Even as America’s politicians harangue the bankers, the bankers are sniping back. On March 13th the chairman of Wells Fargo, America’s fourth-biggest bank, called the Treasury’s ongoing stress test for banks, with its glacial timetable, “asinine.” Amid the ranting, the rot from bad debts is creeping up banks’ capital structures, imperilling any recovery. Initially common shareholders, who bear the “first loss” on assets, were crushed, along with preferred shareholders, who get supposedly safer dividends. Now owners of bank debt, which bears losses once equity is wiped out, live in fear. Junior subordinated debt, which ranks next in the queue, trades at 15-45 cents on the dollar and senior subordinated debt at 65-70 cents. Even senior debt, holders of which rank second only to depositors in America and typically alongside them in Europe, is at 85-90 cents.
It was not meant to be like this. After Lehman Brothers’ chaotic bankruptcy it was judged that big bank failures were too destabilising to tolerate. Hence America’s government injected equity into banks to boost the buffer against losses and to end the freeze in wholesale-funding markets that had made banks wary of lending to each other. But now many worry the buffer is too small-hence the suspense over the results of the stress tests, due in late April. Some politicians are losing patience and want creditors to suffer alongside taxpayers. “These banks can go into receivership … reduce the amount they owe to their bondholders, and come back out much stronger institutions,” argues Brad Sherman, who sits on the House Financial Services Committee.
Haircuts for everyone, although perhaps emotionally satisfying, remain unthinkable. Bankruptcies would cause chaos among depositors and lenders to banks such as money-market funds, insurance firms and foreign governments. They would also contradict the entire thrust of American policy so far, which has seen the authorities guarantee $210 billion of new debt issued by banks. The state would also lose the $240 billion it has invested in banks’ common and preferred equity. Tim Bond of Barclays Capital says the sell-off in senior bank debt is “completely baseless.” One response to market jitters would be to guarantee all bank debt, not just the new stuff. But after repeated bail-outs of American International Group, a bottomless pit masquerading as an insurance firm, the Treasury would need to be sure that banks are solvent. Widespread losses by depositors and senior bondholders remain implausible. But the fate of more junior creditors rests on the stress tests, which will assess whether losses can be absorbed in two scenarios, the worst of which projects a further 28 percent drop in house prices and a 10 percent unemployment rate by 2010.
Just how far up the capital structure might losses go? A pessimistic estimate of American banks’ losses on securities and loans, by two economists, Nouriel Roubini and Elisa Parisi-Capone, points to an incremental hit of $1.3 trillion, on top of the $500 billion American banks have booked so far (which adds up to 13 percent of GDP). To cushion this $1.3 trillion blow, American banks have left just $700 billion of tangible common equity, the purest and most flexible form of capital. However banks will still make underlying profits before provisions that can help absorb losses. David Hendler, an analyst at CreditSights, a consultancy, points out that low short-term rates helped banks boost their lending margins in the fourth quarter of 2008. And this month many big lenders have made positive noises about profits so far this year. Stockmarkets have surged in response.
Based on hints from Bank of America and JPMorgan Chase, which suggest they will make annual pre-provision profits of just under 2 percent of assets this year, in the best case America’s banks would sustain the underlying earnings level of recent years (see chart). Bears, however, think profits will collapse as loan books shrink and capital-market activity withers. Simon Samuels of Citigroup reckons banks’ pre-provision profits fell to 50 percent of their peak level in America during the Depression (compared with 35 percent after Japan’s banking crisis and about 20 percent after Sweden’s). Added to tangible common equity, the best and worst case scenarios for earnings over the next three years suggest a buffer of $1.1 trillion-1.6 trillion. Compared with incremental losses of $1.3 trillion, that is too tight.
Ideally banks’ balance-sheets would have another type of capital which could top up the buffer without spooking depositors or the owners of senior debt and senior subordinated debt. Fortunately that capital exists. American banks have $440 billion of hybrid tier-one capital, in addition to tangible common equity. Much of this is in preferred shares, but there is also about $100 billion of junior subordinated debt at the ten biggest banks alone. This is typically long-dated with deferrable coupons-which is why regulators treated it as tier-one capital. The trick will be to convert this into common equity without putting banks into administration. Given the threat coupons will be suspended for the foreseeable future, and the low prospects for redemption, prices on this debt have tumbled to 15-45 cents. More banks may try to tempt owners to convert it, as Citigroup has proposed with up to $28 billion of its preferred shares and tier-one hybrid debt.
If American banks were to convert all of their tier-one capital into common equity, then after bearing all losses, the available tangible common equity buffer in three years’ time would trough at between 2 percent and 5 percent of assets. Providing profits continue to roll in, that could be just about acceptable, particularly if the government’s plan to buy toxic assets also finally gets off the ground. Some banks may fail the stress tests-and if they do the political climate may demand that more senior creditors suffer. But it looks just about possible that America’s banking system can stagger on without defaulting. In God, and in the squashing of hybrid capital, do senior bank creditors trust.