TARP 3 and 4 Are on the Way

TARP 3 and 4 Are on the Way By John Mauldin

There are a lot of complaints about the use of the first $350 billion in TARP money. How could (now) former Merrill Lynch Chief John Thain have been so tone deaf as to spend $1.2 million on decorating his office with the company clearly in financial trouble? And some of it apparently after the government was kicking in money? Large bonuses for select managers at the last minute before the merger and subsequent major losses? The list could go on and on. The Obama administration has plans to keep such abuses from happening. I wish them l uck, because the next round of $350 billion is just a down payment.

(By the way, we should remember the TARP money is intended to be a loan and not a subsidy. Taxpayers should at least have the chance to come out whole. We will see.)

Professor Nouriel Roubini and his team at RGE Monitor (www.rgemonitor.com) have been noting in speeches in various venues around the world that they estimate that losses from the financial world could be as high as $3.6 trillion. That is composed of $1.6 trillion in loan losses and another $2 trillion in mark-to-market losses of securitized assets.

"U.S. banks and broker dealers are estimated to incur about half of these losses, or $1.8 trillion ($1-1.1 trillion loan losses and $600-700bn in securities writedowns) as 40% of securitizations are assumed to be held abroad. The $1.8 trillion figure compares to banks and broker dealers capital of $1.4 trillion as of Q3 of 2008, leaving the banking system borderline insolvent even if writedowns on securitizations are excluded."

Roubini argues that banks will need an additional $1-1.4 trillion dollars in private- and public-sector investments. Then he and colleague Elisa Parisi-Capone lay o ut in detail how they come up with their numbers. They argue:

"Thus, even the release of TARP 2 (another $350 billion) and its use to recapitalize banks only would not be sufficient to restore the capital of banks and broker dealers to internationally accepted capital ratios. A TARP 3 and 4 of up to $1.05 trillion (assuming generously that all of TARP 2 goes to banks and broker dealers) may be needed to restore capital ratios to adequate levels."

Even with all the government money added to the banking system, net capitalization of US financial institutions may fall to as low as $30 billion, from around $1.4 trillion before the credit crisis. Let's think about what that means. This same exercise in principal works for England and other European countries. England may be down $2 trillion pounds, which is relatively much larger than the US losses.

Senators at the Banking Committee hearings which looked into the appointment of Tim Geithner as Treasury Secretary (and kudos to the five who voted against approving him) were outraged at the problem of giving banks all that TARP money and other Fed commitments, and now they were not lending that money and indeed it looks like they want more! I know this will shock some of my foreign readers, but most of the Senators on the banking committee don't really understand the banking system.

Here's the problem. The banks are lending. If you look at bank lending numbers, there is growth. The banks, per se, are not the real problem with the lack of lending. The real problem is that we vaporized an entire Shadow Banking System that bought securitized debt in a wide variety of forms: autos, homes, student loans, credit cards, etc. That industry exists no more.

Banks over the last ten years became originators of loans, and not actual lenders. They would make the loans and then package them up for other institutions to buy. A pension fund in Norway (or wherever) would look at the rating from Moody's, see AAA, and buy it. Or banks would create off-balance-sheet vehicles (SIVs) to buy their debt and leverage it up, and book some nice profits. In any event, the debt did not end up on the banks' balance sheets for very long.

That process was responsible for the majority of debt that was extended over the last decade. Now that process is broken, and it will not be fixed this year or next year or the year after that. We are going to have to come up with new ways of credit creation and debt processing. You can't go to Goldman and tell them to start making auto loans. They simply don't have the people20to do that. Now, they used to be able to take auto loans from other actual originators and package them and sell them, but they did not make the loans. And the buyers for much of that securitized auto loan paper are gone. And they are not coming back any time soon without greater transparency and real capital guarantees and higher returns. A Moody's (or any rating agency) rating is not worth the paper, as far as the markets are concerned.

In essence, we are asking the banking system, with greatly reduced capital, to do the heavy lifting that all the buyers of securitized debt did a few years ago. And if Roubini is remotely right, they simply do not have the capital to do it. Further, the banks are in a bind. The regulators, properly so, are making sure that banks have adequate capitalization and are marking assets to real market prices. But they simply have less capital to make loans, even with TARP.

And the loans that many banks have made are showing higher losses than normal. Maine fishing buddy and bank maven Chris Whalen of Institutional Risk Analytics thinks that loan charge-offs will be twice the 1990 level, or around $800 billion, not far off from Roubini's number. That will force banks to loan less money and raise capital. Not exactly what the Senators want.

And it will force banks to tighten lending standards. Look at this chart from Binit Patel, Senior Global Economist for Goldman Sachs. It tells the story of a banking industry in crisis: