By Lon S. Cohen
Our banking system has become a disjointed assemblage of parts. The basic blocks seem to make up a theme or a pattern but when taken individually, make almost no sense at all.
In art, we call it Cubism. In finance we call it something we’ve never seen before.
The federal government has $700 billion to spend. The Feds think this can single-handedly prop up the economy, preventing the entire system from crashing down. But the country’s banks are not totally convinced. Some have decided that going it alone is preferable to uncertain terms and restrictions that the government imposes in the deal. While anyone might take free money, the government has yet to establish a model that seems to work, making any relationship tenuous at best and potentially disastrous at worst.
Needed: A Bigger Brush
The Feds started to see the biggest parts of the banking sector start to become unhinged, and they dabbled a little. First it was structuring an emergency takeover of Bear Stearns. Then it was Lehman Brothers. Next Fannie and Freddie. Then AIG came calling with some very scary credit default swaps about to be called in.
Hank Paulson needed a bigger brush to tackle the ever-increasing problems. “The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy,” he said in a September 19th statement when first outlining what would become the Troubled Asset Relief Program. The program, he stated, “must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible.”
After some haggling, Congress and the President passed the Housing and Economic Recovery Act of 2008. In October the Emergency Economic Stabilization Act of 2008 (EESA) established the Office of Financial Stability (OFS) within the Department of the Treasury. Hank Paulson set out to work with his new brushes and paints.
He promised to erase some toxic debt, open up the credit market, and help consumers stay in their homes thereby propping up the economy. Things did not go exactly as planned.
While the Feds were focusing on toxic assets, other elements started to tighten up – student financial aid, auto lending, credit cards and lines of credit. Then, commercial lending began to feel the pinch. Meanwhile, the FDIC was doing a little bit of redecorating of its own by expanding deposit insurance coverage. The Feds also provided a backstop for commercial paper.
On October 14th, the Feds announced the Capital Purchase Program (CPP) under the umbrella of the ever more inaccurately termed Troubled Asset Relief Program (TARP). The CPP was supposed to “encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy” according to a press release. The program allowed the Treasury to purchase up to $250 billion of senior preferred shares on standardized terms. Citing that “nine large financial organizations already have agreed to participate in the Capital Purchase Program” the Feds encouraged other institutions to take advantage of the CPP.
Treasury Secretary Paulson essentially corraled the heads of nine major banking firms into an office in New York City and browbeat them into accepting a new plan that it was hoped would attract many smaller banks to follow suit.
“Our company continues to be a leader in tumultuous times,” stated The Bank of New York Mellon CEO, Robert P. Kelly in a press release. He said that his bank agreed to the TARP money because it’s “supportive of the Treasury’s efforts” to get the markets “working again for borrowers and investors.”
But in an interview on Fox News, ABA President and CEO Ed Yingling stressed his concern for financial institutions agreeing to a government handout. He voiced “big concerns” over bankers’ confusing the Capital Purchase Program, which gives a cash infusion to healthy banks with the type of government take-overs seen at Fannie Mae, Freddie Mac, AIG and most recently, Citigroup.
He thinks that community banks that being offered the money at seemingly amazing deals, are anticipating a hangover the next day.
In a letter to Paulson, Yingling said, “It is completely unfair to ask thousands of banks across the country – and they are being explicitly asked by their regulators – to participate in a program when the impact on those banks is unknown”
One of his main concerns is that banks partaking the CPP might be regarded as weak. They also face the uncertainly of future restrictions by the government that might, “have the perverse effect of discouraging private investment in banks.” He said that something like restricting dividends would be destructive because investors have come to expect solid dividends from banks. He stressed the need for greater clarity from the Feds.
The Government Accountability Office (GAO) also released a report on TARP which recommended that Treasury, among other things, work with the bank regulators to establish a systematic means for determining and reporting on whether financial institutions’ activities are generally consistent with program goals. While they certainly agree that there is a need for this type of action, stating that every state in the nation experienced an increase of loan defaults from 2005 to 2008 – ARMs in both subprime and prime loans experiencing even steeper default than fixed rate mortgages – the GAO stated, “It remains unclear, however, how OFS and the banking regulators will monitor how these institutions are using the capital injections to advance the purposes of the act, including preserving homeownership.”
