By Warren Mosler:
I’m writing this because it’s how it is and I haven’t seen it written elsewhere.
Let’s assume, for simplicity of the math, Citibank pre crisis had $100 billion private capital, $900 billion in FDIC insured deposits, and $1trillion in loans (assets), which is a capital ratio of 10%. (The sub debt is part of capital. And notice this makes banks public/private partnerships, 10% private and 90% public. Ring a bell?) This means once Citibank loses more than $100 billion, the FDIC has to write the check for any and all losses. So if all the remaining loans go bad and become worthless, the FDIC writes the check for the entire $900 billion.
Then the crisis hits, and, again for simplicity of the math, lets assume Citibank has to realize $50 billion in losses. Now their private capital is down to only $50 billion from the original $100 billion. This drops Citibank’s capital ratio to just over 5%, as they now have only $50 billion in private capital and 950 billion in loan value remaining as assets. So now if Citibank loses only $50 billion more the FDIC has to start writing checks, up to the same max of $900 billion.
But now Citibank’s capital ratio is below the prescribed legal limit. The FDIC needs a larger amount of private capital to give it a larger cushion against possible future losses before it has to write the check. So it’s supposed to declare Citibank insolvent, take it over, reorganize it, sell it, liquidate the pieces, etc. as it sees fit under current banking law. But the Congress and the administration don’t want that to happen, so Treasury Secretary Paulson comes up with a plan. The Treasury, under the proposed TARP program, will ‘inject’ $50 billion of capital in various forms, with punitive terms and conditions, into Citibank to restore its 10% capital ratio.
So Obama flies in, McCain flies in, they have the votes, they don’t have the votes, the Dow is moving hundreds of a points up and down with the possible vote, millions are losing their jobs as America heads for the sidelines to see if Congress can save the world. Finally the TARP passes, hundreds of billions of dollars are approved and added to the federal deficit, with everyone believing we are borrowing the funds from China for our grand children to pay back. And the Treasury bought $50 billion in Citibank stock, with punitive terms and conditions, to restore their capital ratio and save the world.
So then how does Citibank’s capital structure look? They still have the same $50 billion in capital which takes any additional losses first. Then, should additional losses exceed that $50 billion, the Treasury starts writing checks, instead of the FDIC. What’s the difference??? It’s all government, and the FDIC is funded by the Treasury in any case.
So what actually changed financially? Nothing, except the punitive terms and conditions. The entire exercise resulted in nothing more than what is otherwise known as regulatory forbearance. All that happened was that Citibank was given permission to continue operations, with punitive terms and conditions, with only 5% private capital rather than the normally required 10%. And note that the government is still on the hook for the same $900 billion should all Citibank’s remaining loans go bad, just like it was before. So there hasn’t even been any more ‘money’ committed. China never did get a phone call. (And the Fed manages any change in reserve balances in the normal course of business, keeping them at its desired level.)
Did anyone involved in this process (without wasting space naming the obvious names) know this? I’d say no, or surely there would have been at least one mention in the media, one editorial, one blog (other than mine) pointing this out. And surely if they knew it was about regulatory forbearance all that political capital would not have been burned trying to get nearly $800 billion in what was thought to be deficit spending passed to do what is still called a ‘bail out at taxpayer expense’ (which also probably caused half the nation to become Tea Party sympathizers).
And as if to demonstrate they still don’t get it, the discussion has turned to paying back the government. Yet all that happens with a pay back is that Citibank raises the required $50 billion in private capital which ‘replaces’ the $50 billion of funding they got from the Treasury, leaving the FDIC responsible for the remaining $850 billion of insured deposits, rather than $900 billion. So all ‘paying it back’ amounts to, at the macro level, is convincing depositors to shift $50 billion of FDIC insured deposits to an equity investment in Citibank. What’s called payback is nothing more than a shifting of risk. It doesn’t alter how much ‘money’ Citibank has, and it certainly doesn’t alter aggregate demand or anything else in the economy.
I have to conclude that no one involved had nor now has a sufficient understanding of what banking is and how it works to be considered qualified to deal with this issue. And now many of the same people, who still don’t have a fundamental understanding of banking, are designing a regulatory reform bill. But that’s another story.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.