Chapter 26. Banks Bounce

“After a crash has occurred, it is important to wait long enough for the insolvent firms to fail, but not so long as to let the crisis spread to the solvent firms that need liquidity—‘delaying the death of the strong swimmers’.”

Charles P. Kindleberger¹

World markets only recovered once investors grew confident that no more big banks would fail or be nationalized. That started a “positive feedback” loop, as confidence made financing easier to obtain in many markets. Governments won that confidence by treating banks with exceptional generosity.

The news that revived world markets came in an internal memo. From October 2008 to March 2009, Citigroup had needed four infusions from the U.S. government to stay afloat. Its share price dipped below $1, making nationalization seem inevitable. Vikram Pandit, Citi’s CEO, wanted to reassure his 300,000 employees, so he told them that “we were profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.” He also said that deposits were “relatively sound,” suggesting that there was no bank run to match the travails of the UK’s Northern Rock.²

This was enough to spur what was arguably the most impressive rally ever seen in the U.S. stock market. That day alone, Citi’s share price rose almost 40 percent, while the S&P grew 6.5 percent.³ Just as Meredith Whitney had marked the top on Halloween 2007, more news from Citi marked the bottom 16 months later.

It had such an effect for two reasons. First, as in any down market, fear swamped greed. As Citi became a penny stock, the S&P 500 touched the ominous number of 666, erasing all of its gains since August 1996. Surveys of investors suggested confidence had never been lower. The weekly survey of the American Association of Individual Investors found 70 percent of its respondents feeling bearish—the highest on record and more pessimistic even than in the desperate weeks after the Lehman collapse. In such conditions sometimes a minor news item, such as Pandit’s internal memo about unaudited figures, can turn confidence around.

Second, central banks had surgically removed the fear from the markets on which banks depend. Government cash had brought investors back into the frozen markets for commercial paper, mortgages, and corporate credit. That created cheaper financing and helped banks. For shareholders, there remained the risk that nationalization would wipe them out, but Pandit’s memo reassured them on that score. That allowed money to return to equities as well.

In sum, although obscured in an alphabet soup of acronyms, the government’s clear message was that no bank would be allowed to fail. Once that message was received, markets entered a positive feedback loop. Just as George Soros might predict, confidence in one market alters the reality of other markets for the better and allows them to recover. Once the central banks had convinced a few key traders that they were serious, correlation once more became a force for gains.

The U.S. government’s bailout package unrolled bit by bit in the days after the correlated crash of October 2008. The Federal Reserve bought commercial paper directly, in effect putting it in the business of lending to companies that were not banks, which was a huge extension of its remit. This signaled that it was safe to buy commercial paper once more, so banks could once more borrow in the commercial paper market.

Britain’s premier Gordon Brown announced a £400 billion bailout for British banks—almost as much as the $700 billion that Congress voted for the TARP, for a country less than one-fifth of the size of the United States. The government bought stakes in troubled banks, a form of nationalization, but the market liked the move. That prompted the U.S. Treasury, still controlled by Hank Paulson under President Bush, to do the same.

Paulson bought direct stakes in big banks, whether they wanted the money or not. This money raised banks’ capital so that they could afford to take more losses. He followed up with targeted rescues for big banks that got into trouble, including Citigroup, which took an extra $20 billion in capital from the government, along with guarantees for a stunning $300 billion of its most problematic debt-backed securities,⁴ and Bank of America, which also received $20 billion, along with guarantees of $118 billion of debt.⁵ The two behemoth banks created in the Holy Week mergers of 1998 were, indeed, too big to fail—and this was a relief for the markets.

Next, there was the Term Asset-Backed Securities Loan Facility (TALF), in which the Fed offered to lend up to $200 billion to holders of student loans, auto loans, credit card loans, and small business loans—all forms of credit that were not yet deep in trouble, but gave reason to fear that the panic would soon spread. The TALF erected a firewall to stop the problem spreading to new areas.

The Fed also said that it would spend up to $600 billion buying mortgage bonds issued or guaranteed by the big agencies such as Fannie Mae and Freddie Mac. This let banks sell the more “toxic” securities on their balance sheet. It also drove up their price and persuaded some speculators to try buying them at cheap prices in the hope of later selling them to the government. The move essentially brought life back to the mortgage market.

