December 11, 2011

Who Got Bailed Out? Hint: It Wasn’t Just Banks

December 11, 2011

Who Got Bailed Out? Hint: It Wasn’t Just Banks

Before we try to understand what bank bailouts are let’s first ask a simple question: what exactly is a bank? It’s best to look at a bank as three sets of people:

(1) stockholders

(2) customers who (a) place deposits in the bank—these are liabilities to the bank, and (b) borrow money from the bank—these are the assets

(3) the employees.

Keep this in mind: a bank’s assets consist of the loans that it owns and whatever physical assets it may own (real estate, for example.) A bank’s liabilities consist of shareholder equity and its deposit liabilities. There are rules which regulate the relative size of the two classes of liabilities. A bank can only take in deposit liabilities which are a certain multiple of its shareholder equity. These rules are international and are set by the Bank for International Settlements.

On September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy protection. Lehman had made large investments in mortgage backed securities. Worse yet, there were highly leveraged. Lehman was not a bank but an investment bank and was allowed by SEC to leverage itself almost 31:1. A 3.5% loss in the value of its mortgage assets could wipe out all of the equity in the company.

The Lehman BK let out of the bag the fact that all the large investment banks and many large commercial banks were holding a ton of mortgage debt which was going to see a much higher default rate than anticipated. The mortgage mess/liquidity crisis was launched. Potential retail buyers of these mortgage backed securities made up of crappy loans stopped buying them and the folks who held them—the investment banks and large commercial banks—were stuck. This created a massive liquidity problem on top of the capital problem created by the losses.

Let’s go back to the statement “A bank liabilities consist of shareholder equity and its deposit liabilities.”

Deposit liabilities consist of the deposits of the regular customers (individuals and businesses) and also interbank lending. Interbank lending is short term (one day to one week) lending from one bank to another. The need for this can arise at the end of any bank’s business day. It may find that it has insufficient cash to cover its reserves. Banks with excess cash lend it to banks which are cash short every day. In general, banks face the task of funding long term loans with short term deposits. Some of these loans are things such as HELOC’s, commercial lines of credit and credit cards where the borrowers have control over the balances.

Post-Lehman what happened is that no one trusted anyone else and interbank lending dried up. Since interbank lending was the normal solution to any bank’s liquidity problem, business as usual was not an option. Banks were not concerned about making money. They were concerned about not suffering contagion from another bank’s ills.

At that point there were two serious problems with banks: (1) because the real value of their mortgage assets was a lot less that they thought they suffered a capital shortfall problem, and (2) the mutual distrust created a liquidity problem.

The risk at this point was enormous. Two thing were done to help. One was TARP which address bank capital and the other was the liquidity programs put together by the Federal Reserve. TARP (Troubled Assets Relief Program) was passed by Congress and signed by Bush II. It authorized the expense of up to $700 billion of which $432 billion was ever disbursed. This was originally intended to shore up bank capital but banks rather quickly got their own capital and paid back TARP loans. Then TARP morphed into a bailout for AIG, FNMA, FHLMC, Chrysler and GM – none of which were banks.

Treasury has collected about $13.7 billion in interest or dividend on TARP and the eventual loss is estimated to be less than $20 billion.

Banks were bailed out but quickly repaid Treasury. But the populist myth misses the point.

Bank stockholders were massive losers. Some such as Washington Mutual were totally wiped out while others were merely heavy losers. The bailout benefited the public in general. Absent a bailout, if banks had become insolvent then either depositors would have lost money or the FDIC (the public) would have made up the difference.

The most significant support when the liquidity crisis occurred came from the Federal Reserve in the form of a number of programs which provided a gigantic amount of money to a massive array of entities. These were broker dealers, banks, credit unions, and corporations.

This is a detailed blog piece I wrote explaining the various Fed liquidity programs.

The liquidity providing provisions of the Federal Reserve saved the economy from much larger disaster. They costs the taxpayers nothing and, in fact, earned a profit 95% of which went to Treasury. The bailout was more to everyone who had a bank account and lost zero than it was to banks per se. Some bank shareholders lost all the value of their equity. Other merely took large hits.

Preservation of the banking system benefited everyone. Letting almost the entire banking system fail was not an option. If these interventions had not occurred the losses to Treasury (the taxpayers) would have been much more massive and many businesses and jobs would have been destroyed.

The message that somehow only banks were bailed out and the public was ignored misses the point as to what the functions of a bank are. It is the taxpayers and the depositors who were bailed out. The bank equity owners took large losses.