Treasury Wants To Make Banks Boring Again By Selling CDOs Of Community-Bank Hybrid Capital Instruments

Publish date:

"Make banking boring again" is a favorite reaction to news that JPMorgan was screwing up its VaR modelling of its attempt to get long gamma with improperly delta-hedged tranches of the CDX.NA.IG.9 and, sure, maybe, but don't tell Treasury:

The U.S. Treasury may pool stakes in small banks bailed out during the financial crisis to entice potential investors as the Obama administration winds down the Troubled Asset Relief Program.

“Some of the investments are smaller and it may not be possible to auction them individually,” Tim Massad, the Treasury Department’s assistant secretary for financial stability, said in an interview. “So one of the things we’re looking at is pooling those investments together.”

You can see how much TARP money remains outstanding at all the wee banks at pages 240-257 here; on a quick look the smallest seems to be the $1.4mm subordinated debentures at Frontier Bancshares of Austin, TX, and there are plenty of other single-digit-millions remaining slugs of preferred or sub debt.* The notion that it would be impossible to sell something at auction for less than $50mm seems weird to me - it's done all the time by, um, auction houses - but you get the idea: these are subordinated fixed-income instruments of small banks that have run into trouble in the recent past; the risks are significant and the potential rewards - particularly in absolute dollar numbers - may not justify the investment of time and effort to understand and bid on them.

So financial structuring can be used to increase liquidity and optimize pricing: let investors buy larger sizes of more diversified investments, and let them buy an instrument with other holders so there can be secondary market liquidity. And you can never have too much secondary market liquidity: investors will bid more aggressively in the government's auction if they know there will be a robust secondary market, and the government's ability to sell out here helps it support the financial system in the future. To really optimize pricing, Treasury could even carve the pool into tranches, so that more conservative investors can put money to work in these banks at lower risk (perhaps evidenced by AAA ratings) than you'd get from just small-bank preferred stock, while more aggressive investors can take more risk for a higher return.

Ha, sort of kidding. Anyway here's another Bloomberg article about Fed regulators panicking about how they failed to stop JPMorgan from losing money in its investing-excess-deposits business:

New York-based JPMorgan’s trading loss, announced last week, occurred in its chief investment office, which oversees about $360 billion, the difference between deposits and what the bank lends. The New York Fed is investigating how other banks it regulates are investing deposits that aren’t loaned out, said the person, who wasn’t authorized to discuss the matter publicly and declined to be identified.

Some have wondered about the social utility of this business generally - shouldn't JPMorgan be using our hard-earned deposits to lend to businesses that are building factories or music ... things ... on Facebook, rather than just investing them in securities bought in the secondary market? What good has secondary-market liquidity ever done anyone?

Anyway. This just struck me as a weird juxtaposition. I'm hoping that the Fed and Treasury will get together and reconcile these differences. Maybe JPMorgan's CIO should be buying pools of small bank preferreds? Could be risk, though. How would they hedge?

Update: A reader notes about the pooled bank preferred auctions:

In the last TARP auction, at least two of the banks were bidders for their own securities. They were perfectly happy with paying a higher price than other “market” bidders because they could still take a gain at 97/98px.

By pooling the securities, the smaller banks won’t be able to take advantage of that opportunity. “How come the big banks got to buy their own back at a discount and you didn’t even give us the opportunity!” UST is very aware of this potential and is currently expending much energy trying to figure it out.

Oh please small banks, form your own mutual investment fund and bid for all of UST's bank preferred CDO! Then dissolve the fund and redeem all your own preferreds. What could possibly etc.

Treasury Weighs Selling TARP Bank Shares in Pools [Bloomberg]
Fed Said to Study How Banks Manage Deposits After JPMorgan Loss [Bloomberg]

* There also seems to be some correlation between teeny size and grandiose-generic naming. So TARP's got $2.7mm out to United Financial Banking Companies (Vienna, VA), $3.7mm out to First BancTrust Corporation (Paris, IL), and $6.6mm to Citizens First Corporation (Bowling Green, KY).


Banks Prove That They Are Not Too Big To Fail By Saying "We Can Fail" On A Piece Of Paper, Moving On

One way you could spend this slow week is reading the "living wills" submitted by a bunch of banks telling regulators how to wind them up if they go under. Don't, though: they're about the most boring and least informative things imaginable and I am angry that I read them.* Here for instance is how JPMorgan would wind itself up if left to its own devices**: (1) It would just file for bankruptcy and stiff its non-deposit creditors (at the holding company and then, if necessary, at the bank). (2) If after stiffing its non-deposit creditors it didn't have enough money to pay its depositors it would sell its highly attractive businesses in a competitive sale to willing buyers who would pay top dollar. This seems wrong, no? And not just in the sense of "in my opinion that would be sort of difficult, what with people freaking out about JPMorgan going bankrupt and its highly attractive businesses having landing it in, um, bankruptcy." It's wrong in the sense that it's the opposite of having a plan for dealing with banks being "too big to fail": it's premised on an assumption that the bank is not too big to fail. If JPMorgan runs into trouble that it can't get out of without taxpayer support, it'll just file for bankruptcy like anybody else. Depositors will be repaid (if they're under FDIC limits); non-depositor creditors will be screwed just like they would be on a failure of Second Community Bank of Kenosha.

TARP Charts!

The Federal Reserve has this new paper out about TARP that does a bit of highly suggestive eyebrow raising about some banks that shall remain nameless. They start from the awkward fact that TARP wanted everything in one bag but didn't want the bag to be heavy, or as they put it: The conflicted nature of the TARP objectives reflects the tension between different approaches to the financial crisis. While recapitalization was directed at returning banks to a position of financial stability, these banks were also expected to provide macro-stabilization by converting their new cash into risky loans. TARP was a use of public tax-payer funds and some public opinion argued that the funds should be used to make loans, so that the benefit of the funds would be passed through directly to consumers and businesses. So you might reasonably ask: were TARP funds locked in the vault to return the recipient banks to financial health, or blown on loans to risky ventures, or other? Well, here is Figure 1 (aggregate commercial and industrial loans from commercial banks in the U.S.): So ... not loaned then. But that's not important! The authors are actually looking not primarily at aggregate amounts of loans but at riskiness of loans and here's what they get: