Some Thoughts On N-word Implications

By the way, that's Nationalization... Just wanted to get that out of the way. So what is so terrifying about nationalization that only the Duo of Doom (Roubini and Taleb) dares to expound on it profusely on prime time CNBC (and engender more boycotts of the otherwise harmless TV station)? Fundamentally, any recapitalization of banks by the government involves stripping or diluting certain asset classes of their value. Nationalization is merely an exercise of common stock dilution taken further, to the point where not just existing common, but preferred, hybrid and potentially junior and senior levels of debt are impaired and even extinguished. If you have never stared at a bank's balance sheet long, think of it as starting with the most unsecured capitalization layer which is always the company's common stock, which is last to receive any recoveries in a liquidation, and going all the way up to the most "riskfree" layer, secured debt, which is first in line in liquidation proceedings.

In 2008 the government really screwed the pooch when it recapitalized banks that failed or were on the verge of failure. Starting with the first failed entity, the GSEs (Freddie and Fannie), instead of wiping out the common stock in an entity that should have been governmentally controlled anyway, and potentially also impairing the thin layer of subordinated debt between the common stock and the senior debt, the government pulled a magic number out of its hat, saying that only 79.9% of the common stock was worthless, that the balance was healthy, and that the debt above the common was worth every penny. Now while the reasons for this are arguable, in my opinion the primary cause for this approach was to not spook foreign sovereign and private investors (who own a lot of GSE senior and sub debt) into thinking that not only this investment, but others, (potentially even Treasuries!) may also be on the edge. The lack of a more decisive security impairment higher in the capital structure is why the GSEs are constantly begging for more capital as the initial recapitalization was woefully inadequate.

After the GSEs conservatorship became effective, the dominoes started to fall, with bank after bank realizing it does not have sufficient cash generating assets to cover its debt let alone provide equity value (if I had to summarize the current crisis in a sentence, this would be it - the inability to find the right balance at which bank asset cash generation can satisfy liability obligations; all other things such as Mark-To-Market, TARP injections, TALF, etc., etc., are just fancy words to hide the simple truth that nobody has any clue at what fair value of assets and liabilities the system will be in equilibrium). Only once the values of assets cover the values of debt (debt, by the way is easily quantified - you know exactly what the notional value is after a 3 second check on Bloomberg; as for assets, nobody has any clue what their values are thanks to FASB's recent failed attempts at elucidation), will any incremental asset value generated create equity value, and only at that point will it make sense to buy bank stocks. It is really as simple as that...

And also not all that simple... Why - because the government, like we said, screwed the pooch, which it did by coming up with not one consistent, underlying methodology of dealing with bank failures but treating each one on a case by case basis, thereby leaving investors guessing how they would be screwed over any time they built up the risk affinity to invest a penny anywhere in a bank's capital structure. Our advice to Geithner, all else being equal, is at least stick to one program, even if it is completely faulty. The market will find a way to correct your mistake... Just don't change the system every 24 hours or whenever is convenient. That would really lead to a financial system collapse. And when we say the government was fickle, it really was. CreditSights has prepared data which we have tabulated to show just how different a random sampling of full-blown (or semi) failures both in the U.S., and globally, were treated by their respective governments/regulators.


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As one can see from the maze of policy reactions in the above 8 cases (which are not exhaustive, there have been many more failures), the only things that have been consistent is that absent an outright (semi) liquidation as was the case in Lehman and WaMu, the debtholders were never impaired. As this it the layer with the largest foreign holdings for most banks, whether these are China, petrodollars, or what have you, these seem to be the sacred cows for both investors and administrators in terms of parking capital. Last thing the government wants to do is piss off China, Saudi Arabia and Japan, in a time when it is relying on them to buy over $1 trillion of Treasuries over the next 12 months.

However, while this may be true for senior debt instruments, the fate of junior debt as well as Hybrid/Preferred layers is not so certain. All nationalization would really do, would be to eliminate certain junior capital tranches. Indicatively, Citi and BofA have about $100 billion in junior instruments (preferreds and hybrids), while the other too-big-to-fail banks have roughly $160 billion among them (Wells, JPM, Morgan Stanley and Goldman), implying there is a U.S. tranche of over $360 billion of non-debt securities that could potentially be eliminated before debt impairments would have to occur. Of course, if Roubini is correct and banks have to write down another $2 trillion plus of assets, then not only the junior debt would be worthless, but much more senior securities will also be eliminated. The threat of potential junior impairment also has lead CreditSights to present the following investment recommendation:

We are moving our stance to marketweight on junior securities within the capital structure based on the possibility for dividend deferrals. We would also tend to upgrade in quality toward better rated names such as JP Morgan Chase and US Bancorp, and less weighted toward Citigroup and Bank of America. Also, Wells Fargo could see more credit quality pressure and this would have us marketweight it for now.

The truth of the matter is that to have a stable and growing financial system, we need to be proactive, and establish leading adjustments - such as write downs that are more extensive than we believe is necessary, in order to start afresh. Old securities values will be wiped out, at both the common, preferred, junior and maybe senior debt levels, but this will provide the only true start possible for new capital, as the bank's assets will not be encumbered with assorted debt and preferred servicing and could go to build true equity value. This will also make the MTM discussion moot. However, the ongoing course is one where taxpayers will keep filling the hole, i.e. lagging adjustments, up until the point that the true asset value is ultimately reached, at which point, equity value will start being generated again. Once all the media propaganda is removed, it really boils down to simple math. The risk, from a game theory point of view, is how would entities, that are currently invested in senior capital structure securities, react once they realize they are massively impaired and will likely not receive par returns. It is this question that Geithner and the administration should be focusing on above all... I believe that if the "global economic system" were to sit down together with all the facts laid out for all to see, in a spirit of honest transparency, then the global asset write-down would be possible, and lead to a true start of value creation for the financial system and subsequently, for every other sector in the economy. Unfortunately, this is a pipe dream, and the government will merely continue its faulty course of throwing good money after toxic assets until there is no more money left to throw.

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