Will big banks now free of TARP’s shackles reach for yield?

By Edward Harrison of Credit Writedowns.

When I read Yves Smith’s recent comments on Bank of America’s repayment of its TARP funds, I couldn’t help but think of a post I wrote six months ago called "Asymmetric information and corporate governance in bank bailouts." The gist is of the post is about the same as Yves’ and it was inspired by lessons of the S&L crisis of the 1980s.

Big banks like Bank of America which are leaving TARP are well-capitalized by most standard metrics. Even Citigroup is well-capitalized (see here) and they have yet to leave the TARP program. But, this is more a result of quantity of capital over quality of capital. We can’t know the true financial condition of any of the big banks; I have my doubts – especially if the economy turns down again.

The S&L crisis is quite instructive in thinking about the moral hazard and poor incentives now in place in the financial system. In an act of wonderful transparency, the FDIC actually has a startlingly even-handed chronology of S&L crisis events on its own website.

Focusing on the policy remedy after the initial banking losses occurred, the FDIC says:

1980-1982 Statutory and regulatory changes give the S&L industry new powers in the hopes of their entering new areas of business and subsequently returning to profitability. For the first time, the government approves measures intended to increase S&L profits as opposed to promoting housing and homeownership.

This policy promotes what is known as ‘reaching for yield.’ And the S&L’s did just that by piling into the nascent high yield market with disastrous results when that market went bust. The Keating Five scandal was an outgrowth of the crony capitalism which occurs when favored sectors of the economy meet economic disaster. Given the bailouts and the relaxation of accounting rules this go round, I’m sure you’re familiar with this shtick.

When the first lot of big banks repaid their TARP funds in June, I had the S&L crisis on my mind, saying:

So, to me it looks a lot like we learned absolutely nothing during this crisis. Sure, Wall Street is chastened and firms will be more risk averse than they were at the height of the bubble. Nevertheless, prior experiences like the S&L crisis in the U.S. and the Lost Decade in Japan demonstrate that allowing zombie companies to remain afloat or promoting overcapacity invites market participants to swing for the fences.

And that’s exactly what I expect to happen. So back to that post on asymmetric information. Here’s how I see it potentially playing out at some firms from the perspective of Phil, the fictitious head of a big bank:

You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit. The company had done a significant amount of work to get to grips with likely credit exposure. And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios. What should Phil do?

Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base. But, there is clearly no incentive for that. After all, hadn’t Phil been beaten over the head before Congress for ‘not’ lending money. Why did Phil have so many billions of dollars in excess reserves at the Fed? Why was he preventing the economy from regaining its footing? Was Phil hiding something? Perhaps Phil and his executive team need to be replaced? On second thought, Phil decides the over-capitalization route is suicidal.

As it turns out, Phil’s internal credit gurus told him there is a 60% chance that the company can lend and make shed loads of money as the economy recovers. There is a lesser but not insignificant 30% chance that the company is under-capitalized if the economy remains fragile and a 10% chance that the company is severely-undercapitalized in a real worst-case scenario. Big Banks lawyers and accountants have told Phil that he can legitimately claim to the public that Big Bank is well-capitalized and proceed lending.

Phil is optimistic that things will turn out well. The fact that his underwater options depend on it is no small incentive to feel that way. But, he has nagging doubts about the downside scenarios of which the public and the government are largely unaware. So Phil decides to ‘reach for yield’ by taking a slightly aggressive strategy which will ensure that the company can make a lot of money now while interest rate spreads are high.

The quantity of capital at all of the big banks is now quite good. But, if the management of any of these institutions harbors doubts about the quality of their capital base, then they have every reason to take on risk. Something to think about in light of Yves’ question Is Repaying TARP Good for Bank of America (and Taxpayers?).

The rest of Phil’s story is here. And do read the FDIC chronology of the S&L crisis. It is very good.