Who would lose money in a bank liquidation? Take a guess …
Simon Johnson , who served as chief economist at the International Monetary Fund in 2007 and 2008 writes on how we have learning nothing nor is the financial system improved in any way since 2008. The changes including the US Dodd-Frank law do nothing to solve Too Big to Fail (TBTF).
Johnson asks one question, yet leaves the answer hanging … Who would lose money in a bank liquidation?
Lets look at Bank of America who open that door nicely with their promise of a ‘fortress balance’ sheet. But rest assured, this same analysis works for any bank as you will see when we get to the punch line.
2010 Annual Report ($ billions)
Balance sheet categories:
Total Loans incl debt secs (assets) 1,236
Securities (fed and others owe to BoA 404
Other Assets (real estate etc) 624
Total Assets 2,264
Total Deposits (liabilities) 1,010
Securities (liabilities to fed and others) 1,327
Total Liabilities 2,037
Off Balance sheet Notes 25
First the good news. BofA has assets that exceed liabilities by 228 billion. Big cushion, right? Of course not and here is why.
In a liquidation scenario, you can bet 100% of the holders of liabilities will want all their money, all $2,037 billion. Especially the Fed who need it to bail everyone out! But what about the assets? When BofA go calling on those debt holders, what % will they get … 90% ? 50% ? 25% ?
Suddenly the $228 billion is not so large. Lets assume 75% pay up. BofA gets $927 billion. For fun lets assume the Fed pays 100% or $404 Bn. Real estate will plummet in a fire sale, but lets say Warren Buffet steps in and pays 75 cents on the dollar or $468 bn.
BofA collects $1,799 but pays out $2,037 – short 238 Bn. Suddenly the capital is down by $466 bn ( that’s 1/2 a trillion)
That was a pleasant scenario because we assumed the loans would attract a 75% return. There were $1.1 trillion in Countrywide mortgages sold off as derivatives between 2004 and 2009. Its hard to value the liability from the balance sheet but it is still out there based on the numerous justifications and positive mentions. In a liquidation, a safe additional $500 bn shortfall could be safely projected.
The impact of depositor insurance, both real and implied:
But you may ask, all of this is meaningless because the Federal Government will step in on liquidation and guarantee all the deposits therefore loan shortfalls do not matter, right? Wrong again.
This is precisely where the TBTF rubber hits the road. When that happens, the government has no choice but take over the bank, with these implications on liquidation, yes liquidation means this happens on a Sunday afternoon and is complete before markets open Monday:
- common stock value goes to zero. Stock disappears from NYSE
- government adds $ trillions to its balance sheet both assets (now worthless loans) and full value deposits (new government liabilities to citizens)
- GBoA (Government Bank of America) begins Monday morning calling up debtors (loans) and asks nicely if they wouldn’t mind continuing to pay down, repay their loans.
- Asset values crash as the largest creditor in the country now considers foreclosures and bankruptcy proceedings on a mammoth scale never seen before
- or … 4 becomes the largest debt write off seen in the countrys history with repercussions on currency and real estate values wiping off decades (centuries) of value.
- Tuesday … Wells Fargo, Citibank and others follow suit as the market freeze refuses to budge and no other country will deal with any American bank.
Who loses in a bank liquidation?
So who loses in a bank liquidation; unfortunately everyone. This is reflected in stock values, asset values and price increases for normal everyday items from currency gyrations and mammoth speculation. There would be societal implications on the streets, chaos everywhere. The concept of a bank disappearing is unforseen, and frightening.
The socialisation of bank liabilities by governments both in US and elsewhere, means they are de facto nationalised. There is no difference between a well run bank and a poorly run bank for that reason alone. In a liquidation scenario it is truly all for one and one for all.
The best solution that I can think is the UK ring fence, or full imposition of the Volker rule. This will at least force the separation of your money from speculative money in the above calculations, and while not perfect that has to be a start. While potentially chaotic, the liquidation of an investment bank does not directly impact day to day commerce, nor commercial business deposits.
And that needs to happen in weeks, not years as is proposed on both sides of the Atlantic. Otherwise we are literally in the situation whereby the above can be likened to the Big Red Button of the Cold War, and we are constantly reminded of how it could be pushed in error. It happened with Lehmans and AIG and could happen again as we watch events unfold in September 2011.
Thoughts on other solutions welcomed.