Time to change the rules

Barack Obama has time to consider how his administration will minister to the ailing auto companies, as their demise will be protracted. In the real economy, failure takes time. Sixty days from now GM will still be there.

But the same cannot be said of Citibank.

Today, after investing almost half of the $700 billion appropriated by Congress to buttress the capital reserves of the banking system, the evidence suggests that the Treasury and the Federal Reserve have not achieved their goal of easing the cost or availability of capital. Instead, the major banks are cutting back credit, increasing fees and looking for ways to further solidify their balance sheets. Unless these trends are reversed, the concerted federal action will have been for naught, the recession will deepen and recovery will be forestalled.

More capital alone is not sufficient to fix the commercial banking sector, and a new injection of funds into Citibank will not allay the fear the continues to grip the system. Like Citibank, all of the commercial banks have problem loans and problem business lines, and, traditionally, new injections of capital would provide banks with the resources necessary to work out those issues. But today, the risks are different, and more dire.

The collapse of AIG two months ago highlighted for all market participants the risks presented by derivative contracts on the books of financial institutions. AIG’s demise came in a matter of days––if not hours––once its credit ratings were downgraded from the double-A level to the single-A level. On Friday, September 13th, AIG was in business. On Monday the 15th, AIG was downgraded. On Tuesday the 16th, the global insurance giant was effectively bankrupt.

In the case of AIG, the rating downgrades resulted from write-downs in its holdings of mortgage-backed securities––to comply with mark-to-market accounting rules––which depleted its capital reserves. The downgrades triggered collateralization requirements under the terms of its $450 billion portfolio of credit default swaps. Faced with demands for collateral that exceeded its financial resources, AIG was insolvent.

The lesson for the major commercial banks that face similar risks was simple: Do everything in your power to rebuild your financial strength and stabilize your credit ratings. Cut back lending, reduce outstanding credit facilities, increase fees, conserve capital, and rebuild your balance sheets. In sum, the lesson for the commercial banks is that if you want to survive––if you don't want to be the next AIG––you should not do any of the things--such as increase lending--that the Treasury is trying to get you to do.

Today, Citibank is rated AA-, which by any measure is a strong credit rating. But the markets are anticipating Citibank’s demise. On Friday, Citibank shares fell 20% to $3.77 and its total market value fell to $20.5 billion, a decline of 90% from a year ago, and less than the $25 billion that the US government gave Citibank just last month. In the credit default swap market, the cost of insuring against a Citibank default rose 20% on Friday.

In normal times, a downgrade to A+ would not be a catastrophic event for a commercial bank, but these are not normal times. While there has been no public indication from Citibank of what the financial consequences of a credit rating downgrade to single-A would be, Citibank is currently the guarantor on $1.6 trillion of credit default swap contracts––almost four times the size of AIG’s portfolio––and it is not unreasonable to imagine that those contracts have comparable collateralization terms. If this is AIG all over again, a downgrade of Citibank’s ratings would lead to the swift collapse of what one year ago was the nation’s largest bank.

But this is not just about Citibank. Over the next several days, the Treasury may announce its plans to pour billions more into Citibank. But even if Citibank survives, the Treasury will not have addressed the fear that is gripping the banks. For this, the Treasury and the Fed need to change the rules of the game: They have to tackle head-on the two issues that conspired to lead to AIG's swift collapse.

First, they should change the mark-to-market rules that have made the balance sheets of financial institutions captive of swings in asset market prices. These rules exaggerate the importance of unrealized gains and losses, and exacerbate economic volatility by undermining stability in the banking sector. Instead, consideration should be given to rules that allow for the smoothing of unrealized gains and losses over time, as is the case in pension fund accounting, to mitigate market volatility by recognizing gains and losses over a multi-year period.

Second, immediate regulatory action should be implemented, vitiating the linkage between changes in credit ratings and collateralization requirements under outstanding swap agreements. While changes in bond ratings have always had effect on an entity’s cost of capital over time, the rating agencies never intended for rating actions to trigger cataclysmic events. In fact, until the collapse of AIG, the collective impact of the collateralization triggers in swap contracts was barely recognized as a material risk factor for financial institutions. Any counterparty who objects to this change should be free to void the agreement to which they are a party.

With the implementation of these two steps––changes in the mark-to-market rules and removing the collateralization provisions from existing derivatives contracts––the Treasury can immediately reduce the pressure on Citibank and on other financial institutions. Then they can focus on the real job of recapitalizing the banking system, and perhaps the banks will get back to the business of lending.