Will Timothy Geithner succeed in saving the banks or merely flush hundreds of billions of public dollars down a black hole?
The answer likely will be determined more by the strength of the economy than by the design of the treasury secretary's most recent efforts to shore up the floundering industry.
Geithner continues to argue that large amounts of government capital will be invested in struggling banks. Despite pushing legislation that would allow the government to seize and wind down failed financial conglomerates, he shows no inclination to let the largest institutions fail. "A core part of our plan involves making sure banks have enough capital to provide the lending we're going to need to get recovery back on track," Geithner said March 29 on ABC's "This Week with George Stephanopoulos." "Some banks are going to need some large amounts of assistance."
The Treasury is conducting "stress tests" to determine how much additional capital commercial banks across the country will need to weather a more serious downturn in the economy and still provide the lending necessary to lift the country from the current recession. The Treasury will assess banks' strength under two scenarios: first, a baseline that corresponds roughly with various professional forecasts for GDP, unemployment and housing prices. The second assessment will assume a more adverse environment, with GDP shrinking 3.3% this year and housing prices plunging a further 22% lower than in 2008. Unemployment will bottom out next year at 10.3% under the more adverse estimate.
By all indications, Geithner intends to offer banks the capital they need to make it though this tough environment, even though by his own estimate he has only $132 billion remaining to draw upon from the $700 billion Troubled Asset Relief Program. If he wants more money, he will have to get it from a hostile Congress.
But whether the stress testing will even provide a realistic assessment of the industry's conditions is a big question. The state of the industry at any moment depends on the severity of the downturn. "What happens with the banks is highly dependent on what happens with the economy," says Chuck Muckenfuss III, partner in the Washington office of Gibson, Dunn & Crutcher LLP and a former senior deputy comptroller for policy at the Office of the Comptroller of the Currency.
Geithner wants private investors to buy up toxic mortgage portfolios from banks so they can shore up their balance sheets, but there would still remain a large overhang from credit cards and commercial real estate that are now beginning to have problems.
"Credit card losses correlate perfectly with unemployment," he says.
Many of Geithner's critics argue that he has woefully underestimated how deep the downturn will go and thus how much money will be needed to prop up troubled institutions. "If the economy suddenly turns around and we have a spectacular recovery, then many of these issues will naturally go away, but that's not likely," says analyst Martin Weiss, president of Weiss Research Inc. in Jupiter, Fla.
Weiss says all federal banking regulators have underestimated the problems that banks face. There are 252 banks with assets of $159 billion on the Federal Deposit Insurance Corp.'s problem list of troubled institutions. But Weiss calculates that there are actually 1,568 banks and thrifts with $2.32 trillion in assets at risk of failure.
There may be more behind regulators' willingness to let struggling institutions limp along than just faith in an economic turnaround. Aggressively shutting down institutions will not only tax the agencies' staff but also would likely worsen problems for banks by further depressing housing prices and consumer confidence. "They're trying not to create a public panic, but they also are being mindful of their own limitations and the industry's," says Walter Moeling IV, partner in the Atlanta office of Bryan Cave LLP. "If we have 20 failures in Atlanta and they average $350 million in assets, that's $7 billion of Atlanta real estate dumped on the market at prices well below even current levels. So the market gets worse and the next 20 banks go down."
Weiss argues that a downturn as severe as the Great Depression is not too dramatic a scenario under which to assess banks' vulnerability.
Under his measurement, the biggest banks at risk of failure include Citibank NA, the nation's third largest commercial bank with $1.2 trillion in total assets, J.P. Morgan Chase & Co., HSBC Bank USA and SunTrust Bank.
Citi, he says, holds $2.94 trillion in credit derivatives, most through credit default swaps. The bank's credit exposure represents 259.5% of risk-based capital, he says. J.P. Morgan holds $9.2 trillion in credit derivatives, roughly half of all derivatives held by U.S. commercial banks. Weiss calls J.P. Morgan "ground zero" of any systemic crisis, meaning its failure would trigger others throughout the financial system.
Weiss says Bank of America NA., despite a high credit exposure of 177.6% of risk-based capital, is unlikely to fail because of several years of strong asset quality and profits.
Although the Treasury may not be bracing for Depression-like numbers, the White House last week acknowledged that it's not crazy to worry things could get that bad. Speaking to a banking industry conference last week, the director of the National Economic Council, Larry Summers, said, "We are now living through ... what almost certainly is the most serious set of economic and financial threats the United States has faced since the Great Depression."
Noting that his daughter's American history class studied the Depression thoroughly but ignored the country's other major economic downturns, Summers suggested that today's policymakers must make sure the current troubles end up as nothing more than footnotes in future history books. "We have a central challenge now to do everything we can to make sure the events we are now living through, significant as they are, do not figure in a prominent way ... several decades from now."
With so much dependent on the economy, why not just wait and see how banks fair? Weiss argues that the government will find itself in the same position it did with Bear Stearns Cos. and Lehman Brothers Holdings Inc. -- struggling to cobble together a panic solution following a surprise failure.
"Dealing with these banks proactively will still have severe repercussions, but at least you manage it on your own time," he says. "But regulators don't want to take on such a big monster, and they fear the consequences in the marketplace. My point is that's going to happen anyway."