Cutting the Gordian Knot

The virtue of nationalization from the perspective of Geithner and Obama is it would cut the Gordian Knot that ties together valuations of bank assets and capital adequacy.

The government, notwithstanding its many financially reckless actions, still enjoys the ultimate presumption of solvency. If it runs short of cash, it can print money.

By wiping out the shareholders – and perhaps the bondholders – of banks such as Citigroup, the Treasury can avoid the headaches of trying to strike a balance between restoring the solvency of the banks (in the interests of stakeholders) and restoring a fully functioning credit system.



And because the government’s capital is automatically adequate whenever it extends guarantees of “full faith and credit,” this obviates the immediate need of bringing extra cake make-up to the funeral parlor to dress up the toxic assets of the banks.

Remember last autumn when former Treasury secretary Hank Paulson tried to buy those assets with $700 billion TARP program?

He was stopped in his tracks by the realization that transactions to acquire the toxic assets would spoil the fudge built into America’s Generally Accepted Accounting Principles (GAAP). This permits banks to operate while insolvent, provided they keep up an artful pretense.

Accounting for Banks’ Insolvency

Without delving too far into the tortured world of GAAP accounting, it involves a hybrid of mark-to-market and book value accounting.

Under GAAP rules, if institutions pretend they are holding the assets to maturity they can carry them at book value without marking them to market. But here’s the catch: If they sell a portion of them, the remaining assets must be marked to market.

Let that happen and almost all the U.S. banks would be insolvent.

It is a thorny problem. You see, if the government allows the banks to keep lumbering along with their current capital structures, these fatally wounded institutions will require trillions of dollars in new capital or bailouts, which will have to be accounted for in some fashion.

Citi, for example, is trying to run a $2 trillion balance sheet on just $10 billion of equity. Do the arithmetic. That is the leverage of a tightrope act.

It means the potential amount of capital needed to fill the gap between the value of Citi’s assets and its market value would be truly stupendous. And it isn’t going to be forthcoming on a basis that would be palatable to existing Citi shareholders, much less to taxpayers.

After pumping $45 billion into Citigroup in the form of preferred shares or convertible debt, the government already holds about an 80% claim on the economic value of the firm. And there just isn’t enough room in the current Citi cap structure to permit taxpayers to earn a return on further investment at the scale required.

Does Bay Street, Toronto, Hold the Key?

If the government nationalized Citi and other zombie banks, it could warehouse their toxic assets until these assets mature or until they can be placed into “bad banks” on the Swedish model. And removing dodgy assets from the banks’ books would allow them to become economically viable again.

But that is only part of the issue. As Senator Schumer rightly suggested, governments cannot run banks. Even liberal Democrats understand this. And an attempt will be made to return the core banking functions to the private sector.

The question is: Where will the Feds find qualified institutions to take over the franchises of the zombie banks after they are embalmed and buried?

My answer: They are lined up in high-rise towers along about a four-block section of Bay Street in Toronto.

As President Obama recognized during his visit to Ottawa, Canada’s financial system is far stronger shape than America’s.

For a start, Canada’s five leading banks are solvent.

A Bloomberg report a couple of years ago underscored the market perception of the relative strength of Canadian banks. Their market caps already reflected a considerable premium over U.S. banks; on average, Canadian banks were capitalized at $2.60 for every dollar or book value, as compared with an average of $1.70 in the U.S.

Canada’s Bacon Is Safe

If the zombie banks are indeed to be interred and replaced with viable institutions, Canada’s big banks are among the leading candidates to fill the void created in the current collapse. At least their balance sheets are clean!

As Toronto-Dominion Bank CEO Edmund Clark recently explained, “Canada will emerge, as long as we don’t do anything stupid, as the only country in the world where the banks didn’t need government help.”

Canadian banks have written off an aggregate of only US$13.7 billion since 3Q 2007 as compared to more than $1 trillion in the U.S.

Part of the reason Canada’s banks are in strong shape is that the U.S. housing bubble did not cross the northern border. Canadian law does not permit the deduction of interest on residential mortgages. So Canadian home buyers typically seek to extinguish their mortgages as quickly as possible, rather than leverage them as tax shelters the way Americans do.

What About Smaller American Banks?

There are still some smaller banks in the U.S. that have operated on a more conservative gearing.

Many of these smaller, more conservative banks are solvent. But after decades of consolidation in the banking sector, America’s solvent banks may be too small to absorb the franchises of giants such as Citigroup and Bank of America.

The problem is the government’s bank rescue efforts have further weakened the ability of sound U.S. banks to expand. For one, the government forbids banks that accepted TARP funds from expanding through acquisition until those funds are repaid.

Admittedly, this is a relatively low obstacle, as politicians could change this rule in a few days. But Washington would have a more difficult time restoring the margins for conservative banks that have been undermined by the bailout efforts.

See, the vain attempt to resuscitate the zombie banks led the Fed to slash interest rates; and banks depend on the interest rate spreads to profit. So by driving rates down to invisibly low levels, the government has made the U.S. banking sector, as a whole at least, temporarily unprofitable – even for soundly managed institutions.

Prime Candidates

Other than a couple of large British banks, such as HSBC and Barclays, the leading Canadian banks are the best candidates to expand into the void created by the insolvency of the big U.S. money center banks.

Canada is the largest trading partner of the U.S. And the big Canadian banks have experience operating at a continental scale.

Two of Canada’s biggest banks recently expanded into the U.S. in a big way.

Canada’s largest bank, Royal Bank of Canada (TSE/NYSE RY) (recent price: $21.65), recently acquired Centura Banks and now operates more than 225 branch offices in America’s Southeast. (RBC has 1,700 branches in Canada and over 300 outside Canada.)

Canada’s second bank, Toronto-Dominion Bank, recently expanded into the U.S. by acquiring Commerce Bank in the mid-Atlantic. Toronto-Dominion also owns Banknorth in New England. A federal judge blocked TD’s efforts to operate its Banknorth branches as TD Commerce Bank. So Toronto-Dominion decided to do business in the U.S. as TD Bank. It has a network of over 1,000 branches.

As the credit crisis in the U.S. meanders along, businesses and consumers who want to get loans should learn to speak Canadian. They should march into a local office of The Royal Bank of Canada or Toronto-Dominion Bank and ask if they can "bum a few loonies, eh."

If they meet a real Canuck, and his “ginch” (underwear) is not too tight, they answer might just be yes.

To Your Success,

James Dale Davidson

Editor,

Abundance, Crisis Strategy Alert