Using computerized models provided by the five big firms, the SEC, under its
new Consolidated Supervised Entities (CSE) program, allowed the broker-dealers
to increase their debt-to-net-capital ratios, sometimes, as in the case of
Merrill Lynch, to as high as 40-to-1. It also removed the method for applying
haircuts, relying instead on another math-based computerized model for
calculating risk that led to a much smaller discount.
The SEC justified the less-stringent capital requirements by arguing it was now
able to manage the consolidated entity of the broker-dealer and the holding
company, which would ensure better management of risk. "The Commission's 2004
rules strengthened oversight of the securities markets, because prior to
their adoption there was no formal regulatory oversight, no liquidity
requirements, and no capital requirements for investment bank holding
companies," a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in
turbulent times, the SEC also decided to rely on the five big firms' own
computer risk models, essentially outsourcing the job of monitoring risk to the
banks it was supposed to supervise. Over subsequent years, all would take
advantage of the looser capital rule to increase leverage.
The leverage ratio - a measurement of how much the companies were borrowing
compared to their total assets - rose sharply at Bear Stearns, to 33 to 1. In
other words, for every dollar in equity, it had $33 of debt. The ratio at the
other firms also rose significantly. This advantage enabled the Big Five to go
on a frenzy of acquisition, expanding risk to the entire financial system. The
abuse of leverage was particularly severe in the hedge fund industry in which
the Big Five were big players both in proprietary funds and as broker-dealers
for large hedge funds which in turn were highly leveraged. (See
Killer touch for market capitalism, Asia Times Online, October 30,
2008.)
Government bailouts and bank executive pay
Banks that received bailout money had paid their top executives nearly $1.6
billion in salaries, bonuses, and other benefits in 2007. Benefits included
cash bonuses, stock options, personal use of company jets and chauffeured cars,
home security expenditure, country club memberships, and professional financial
management fees. The Barack Obama administration has promised to set a $500,000
cap on executive pay at companies that receive bailout money, but the proposal
would also allow banks to give unlimited amounts of stock to these same
executives, presumably tying compensation to performance, even though much of
the recent rise in the price of bank shares were the direct result of
government bailout. The losses are still there, only now the taxpayers are
paying for them rather than bank shareholders.
On January 15, 2009, the out-going George W Bush administration and its
Treasury team under secretary Paulson issued interim final rules for reporting
and record-keeping requirements under the executive compensation standards of
the Capital Purchase Program (CPP).
On January 20, Barack Obama assumed office as the 44th president of the United
States.
On January 21, the new Obama Treasury under Secretary Timothy Geithner
announced new regulations regarding disclosure and mitigation of conflicts of
interest in TARP contracts. It was the first sign that Obama's "politics of
change" might not be what it sounded like to voters during the campaign.
On February 5, the Senate approved changes to the TARP that prohibit firms
receiving TARP funds from paying bonuses to their 25 highest-paid employees.
The amendment was proposed by Christopher Dodd of Connecticut as an amendment
to the proposed $900 billion economic stimulus act then yet to be passed. The
fundamental flaw of TARP, the myth that the transfer of hundreds of billion of
toxic assets from the private sector into the public sector can make them less
toxic, was left unchanged while distraction on a minor point on executive
bonuses was held up as a sign of the new populism.
The bank stress tests
On February 10, 2009, the newly confirmed but still understaffed Geithner
outlined his plan to use the $300 billion remaining in TARP funds, announcing
his intention to use $50 billion for foreclosure mitigation and to use the rest
to help fund private investors to buy toxic assets from banks. Nevertheless,
this highly anticipated speech coincided with a nearly 5% drop in the S&P
500 and was criticized for being short on details.
On February 26, the Obama administration, in unveiling details of its
financial-rescue plan, laid out a dark economic scenario it expected banks to
be able to withstand, the starting point for what could become a significant
new infusion of government cash into the banking system.