In March came quantitative easing, the jargon for a central bank buying government bonds to push prices up and yields down—a form of printing money. Central banks hate doing this, so this was a clear sign to the markets that the Fed would stop at nothing to keep the banks from collapsing.

The Obama administration and new Treasury secretary Timothy Geithner even announced a Public-Private Investment Program (PPIP), which came close to a bribe to buy toxic assets. Banks would be invited to put up bundles of toxic debt for auction, and fund managers approved by the government would then bid for them. The money they put forward could be multiplied up to 12 times by cheap loans offered by the government—a move that directly mimicked the extreme leverage that had helped exactly these assets get overvalued in the first place. This suggested total desperation to get these markets moving. The more the assets proved to be worth, the more the exercise would cost taxpayers (because they would pay a higher price for the assets), while the fund managers, if they made a killing, would keep their leveraged profits.

In April 2009, the United States even allowed banks to fudge their accounts. Under “fair value” accounting, banks had to value their assets at the price which they could fetch in the market. They complained that in the event of a panic, they had to mark down to irrationally cheap values, even to the point of rendering themselves insolvent. The new rules, rushed through by the main U.S. accounting standards body amid complaints of political pressure from big investor groups, gave banks a little more flexibility. Rather than see the value of their assets plummet with the market, they now had some leeway to assume a higher price.

All of these measures sound like desperation. They were. But their effect on markets is best understood using game theory. Politicians were daring investors to take risks. There was no money to be made by making secure investments, because interest rates were zero. Bond yields were not going to rise because the Fed and the government would not let them. The government was not going to allow another Lehman debacle either. Moral hazard was back—if a big bank took one risk too many, they would be rescued. That made risk-taking irresistible.

Now, consider the games that individual fund managers play against each other. Staying in cash paid them nothing. Their peers, against whom they were judged, made big profits as markets recovered. Therefore, the pressure to start buying riskier assets was overwhelming, even for those who believed the government’s desperation tactics would end with another crash. The herding instinct was made stronger by the effects of confidence returning to different markets. Activity returned to commercial paper markets, and then to mortgages and good-quality credit. That relieved pressure on banks (even as the economy was in freefall), so investors started buying stock.

Having launched on this strategy, governments then had to play for time, to ensure no further panic before confidence in markets could take hold. In the United States, the Obama administration did this by taking months carrying out stress tests—computer simulations to see how big banks would fare in a severe economic downturns. Many complained that they were barely even “stress” tests, as the scenarios they tested were far from the worst imaginable, but the wait for the results—which were leaked in advance—helped to take heat out of the situation.

When the stress test results appeared, they showed that ten big banks must raise an extra $75 billion in capital.⁶ Months earlier, this would have been impossible, but with markets riding higher on hopes of a China-centric global recovery, banks found buyers quickly, underscoring the new-found confidence.

The strategy of playing for time had worked, at least so far. It was not indefensible—the longer that banks could continue trading with access to historically cheap credit, the longer they could accumulate profits. Those profits could be added on to their capital, steadily making them more solvent. Investors, knowing this, lined up to offer them more money to wager.

Banks (and money markets) rest on confidence. This confidence in itself reduced the toxicity of the most impaired assets, by raising their prices, and made financing easier for everyone to come by. By the end of 2009, the more successful banks were making big profits and thereby making themselves very unpopular.

But there was still ample reason to worry about the health of banks. Banks that were not too big to fail, tended to fail. In 2009, 140 U.S. banks failed, the most since deposit insurance was introduced in the 1930s.⁷ Rising unemployment—which reached 10 percent in 2009—tends to bring higher defaults in its wake, much commercial real estate appeared to be overvalued, and many of the most ill-advised subprime mortgages were due to be reset to new interest rates. Any of these factors might yet overwhelm the buoyant animal spirits of the banking system—just as subprime losses had forced the credit bubble to burst in 2007.

But the calculated gamble that markets could continue their virtuous circle until the banks had dealt with the overhang of bad debt on their books carried on working for many months. In the 1930s, the greatest fear was fear itself; in the age of Barack Obama, the greatest hope for the banking system was hope itself.

In Summary

• Markets’ recovery rested on recovery by the banks, which in turn rested on unprecedented and costly government attempts to bolster confidence.

• This policy avoided the bank nationalizations that had been anticipated. The critical question for 2010 and after is whether confidence can be sustained once the emergency measures end.

• If not, banks are reliant on the moral hazard created by government guarantees—and nationalization might be preferable.