ADMINISTRATION

Headwinds Ahead

The shortage of capital on Wall Street will be making its way to Main Street soon.

by John Maggs

Sat. Apr. 19, 2008


The verdict is in. Three weeks after the Treasury Department proposed the biggest changes to financial regulation in 70 years, the experts pretty much agree that the proposals would do little to ease the current crisis in credit markets. (One of the experts is Treasury Secretary Henry Paulson Jr., who said that the recommendations were not intended “as a response to the circumstances of the day.”) Likewise, legislation on Capitol Hill to slow the rate of home foreclosures does not directly address the problems in America’s banks and financial institutions that led the Federal Reserve Board to rescue Bear Stearns and open its system’s vaults to other Wall Street firms.

For many people, the connection between the apparent recession, the housing downturn, and the turmoil on Wall Street is unclear. One particularly confusing dimension of this is the credit “crunch,” which those who are most worried call a crisis and those who are confused term a mess.

Every now and then, some banker or government official will announce that banks have sharply curtailed their lending to businesses or that the financial crunch has eased slightly, as it did toward the end of 2007. Nothing about these developments, good or bad, seems to make much sense—the stock market sometimes reacts to the pronouncements and sometimes not. For the most part, no one explains what is actually happening, and why. The credit crisis hasn’t prevented most people from obtaining credit cards or financing a car—interest rates are still fairly low. A survey by the National Federation of Independent Business found that small and medium-sized companies are still able to borrow money to expand.

Alas, this is likely to end because the shortage of capital on Wall Street will be making its way to Main Street soon. Wall Street investors and the major banks that finance deals have been the primary victims so far, but below them, smaller banks will inevitably be forced to sharply curtail their lending, raise interest rates, or both. And that is when the credit crisis becomes a burden for everyone—what former Fed Chairman Alan Greenspan called a “50-mile-per-hour headwind” during the last credit crisis, in the late 1980s.

Proposals from Congress and the White House don’t address the credit crunch. Banks would prefer to curtail lending, but the Federal Reserve would rather see them raise more capital.

The roots of the current situation lie in the belief, shared by nearly everyone over the past few years, that the unprecedented gains in home prices since 2001 would continue. Investors, banks, and any institution with money looked at the meager gains in the stock market and in nonmortgage lending and decided to cash in on the real estate boom by creating new securities—bonds—based on skyrocketing home values. Homes had never lost value in a sustained way, so risky mortgages were deemed safe—even to the point where foreclosure was not considered a threat because the foreclosed property would still likely gain in value or at least not lose value.

However, when investors and homebuyers realized that there was a speculative bubble in real estate, and when home prices fell more than ever before, all of those mortgage-backed bonds suddenly lost a lot of value. How much they lost is still in doubt because home prices haven’t stabilized yet and few investors are willing to take a chance on the bonds’ ultimate worth. This is the origin of the financial “paralysis” or “freeze” that the experts refer to.

Based on the headlines, one might think that this crunch primarily involves hedge funds and other private investors. It is true that a vast world of private lenders and borrowers was instrumental in creating many billions of dollars in mortgage-based securities and that this world is largely beyond the reach of regulators.

But it all comes back to the old-fashioned banking system, because it is banks that, in one way or another, created these securities or lent money to the hedge funds and other investors who created and traded the bonds. Take Bear Stearns, the Wall Street firm that the Federal Reserve bailed out. In many ways, Bear acted like a bank, arranging financing for deals—but it isn’t a bank.

Most significantly, Bear wasn’t bound by the many rules that the Fed and other regulators impose on banks to try to ensure their solvency. The Fed normally doesn’t concern itself with Wall Street firms—indeed, it did nothing when Refco, a Wall Street firm with $17 billion in assets, collapsed in a scandal in 2005. But Bear Stearns was intimately connected with other institutions, including banks, in helping to create mortgage-backed securities and managing the new markets to buy and sell them. With banks so involved in Bear’s business, the Fed saw a threat to the banking system if the firm went bankrupt.

