banks had some capital to start with — in some cases excess capital against regulatory standards.
All up — we have almost certainly raised or passed to the government — or within two years will have earned — something approaching 1.5 trillion.
There is no capital shortage. Get used to it.
Mark Thoma says of this, "I don't agree with his diagnosis of the fundamental problem," but doesn't explain further. I myself don't have the smarts to either agree or disagree. Still, Hempton's observation here is one that's been bugging me for a while. It's true that in this particular post he doesn't seem to be taking account of forced selling and systemic deleveraging, which would be causing problems even if overall capitalization were adequate. What's more, even if overall capitalization were OK, it might still be the case that the capitalization of the big money center banks is inadequate, and those banks occupy a special place in our financial system.
So I'm not sure. But I'd still like to have some idea — even a vague, provisional idea — of just what the experts think the capital position of the American banking system is right now. How big are the losses so far? How much uncertainty is there in these estimates? Why? Is it because banks don't provide the needed information, even to regulators, or because it's fundamentally difficult to calculate regardless? As a layman, it's been pretty eye opening over the past few months to realize just how little even the experts seem to know about what's really going on and what the scope of our current problems are, but certainly a basic understanding of the scale of banking system losses is an absolute minimum piece of information we need before we can figure out what to do next. Isn't it?
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Comments
I don't think anyone knows what the central problem is and I am beginning to tune out blowhards who claim to do.
Could it be that the main issue is just a lot of very baaad chickens coming home to roost all at the same time? We, along with the rest of the non-primitive world, have been engaging in a lot of activity that runs the gamut from careless to shady to completely horrible and fate has decreed that now is time to pay the various bills.
Further, the causality argument may be just wasting precious time. I think Obama is beginning to settle on the right approach ? carpet bombing with stimulus. 'Big and bold' and even if it is overdone the consequences will be better than if we chose a measured approach that is tailor made, but for the wrong problem and late at that.
I don't think anyone knows what the central problem is and I am beginning to tune out blowhards who claim to do.
Could it be that the main issue is just a lot of very baaad chickens coming home to roost all at the same time? We, along with the rest of the non-primitive world, have been engaging in a lot of activity that runs the gamut from careless to shady to completely horrible and fate has decreed that now is time to pay the various bills.
Further, the causality argument may be just wasting precious time. I think Obama is beginning to settle on the right approach ? carpet bombing with stimulus. 'Big and bold' and even if it is overdone the consequences will be better than if we chose a measured approach that is tailor made, but for the wrong problem and late at that.
You have to get past this layman/expert dichotomy because all of the experts have dogs in the fight. It's your job as a citizen to figure it out.
Do you or do you not think that removing the incentives for banks and commercial paper issuers is at the root of the problem? http://en.wikipedia.org/wiki/Talk:Emergency_Economic_Stabilization_Act_o...
The pre-tax, pre-provision operating profit of S&P financials used to be above 400 billion and is probably still above 350 billion. Two years of that and there is another 700 billion.
Even if this is true, this profit is presumably going to the companies that are not in trouble -- so how does that help?
As a layman, it's been pretty eye opening over the past few months to realize just how little even the experts seem to know about what's really going on and what the scope of our current problems are...
Two observations:
1. We are all laymen now.
2. The next bubble to pop is the bubble in "Experts".
We won't reach a bottom until we throw out the "experts" and start thinking from first principles. Let's go back to a simpler world where laymen can understand the basic elements of their economy. Perhaps that is where we are getting as we slowly bid goodbye to complexity and obfuscation and the agents that brought us here.
According to this article, the 93 financial companies in the S&P 500 had an aggregate $7 billion loss in the 4th quarter of 2007.
It's unlikely that they have become more profitable since then. So where does this $350 in annual profits come from?
Kevin, we may never find out the answer to your fundamental question: How big are the losses?
Are you taking about a "paper loss" or a "realized loss?" I think at this point we don't believe in anything "on paper" because that is based on assumptions and models. The only real way to find out the answer is to actually go ahead and realize the losses (or gains). But you and I know this isn't going to happen.
Our financial system is built on the fundamental belief that the system has no conclusion; that it continues forever. The marginal buyer or seller provided the only clue of an asset's "market price" and everyone implicitly believed that. The key to all of this is confidence in the system, which basically means trusting that the people running the system were honest (even if they were brutally competitive) and knew what they were doing. Somehow we found out that our trust and confidence were misplaced. And that realization is unraveling the system.
A system that was built on the premise that it is a perpetual machine is being asked to freeze long enough so we can get a snapshot of its intrinsic value. But we can't get that snapshot because at some point that boils down to coming up with intrinsic values for the hard assets all the paper (stocks, bonds, derivatives etc) is derived off of.
Try this simple exercise: What's the intrinsic value of your home?
I just ran across this very relevant article at NYTimes:
Psychics are thriving as clients turn to them for financial advice. "People are sensing that the traditional avenues have not worked," said Tori Hartman, of Los Angeles.
http://www.nytimes.com/2008/11/23/fashion/23psychic.html?_r=1&hp
Let's go back to a simpler world where laymen can understand the basic elements of their economy.
