Winter springs eternal so far for 2009. More than a year into the biggest banking crisis America has experienced in recent history, and the financial tempest remains strong. Just when we thought the government had stabilized the financial system, Citigroup
To gain insight into the latest developments in the financial system, as well as how the new Obama administration should handle this crisis going forth, I talked with Bert Ely, an expert on monetary policy and the regulation of banking and financial services.
Bert Ely is president and founder of Ely & Co., a monetary policy consulting company that monitors the banking and thrift industries, the payments system, and the growing federalization of credit risk. Ely, an early predictor of the S&L crisis and the non-crisis in commercial banking in the early 1990s, has specialized in deposit insurance and banking structure issues for nearly 30 years.
What follows is an edited transcript of the interview:
Jennifer Schonberger: Where do we stand in relation to Sept. 15, when everything in the banking system came crashing down (notably Lehman Brothers)?
Bert Ely: We're not out of the woods yet. There's still tremendous uncertainty about the conditions of the banking industry and conditions of individual banks, and of course, that reflects continued economic uncertainty of how this crisis is going to play out.
Schonberger: How has globalization played into this crisis?
Ely: Globalization plays an important role, but it's a variety of factors. No. 1 today, unlike the 1980s, the U.S. borrows enormous amounts of money from abroad, which is why toxic assets got spread all over the world. Twenty years ago, that wasn't an issue. Second, technology has permitted the creation of a lot of sophisticated financial instruments that turned out to be very problematic. In the 80s, the situation was much more contained in the U.S. and in the savings and loan industry. I did not worry about the global financial system collapsing.
Schonberger: Going forward, how should President Obama and his administration handle this crisis? What needs to happen that hasn't happened yet for the banking system to recover?
Ely: From a government policy standpoint, they have to keep the big turkeys afloat, specifically Citigroup, while they're working through their problems, and keep the credit system functioning. Banks are lending, and they have increased their lending. Commercial bank lending rose 5.7% from December 2007 to December 2008, according to Federal Reserve data. I worry that we'll get congressional mandates to increase lending even more, and to force banks to engage in risky lending, which would be bad policy.
Perhaps the toughest issue they have to deal with in the short term is the problem assets on banks' balance sheets. There are basically two approaches: First, there is the bad bank, or aggregator banks, which was TARP's original purpose. They never figured out how to price the assets, and they still haven't figured that out. The other approach, which is the approach they took with Citi and Bank of America's Merrill Lynch assets, is asset guarantor -- an insurance, loss-sharing mechanism between the bank and the taxpayer with regard to troubled assets. That's the big policy debate of the moment: to use the asset insurance/guarantee approach or to use some variation of a bad bank, or aggregator bank. I'm highly skeptical of the workability of the bad bank idea, but there's a strong push for it right now.
Schonberger: Many argue the toxic assets are the root cause of the current failure in the American banking system. Why are you skeptical of the workability of the "bad bank" approach, and what action would you take instead?
Ely: Toxic assets can be a problem in terms of the capital impact on a bank; whether you sell the toxic assets into an aggregator bank, or you keep them on the bank's balance sheet, ring fence them somehow, and then protect the bank with some sort of asset insurance that absorbs a lot of the down side risk. However, the assets are still there. They're losses the bank has to recognize, and you have to manage them. I question the feasibility of shifting the ownership and management of these assets into a government controlled entity. It's not clear to me why this aggregator bank is going to be able to do a better job of dealing with these toxic assets than the banks that now have them on their books. For those banks that are very sick, an asset insurance or asset guarantee should be put in place. I think the agreement that the Treasury created with Bank of America is a pragmatic model for doing that.
Schonberger: Do you think that the current policy approach of injecting capital into the large problem banks is effective?
Ely: The current approach is fine, providing you don't put too many strings on it -- and I'm very concerned about that as well as keeping the problem banks afloat until they get their problems resolved. The problems are resolved either by being acquired, or if they're too big to be acquired, going through a downsizing and reorganization process. With the few big ones, I think you put them in intensive care and you downsize them and deal with their problems until they reach health … we're really focused on Citi here -- that's the big problem.
Schonberger: Do you think the government should force banks to take writedowns?
Ely: First you have the accounting rules governing in that regard. The problem is if the writedowns are severe enough, then the bank has to be shut down. Cleaning up the smaller banks is not the challenge because we can resort to our classic bank failure resolution policy. Most of these banks are going to be able to work through this. It's not like they've never had periods of losses and huge credit problems. The tougher public policy challenge is how to clean up the big banks -- notably Citigroup and Bank of America.
I think that Bank of America is in a lot better shape than people think. It has a lot of forward earnings power that is being swamped now by the Merrill Lynch acquisition, which, in hindsight, was probably not a good move. Citi's problems ultimately seem to be more managerial than anything else. The bank needs to get a banker in there that will pull together what has not been a well-managed operation.
Schonberger: How much of a viable possibility is nationalization of the big problem banks?
Ely: Nationalization should only be for the occasional institution that will quickly break up and cannot raise private capital. To the extent that there is any explicit takeover, it ought to be short term and done only because current management isn't moving fast enough to deal with these problems. Citi is the only one that fits into that category.
Schonberger: How will the new Wall Street/the new financial system look after we emerge from this crisis? Is the era of leverage completely over?
Ely: No. I would worry that public policy changes will set us up for another disaster because public policies -- notably the tax laws -- are the root cause of this crisis. They distort the financial system, and I worry about what's going to come out of it. Everyone is against leverage. The problem is the financial engineers are going to try to figure out how to maximize leverage [regardless of what's happened]. Regulators can talk all they want about trying to reduce leverage, but that's no match for the financial engineers.
Schonberger: What indicators can we watch to see where things are headed next?
Ely: One of the things I look at a lot are stock prices. As these prices come back, it will be a sign that investors' confidence is being restored. I'd also examine the yield curve. It's hard to measure, but also sort of a calming down of fears and concerns about what's happening.
Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. BB&T is an Income Investor recommendation; Bank of America is a former Income Investor selection. The Motley Fool has a disclosure policy.