Making a Loan Only After It Goes Bad
“The banking system is healthy.”
Ben S. Bernanke, Federal Reserve chairman, Oct. 15
“Our bank regulators must evaluate regulatory capital requirements applicable to bank exposures to off-balance-sheet vehicles.”
Treasury Secretary Henry M. Paulson Jr., Oct. 16
Out of sight, out of mind.
AsAmerica’s big banks reported poor quarterly results this week, it washard to know what was more distressing: the news, or the fact manybankers were clearly surprised.
They were surprised becausebanking has evolved to the point where a large part of the revenuecomes from things invisible to readers of financial statements, eithercommitments to make loans, or through vehicles carefully engineered tostay off the balance sheet.
A notable illustration came from Citigroup.Its write-offs were half a billion dollars more than the bank hadforecast only two weeks earlier, and its optimism about the fourthquarter was toned down considerably.
But the most impressive factwas the bank’s explanation of why its nonperforming corporate loantotal had doubled, to $1.2 billion, in just three months.
Citiexplained that the bulk of that came from just one loan — and it was aloan that had not even been made a few months earlier. Citi had taken afee to provide a backup line of credit to a structured investmentvehicle — a line that would be called on only if the S.I.V. could notborrow and a German bank could not meet its promise to make the loan.
That happened, so Citi forked over the cash and immediately put the loan on nonperforming status.
That’s a neat trick. You don’t make the loan until you know it will be a bad loan.
Henry M. Paulson Jr., the Treasury secretary and former chief executive of Goldman Sachs,says many banks “appear not to have fully appreciated all of the risksassociated with the securitized assets on their balance sheets or themany risks associated with commitments to provide liquidity tooff-balance-sheet vehicles, such as conduits and structured investmentvehicles.”
What you don’t know really can hurt you.
Mr.Paulson mobilized the big banks to find a way to rescue S.I.V.’s bypurchasing assets from them. The idea is that the new super-S.I.V.,called a Master Liquidity Enhancement Conduit, would be able to borrowin the commercial paper market — something the S.I.V.’s cannot now do —because the banks would provide backup lines of credit to reassureinvestors.
The convoluted structure speaks volumes about howbanking has changed. The banks considered and rejected a suggestionthat they just lend money to the S.I.V.’s directly. Nor did they wantto buy the S.I.V.’s assets — supposedly safe securitization products —for their own balance sheets.
Even if it works, the new conduit— promptly dubbed a FrankenFund by some — just buys time. Thesecuritization model, in which risky loans were largely financed byinvestors who thought they were making safe investments, has notrecovered from the shock of learning that financial alchemy had notturned junk into gold.
Until — or unless — it recovers, themajority of new mortgage loans will be made only because thegovernment, or an enterprise with government backing, is willing toguarantee them. Investors will still buy securities backed by thoseloans.
But if a loan does not meet the government’s standards —perhaps because it is too large — most borrowers must find a bankwilling to make the loan and keep it on its balance sheet.
Howold-fashioned is that? Banks do not want to tie up their capital for 30years. They long for the go-go years when they got fees without havingto actually put out the cash for very long.
Mr. Bernanke,the Fed’s chairman, voiced the conventional wisdom when he said thebanks were in good shape. He is in a better position than the rest ofus to know that is true, but so were the bank managements who weresurprised.
Gary L. Crittenden, Citigroup’s chief financialofficer, told my colleague, Eric Dash, that Citi, in manufacturingproducts to sell into the securitization market, had focused on thewrong thing. “We had a market risk lens looking at those products, notthe credit risk lens,” he said.
Now Citi, and its competitors,are learning just how much credit risk they took on. Mr. Paulson wantsto make sure that regulators force them to have adequate capital forthose risks, and that accounting standards force disclosure of therisks.
Those are good ideas, although they may be a little late.
With the securitization market in trouble, we need the banks to beable, and willing, to revive their traditional roles as financialintermediaries. Their decision to avoid that in setting up thecomplicated “Master Liquidity Enhancement Conduit” is not anencouraging development.