The GAO report states that Treasury hasn’t addressed some of what they call “critical issues.” Some of those include how to determine that the CPP is achieving its intended goals, and monitoring compliance with “limitations on executive compensation and dividend payments.” They implore the Treasury to implement a system of internal control on the OFS, and said, ”A strengthened communication strategy could help avoid information gaps as market conditions and TARP continue to evolve.”
Back to the Well
While banks tried to wrap their heads around the two programs and how they related, AIG came back to the government looking for a loan increase. This did not instill confidence in the deal the Feds were currently trying to sell to the banking system. The AIG loan was initially hammered out with an interest rate of over 11 percent. Bernanke himself said that it was “a very tough deal that we struck.” Turns out that 11 percent APR on billions of dollars might be just a little too strenuous. Under the new terms, the interest rate was lowered to three-month Libor plus 300 basis points.
Banks began to wonder if the Feds were really giving them the best deal, especially since they were insisting that even healthy banks tap into the CPP. Limitations in executive compensation, dividend payments, and repurchases of stock are all part of the deal when applying, scaring off some banks considering that this may be just the tip of the iceberg for compliance, opening them up to a whole slew of ramification later on down the line if things don’t turn around.
No wonder the banks were worried and no wonder the TARP wasn’t initially well received, especially by smaller banks. In October, a Banc Investment Group poll showed 66 percent of the 188 bankers surveyed said they either were unlikely to use or definitively against the idea of accessing TARP capital, and only 8 percent said they would probably use TARP. The terms offered with the money seemed just a little too abstract.
Fine, Thank You
Smaller banks also had been doing pretty well on their own. In a report, “The Banking Crisis: A Back to Basics Lesson,” Celent, a financial research and advisory firm, revealed the source of banks’ unwillingness to participate in TARP.
“Large banks tend to look at mortgages as something to be originated and sold. They forgot about the risks associated with originating and warehousing loans,” said Bart Narter, senior vice president of Celent’s banking group and author of the report. When the bottom dropped out, many banks were left holding these toxic assets before getting them off the books.
While he admits that many large banks are doing just fine, in the report he says that loan losses are driving problems at banks over $10 billion in assets. Net charge-offs relative to loans is a big indicator; large banks are experiencing five times the amount of charge-offs as smaller ones.
But the expectation is that the economy will not improve much in 2009. As things get worse, though, more banks seem to be signing on to the program despite their stability.
M&T Bank, a Buffalo-based bank, said it applied for funds despite its strong position. “Even though our capital ratios are well in excess of the regulatory minimums, we believe it is important to join the industry in support of this program established by the Treasury Department to address the disarray in the financial sector,” said Rene Jones, Chief Financial Officer and Executive Vice President of M&T in a public statement.
Some banks used the money as a bulwark against an expected bumpy year ahead. State Bank, a community bank with seventeen branches located in Nassau, Suffolk, Queens and Manhattan, elected to apply for TARP funds “to fortify our already strong capital base,” stated CEO Thomas M. O’Brien.
An Abundance of Caution
“Given the precipitous drop in the economy, bankers now want a higher margin of safety going forward,” said Chris Nichols, Chief Executive Officer of Banc Investment Group. “This abundance of caution has prompted community banks to re-evaluate their initial reluctance to consider TARP funds. Because many banks want to position themselves to withstand another Depression era-type shock and still make loans to their communities, TARP capital has become an attractive option.”
The previously mentioned Banc Investment Group survey showed that in one month the number of community bankers who said they’d participate in the CPP dramatically increased from 8 percent in October to 56 percent in late November. And 3 percent said that they had already gotten approval.
Yet, some smaller banks, like The Bridgehampton National Bank on Long Island, began to weigh the program’s pros and cons, at the Federal Reserve’s urging.
“We recognize our responsibility to judiciously consider these programs,” said Kevin O’Connor, President and CEO of Bridgehampton Bank’s parent company Bridge Bancorp. “Like other strong community banks, we are considering participation in the CPP. However, we are concerned that there is the perception that this is a bailout. It is not.” He added that in the interests of shareholders, the bank may not even consider taking part if the some terms, such as lending requirements and potential restrictions on dividends, are not made clear.
“The bankers are clearly concerned about their ability to make good business choices in a highly regulated and micro-managed environment,” said Sharyn O’Halloran, a George Blumenthal Professor of Political Economy and Professor of International and Public Affairs at Columbia University in New York City. “Limitations on pay, dividends, and strategic choices that involve risk-reward returns would cut into their bottom line.”