I am not so sure that will work better. In all the fields that I brush up against (computer software, computer hardware, electronics) we are better off for having experts. As far as "basic elements" goes, just for example, if I handed you a handful "basic" electronic parts and their data sheets, along with basic instructions for assembly, do you think you could do it? Most people cannot. Should we go back to a simpler world where laymen can understand the basic elements of their electronics?
Perhaps the difference in an economic system is that the system, unrestrained, is unknowable -- as fast as someone figures out an advantage, they destroy that advantage. What we need, is actively maintained (against financial "innovation") and enforced rules and regulations, and sensible separations between the evaluators, regulators, and actors, to prevent the sort of nudge-nudge-wink-wink corruption that we've seen happen here. The layman doesn't need to understand it, but the laymen DOES need to understand that the stock/bond/mortgage raters are not working for the stock/bond/mortgage sellers. There's got to be actually independence.
dr2chase: I brush up against the same areas as you do (more software than hardware) in my professional career. Expertise in engineering is grounded in experience and fact. Folks who publish in refereed journals and who build/diagnose complex systems are indeed experts.
The reason I used quotes around experts in my previous post is because I think that even if they have experience, they are not dispassionate experts akin to experts in an engineering discipline.
When I say "basic elements" I'm not referring to the basic building blocks of complex systems. I'm talking about the basic underlying principles underpinning a complex system. For example, if you are a bank that makes money by making loans, the basic principles are:
1. You are able to lend at a higher interest rate than the rate at which you can borrow
2. You have proven, sound lending standards that guarantee that given a large capital base, you can recover most of the money you lent
Clearly it was #2 where we lost transparency and lost touch with the basics and built fragile layer upon fragile layer of complexity. The fact that these were hard to explain to layman was the clue that this was built on hot air.
Wall Street took some basic principles (risk, reward, yield, return on investment, cost of capital etc) and built an increasingly complex financial system and appointed themselves as the high priests of this system.
I have posted this thought in other posts before, but let me reiterate. As laymen we should cut through this crap and ask a simple question before buying an asset (e.g. stock): "What am I getting in return for my money?" If I am buying stock in Microsoft I may not know how to build software, but I should be able to have a sense of what I am getting in return for my cash payment for a share of Microsoft (dividends; increasing market value based on competitive position and prior history etc). If a majority of laymen demand this basic transparency in the financial system, Wall Street will not be able to get away with the kind of crap they got away with so far.
Submitted by Rick B (not verified) on Sun Nov. 23, 2008 2:28 PM PST.
The reason I used quotes around experts in my previous post is because I think that even if they have experience, they are not dispassionate experts akin to experts in an engineering discipline.
I think you are on to something, rational.
People are limited intellectually. They can only focus on one thing at a time and obtain information relatively slowly, so experts in any given area are rare.
Henry Paulson is NOT an expert in economics. He is a salesman of economic products, and his expertise appears to be in the techniques of sales and management. He is also a conservative ideologue or he wouldn't be Bush's Treasury Secretary.
One of the things that has rally disturbed me with the Bush administration is their disdain for collecting facts. How many reports has the Commerce Department simply quit publishing? This goes along with their method of deregulation. If no one knows how the overall system actually is working, then no one can regulate the individual banks and players in the system. Voila! Stop collecting and reporting data and you get deregulation.
Refusal to collect and publish data also feeds into the conservative "know-nothing" ideology and their disdain for experts and scientists. One of Palin's selling points to conservatives is that she is specifically NOT an expert. For some reason that makes her more attractive as a leader to the conservative "know-nothings."
If the Republicans want an economic leader, do they choose an expert or a salesman? How many salesmen do you know who will defer to experts as knowing more about economics and the financial system than they do?
I think these factors have a lot to do with the loss of transparency and loss of touch with the basics you write about. And I think that the superiority of salesmen over experts is built into the Wall Street banking culture.
Submitted by Jassalasca Jape (not verified) on Sun Nov. 23, 2008 3:42 PM PST.
dr2chase @ 4:19,
Your analogy assumes that experts have incentives to reduce complexity. In engineering, that is often correct, because an engineer can expect to absorb the cost of the risk that results from excessive complexity. When a space shuttle explodes or an airliner goes down, the cause can be traced back to a finite set of decisions by specific people, and careers suffer.
You have a very different problem on your hands if the players benefit from raising the level of complexity. This does happen in under-regulated markets. Gratuitous complexity can create a gap in knowledge that they can be exploited in the market. That's what's happened with all of the CDS jazzola.
You sometimes see a similar phenomenon in software projects. A single engineer who adds code that only he understands makes himself (temporarily) indispensable to the project. But this, too, generally has an unhappy ending.
In both cases, a short-term incentive to create runaway complexity is bad for the project as a whole. It broke Emacs. It's now trying to break the economy.
I don't think anyone knows what the central problem is and I am beginning to tune out blowhards who claim to do.
Could it be that the main issue is just a lot of very baaad chickens coming home to roost all at the same time? We, along with the rest of the non-primitive world, have been engaging in a lot of activity that runs the gamut from careless to shady to completely horrible and fate has decreed that now is time to pay the various bills.