According to the Fed’s data, the 50 largest American banks (known as bank holding companies) had total assets at the end of 2007 of about $10 trillion. This is lot of money; for comparison, all American households had combined assets of about $7 trillion in 2007. The big banks’ assets include deposits, stocks and other securities, office buildings, and the like. Despite the recent fixation with private equity and the “shadow banking system,” it is the health of these large banks, and the smaller ones that are regulated by the Fed and other federal agencies, that is crucial for easing the credit crunch.

When mortgage-backed securities started plummeting in value, banks that owned them, and/or had loaned money to others who held the securities, faced a choice: either hold the securities and wait for prices to recover, or “write down” the value of these assets to current market values to remove doubt and get the tax benefits of taking a loss. Holding on to the assets, though, creates a problem—assets are “risk-weighted,” which means that riskier ones are worth less. The rating agencies, which did a bad job of assessing risk over the past few years, have been trying to regain some credibility by rapidly downgrading the risk rating for mortgage-linked securities. A downgrade means that these assets are worth less.

Any bank has a problem when its liabilities—what it lends out—stay the same but its assets decline in value. Every bank is required to maintain assets that total at least 8 percent of its liabilities. (The formula is complicated, but that’s the bottom-line number.) These ratios are known as “guidelines” because the Federal Reserve enforces them in an informal way. But if a major bank was ever close to 8 percent on an ongoing basis, the Fed would have long since intervened and forced it to take some action.

So where are we now? At first blush, things don’t look so bad. At the end of 2007, the 50 largest banks regulated by the Fed had a total average capital ratio of 11.1 percent. But that was down from 12.2 percent in 2003 and 11.6 percent in 2006. The trajectory has been even sharper for some banks. Citigroup, which has announced some of the largest losses from mortgage-linked securities, saw its capital ratio fall from 12.2 percent in 2005 to 11.7 percent in 2006 and 10.7 percent in 2007. PNC Financial Services recorded one of the lowest ratios among the big banks, 10.24 percent in 2007.

Two things have happened since the end of the year: Losses have lowered these percentages significantly, by all accounts, and pressure from the Federal Reserve has led big banks to raise at least $50 billion in new capital. Lyle Gramley, a former Fed official, said that a bank can do this in one of two ways—either sell some of its assets or sell a piece of itself in the form of stock. Citigroup did both. It sold its Diners Club subsidiary for $165 million earlier this month, and it sold a 4.9 percent stake in Citi to the Abu Dhabi Investment Authority for $7.6 billion.

Ultimately, the Fed has the power to force banks to sell more stock or face restrictions that could spark a run on assets.

Two forces, however, are still encouraging Citigroup and other banks to restrain lending. First, despite pressure from the Fed to raise capital, banks would prefer to play for time. Instead of selling their most profitable assets, banks would prefer to improve their ratios by cutting back on lending—less lending leads to steadily lower liabilities.

Ted Truman, a former Fed and Treasury official, said that banks are also affected by the uncertainty over their own financial positions—worrying that the securities they own may continue to drop in value. With the 8 percent floor in mind, banks are hoping that a pause in lending will provide enough time for those securities to hit bottom. Government-owned sovereign wealth funds in the Middle East, such as Abu Dhabi’s, may be losing their appetite for American banking, Truman said. Even these flush investors want to hedge their bets on the U.S. financial system.

Going forward, banks will continue to see their capital ratios deteriorate as their debt-based assets are downgraded, and the Federal Reserve will have to decide how much capital replenishing they should have to do. Banks will want to preserve their most profitable assets and curtail lending.

Ultimately, the Fed has the power to force banks to sell more stock or face restrictions that could spark a run on assets. Alternatively, Fed officials might ease the capital ratio guidelines temporarily, or indefinitely, for some banks or for many. Of course, that step might encourage banks to return to risky, high-yield loans. Easing the capital restrictions could present the “moral hazard” that Fed officials have warned against, but it may be the necessary price for persuading banks to lend at all.

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