O’Halloran says TARP’s purpose was to provide an intermediate fix for taking those toxic assets like mortgage-backed securities off of the balance sheets of the large financial institutions and create liquidity in the market. But for long-term impact the TARP had to be followed up with two more actions. 1. An increase of liquidity generated by the Federal Reserve Board and 2) a broader based stimulus package, part of which would have to include mortgage modification.
A Crisis of Confidence
“Unfortunately, the TARP was sold as a stand-alone quick fix to a complicated problem and therefore did not produce the investor confidence necessary to bring the system back into equilibrium,” she concludes. “The government was well behind the curve. What they have yet to realize is that this is a crisis of confidence and therefore have not pursued the set of policies that will facilitate lending among institutions and, in turn, businesses and consumers.”
When banks are hesitant to take part of what is perceived as a bailout or the program is not enough to stem the tide, other action must be taken, some at the state level.
“Overall, the New York State regulators have sought to increase the scope of their regulation to bring a larger number of institutions and instruments under its regulatory umbrella, while at the same time being flexible in the application of the rules to facilitate companies facing extraordinary distress,” said O’Halloran, citing help that New York State provided for Goldman Sachs to become chartered as a bank holding company under the New State bank supervisors and in the case of AIG where New York State insurance regulators waived some of the capital requirements, allowing the parent company to use funds of subsidiaries for capital reserves purposes.
Kisha J. Wright, Director of Technical Program Compliance and HUD Counseling at the Long Island Housing Partnership, Inc. said that banks are becoming more proactive in offering mortgage assistance to consumers.
“Within the last 6 months lenders/servicers have been more creative and flexible in offering homeowners different options in lieu of foreclosure,” said Wright. “More Loan Modification Agreements have been offered where the Lenders/Servicers have changed clients adjustable interest rates to fixed rate loans and when clients have had fixed rate loans of nearly 8 percent or more the lenders/servicers have in turn reduced the those interest rates anywhere from 3 percent to 5 percent.”
Some of these reductions are temporary, to get homeowners over a financial hump of 3-5 years, but in the rare case, they have been fixed at the lower rate for the life of the loan. Extending the existing terms of the loan out to 40 years is another option banks have been pursuing. Some banks have even offered a Stipulation Agreement/Loan Modification also known as a Stip MOD to modify consumers’ mortgages. The bank lowers the monthly payment for a predetermined period. Then the bank adds the arrears to the principal balance.
“We must keep in mind that all these options do not apply to each situation but rather each homeowner has individual circumstances and depending on the actual investors pool servicing agreement will dictate what options can be offered,” Wright said.
Wright stressed that banks have definitely “tightened their lending strings” due to the current housing crisis by raising the bar on clients’ FICO score requirements, requesting reserves be in the bank and making sure clients can afford their mortgage going forward.
She also wants banks to keep their lines of communication open with certified HUD Housing Counseling Agencies, such as the Long Island Housing Partnership, which seek to prevent borrowers at risk from entering foreclosure.
Rewriting the Rules
Still, the troubles are piling up with the economic picture looking more fractured and dismal than ever. There are few bright spots in the composition and economic indicators do not paint a pretty picture.
The Federal Reserve reached out to the biggest banks at first to provide a show of confidence in the banking system.
“Because some institutions – as we now know, CITI – were in tremendous danger of becoming insolvent. Therefore to prevent a run on the weakest institution, all large institutions had to buy in,” said Professor O’Halloran in the fall. This downward spiral of major institutions has made banks more nervous about the TARP. “These are not reorganization programs; these are managed liquidation programs,” said O’Halloran. Moving forward he said, the Feds will focus on rewriting the rules that govern the financial services sector.
“But the problem is not a lack of regulation,” she said. “In fact, banks and their holding companies are highly regulated entities. The problem is that the statutes passed by Congress and enacted by the president specifically prohibited regulators from overseeing certain instruments like SWAPS and CDOs because they were not declared not to be securities. Therefore, it is not the failure of functional regulation or rules-based regulation at the heart of the current crisis. Instead, it represents a failure of the political process to adequately address the need for transparency and disclosure to ensure the efficient functioning of markets.”
“Regulators were asleep at the wheel with mortgages and their monitoring of the GSEs. Congress shared the blame by choosing not to regulate CDOs,” said Celent’s Bart Narter. “There is a pendulum that swings back and forth.”
Lon Cohen is a freelance writer based in New York. He has more than seven years’ experience working in and writing about the banking industry. You can reach him at email@example.com