Further, the causality argument may be just wasting precious time. I think Obama is beginning to settle on the right approach carpet bombing with stimulus. 'Big and bold' and even if it is overdone the consequences will be better than if we chose a measured approach that is tailor made, but for the wrong problem and late at that.
How can someone say "nobody understands"?
Isn't it clear Republicans changed the laws and then everything went cuckoo?
Of course Wall Streeters are a greedy bunch, and they're paid to be. But, in this environment of obfuscation and hyper complexity it's the powerful insiders who are well connected and who have the most security through wealth who should have this game well in hand.
We, the public, are just bystanders, watching as the game is played and seeing Paulson deny use of the Bair plan to fix mortgages and reading about Phil Gramm's midnight raid on law and seeing banks refuse to lend money after they've received a government bailout/welfare check.
Who will 'win' in the end?
I suspect, as we have all seen throughout the Bush administration, some few insiders favored by the Bush mafia will do alright and everyone...everyone else will suffer badly.
And, just in case I'm wrong I'm buying a credit default swap against the default of America. No wait, I'll take two -- can't pass by the opportunity to get rich taking advantage of this "opportunity".
Kevin, as I understand things, you've put your finger directly on crux of the problem. How to value the junk on the financial institution's balance sheets, especially when that junk/risk is parceled up among a number of different parties whose exposure is likewise unknown. By contrast with a normal run on the banks, the banks have now lost confidence in themselves (their ability to value their own assets), and are acting as cautiously as they can. Perhaps irrationally cautiously, if what Hempton says is correct. One possible solution, seems to me, would be for the government to start lending money directly to salvage the economy--at least until they can figure out how the banks can value these assets. Almost nobody is talking about this though, presumably because all the experts work for the banks who are hoping for more government handouts? Ideological opposition to more direct government intervention, perhaps? Any thoughts?
I think Hempton is wrong. I think bank capitalization (or at least confidence in bank capitalization) remains a big problem and a big overhang for getting the economy moving again. I see two main issues, I would have with his analysis. 1)Although its true that $2 trillion in bank losses is about the highest estimate in the market, many are starting wonder if it can go higher. Last week it was commercial mortgage back paper and credit cards and everyone is wonder what the next shoe to drop will be. 2) I think its wrong to say the banks had much of a capital cushion before the crisis and in fact I think they now realize they started off fairly undercapitalized. Regulatory capital ratios looked ok, but capital to asset ratios look weak. Over the years the banks have found ways to reduce risk assets as calculated under regulatory ratios and found ways to manage risks that did not turn out very well.
So 1)$2 trillion is increasing looking like a conservative estimate of bank losses and 2) not only do banks have to match losses $ for $, but they probably have to raise more as they realize their capital was not as strong as they thought at the start of the crisis.
Submitted by Steve Sailer (not verified) on Sun Nov. 23, 2008 8:45 PM PST.
In 1907, the markets crashed and calamity loomed. So J.P. Morgan summoned all the heads of companies to his house and told them to bring their books. Morgan's smart boys then figured out how much each company was actually worth and what each firm would have to do to get out of the hole it was in, and Morgan told CEOs to do it. They did it.
It turned out that the situation in 1907 was bad, but not as bad as not knowing how bad it was had been. The economy was back growing again fairly quickly.
Why isn't something like that happening now? Possible reasons:
- Everything is infinitely more complicated now.
- Lack of J.P. Morgan-quality leadership.
- The actual situation is so terrible that nobody wants to know.
The problem lies exactly in the unknowns.
Once the housing market stopped appreciating and turned downwards, and the sub-primes started forcing foreclosures, evryone holding CDOs couldn't be sure of their value. Because nobody could value them, their value dropped precipitously. That is, assets held depreciated extraordinarily quickly.
At the same time, CDSs, which everyone had been using to bet against (or for) a companies ability to pay their debt, became a one way market as particularly financial companies earnings took a sharp down-turn.
Think of it like musical chairs. Everybody has been having a gay old time dancing and laughing, then the music stops. And when the dancers look around there's not one chair gone, but almost all of them. The reality comes to all of them at the same time that this is not going to be a pretty contest.
The CDS market was an extraordinarily unregulated market, especially given its size reckoned to peak at $62 trillion -- yes, a "t" -- and $52 trillion at the time of Lehman's failure. When Lehman failed nobody knew who had how much risk with whom. All those who had business with Lehman knew because they took the loss. But nobody knew where their next loss might come from and how big it might be.
There was no risk management.
So in short, unless the loss is realized nobody quite knows what their exposure is but they know their assets are vastly depreciated, the credit market is illiquid so they'd better hang on to what they've got.
Everybody has gone from dancing and throwing risk around like confetti to fighting like hell to get their seat into one of the few chairs left.
And bank shares are now so low it is expensive to raise fresh capital, if anyone would put up the money.
Which is why, if the taxpayer is putting up the capital, they need to be taking a substantial equity stake.
I just read that Hempton piece (actually one he wrote today which made the same points and links to the one you talk about here) and have a question: if he's right, isn't it pretty much the most important thing in the world that the relevant people know he's right?