The first step in the latest effort to shore up the banking sector would be a
series of "stress tests" to assess whether the largest 19 US banks could
survive a protracted slump. To ensure banks can survive even if the
unemployment rate rises above 10% and home prices fall by an additional 25%,
the administration would conduct stress tests that would end up requiring some
institutions either to raise private money or accept a bigger investment from
the government. The tests assumed a 3.3% contraction in GDP in 2009, which
would be the worst performance since 1946. And it assumed home-price declines
of another 22% in 2009 and 7% in 2010.
The stress tests assumed an unemployment rate averaging 8.9% in 2009 and 10.3%
in 2010. Because that is an average for a whole year, the tests envision the
jobless rate reaching higher than the average in some months. The rate was 7.6%
in January. In March the unemployment rate for California was 11.2%; for
Michigan, it was 12.6%. The Fed said it did not expect the economy to
deteriorate as sharply as the test scenarios, but it wanted to be sure banks
would be prepared for worst-case eventualities. Yet many believed the
government's dark scenario was not dark enough on both unemployment projections
and inflation expectations.
Laurence Meyer, a former Fed governor (1996-2002), a vice chairman of
Macroeconomic Advisers LLC, a forecasting firm whose models are widely used in
Washington and New York, told the press that "I don't have any problem
believing the unemployment rate is going to move to 12% or that vicinity."
Meyer said regulators had to strike a delicate realistic balance in designing
their tests - a truly grim scenario such as the economy contracted by 9% as in
1930, 6% as in 1931 and 13% as in 1932 could force banks to raise more capital
than they were capable of raising, driving them further into the government's
arms. In other words, the dreaded "N" word - nationalization. "You don't want
to know the answer to some of the questions you might ask," Meyer told the
press.
The tests were completed by the end of April but the results were not released
until May 8 because banks were reported to have disputed the results. The Wall
Street Journal reported that as a result of intense negotiation with banks, the
Fed significantly scaled back the size of the capital hole facing the nation's
biggest banks.
As used in the stress tests, Tier 1 common capital ratio is an estimate of
capital available to common shareholders as a percentage of a bank’s
risk-weighted assets.
The Fed has told banks it looked at the Tangible Common Equity (TCE) ratio,
which measures how much shareholders would have left after liquidation. The TEC
ratio shows the equity of a bank minus its preferred shares, goodwill and
intangible assets as a percentage of tangible assets. The Fed wanted TCE to be
at least 4% of a bank's risk-weighted asset. Citigroup's TEC was only 1.9%,
Bank of America 2.9% and Wells Fargo 2.9%.
Citigroup, which has already been bailed out three times amounting to $45
billion, reportedly needs to raise up to $10 billion of new capital as a result
of the stress tests. Bank of America, which has had $45 billion in government
aid, was found to need $33.9 billion. Regional banks Wells Fargo ($13.7
billion) and PNC Financial ($600 million) were also among the banks that would
need to raise more capital.
Citigroup is believed to be considering a plan to convert more than $15 billion
in trust preferred shares - a hybrid of debt and equity - into common stock.
Since trust preferred shares are held by non-government investors, this
conversion could enable government authorities to inject further funds into the
bank without raising its stake beyond the 36% it has already agreed to buy.
Citigroup would have to force holders of trust preferred shares to convert them
into common stock, which ranks below those securities and does not pay a yearly
interest rate, by threatening to stop paying interest if they reject the offer.
Banks have 30 days after the stress tests to give the government a
recapitalization plan and up to six months to correct any capital shortfall.
The Fed's strong preference is for banks in need of fresh capital to either
raise it through private capital markets or by selling assets. Banks that
cannot raise private capital may have to sell to the government big stakes in
their common equity to meet capital requirements.
Unlike the Bush administration's effort to pump $250 billion into banks, the
Obama team did not commit a set amount of money to the effort. Obama said after
taking office that banks would need additional funds beyond the $700 billion
rescue package approved by Congress in the fall of 2008. The government's
investment would come in the form of convertible preferred shares, which
institutions could choose to convert into common equity at any time.
Regulators and investors have become increasingly concerned about the amount of
common stock banks hold, since that is a bank's first line of defense against
losses. Regulators said they expect banks would convert the shares to common
equity as needed to help protect against losses.
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