Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors -- maybe even you and me.

Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading -- bets made for a bank's own behalf -- is really just a small part of their business.

Lately, Wall Street's captains of capitalism have been aggressive in pushing the "we take big risks for our customers, not for ourselves" line of argument.

That's especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.

The notion that risk is being taken for customers as opposed to for the firm's own benefit is somehow supposed to make it seem more palatable and somehow less risky.

Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there's good reason for that image: Wall Street firms don't break out the dollars they take in from client trades versus those generated by prop trading.

Yet from the perspective of Wall Street bankers, it's perfectly logical to see much of their risk taking simply as part of trades for their customers.

Here's how:

Let's say a hedge fund calls up an investment bank and asks it to help buy a large block of shares, but it doesn't want to pay much more than a given sum and intends to finance part of the transaction. That may force the investment bank to commit some of its own capital to acquire those shares in a series of separate transactions, so as not to create an undue spike in the stock's price.

To protect itself from losing money, the investment bank may go out and enter into a number of other trades or derivatives transactions -- all intended to reduce, or lay off, its risk of a loss on the customer transaction.

And in all likelihood those follow-on trades will prompt the investment bank to engage in a series of other trades to minimize its exposure to something going awry with those hedges.

At the end of the day, what looks like a simple customer order to buy stock on margin may end up creating a daisy chain of transactions that the customer wasn't even aware were taking place. But in the mind of a Wall Street banker, all these follow-on trades are simply part of the process of completing the customer's order.

Not surprisingly, some of these follow-on transactions can rake in sizeable revenues for a bank's trading desk. That's how an ordinary customer request to buy stock can generate revenues far in excess of whatever fees the initial trade may have produced.

Of course, if things go wrong, an investment bank can just as easily lose money on some of these follow-on transactions, and that's why there's risk involved in the process.

It's hard to see what distinguishes some of these transactions from what an outside observer might label as prop trading -- a group of traders sitting around with a pile of firm capital to do with as they please. But that's not the way that bankers think about customer trades.

Maybe it's all just a case of semantics, and trying to make a distinction between customer trades and prop trading is fruitless. Ultimately, maybe all trading activities by investment banks should just be viewed as risky.

The key to taming the giant banks is to put them in a position where they must turn away customer business because of the potential risk associated with all these follow-on trades.

One way to do that would be to impose hard-and-fast caps on the size of bank balance sheets, as it would deter them from engaging in transactions that add to their assets and liabilities. To avoid any unfair advantage, the caps on bank balance sheets would have to be agreed by regulators and policy makers around the globe.

But a balance sheet cap would be easier to impose and monitor than the increased capital holding requirements Treasury Secretary Timothy Geithner is proposing for global banks.

And better yet, a balance sheet cap would have the added benefit of fostering more competition between banks by driving some business to smaller institutions.

It's time for someone in the Obama administration to read the riot act to Robert Benmosche, American International Group's new $7 million chief executive.

Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer's corporate offices in New York.

And in the short term, Benmosche's vacation strategy appears to be paying dividends.

This week, AIG's shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG's still viable divisions.

Maybe Benmosche should consider relocating AIG's headquarters to Dubrovnik.

But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company's outstanding shares.

The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: "If the U.S. government doesn't continue to support AIG, we will fail."

The trouble is that the government continues to act as if its support of AIG is unconditional, which is why Benmosche can feel free to set his own leisurely timetable for selling AIG's assets. The former MetLife chief executive knows no one from the government is about to tell him what to do, even though American taxpayers effectively own 80 percent of the company.

But Treasury and the Federal Reserve need to be taking their cue from the Federal Deposit Insurance Corp in how to handle AIG.

Behind the scenes, Sheila Bair, the FDIC chairman, has been exerting a lot of pressure on her agency's biggest ward--Citigroup--to make changes to its management and business strategies. Treasury and the Fed should do much the same with AIG.

There's no reason for the federal government to be acting as a mere bystander in all this. After all, the government bailed out AIG chiefly to prevent a run on U.S. and European banks that had purchased hundreds of billions of dollars in guarantees on risky securities. In those scary days immediately following Lehman Brothers' collapse, AIG was too big to fail.

But nearly a year later, that is no longer the case. If AIG were to fail now it would be painful but more manageable because of the steps the Fed has taken either to guarantee or remove the most troubling assets from its balance sheet.

Yet the government's kowtowing to AIG leaves some scratching their heads.

"The controlling party here should be the government," says Brad Golding, a hedge fund manager with Christofferson, Robb & Co, who frequently shorts financial stocks, including shares of AIG in the past. "When he was made CEO, (government officials) should have called him and said: 'You are occupying this role at our whim.'"

There's talk about the Obama administration using the one-year anniversary of the demise of Lehman Brothers to give new life to its flagging financial regulatory reform package.

That's a fine idea and one that's no doubt necessary in light of the way many on Wall Street are returning to business as usual.

But here's something else Team Obama should do: Use the anniversary of the AIG bailout to set a hard-and-fast deadline for dismantling the insurer and getting the taxpayers' money back.

Hard as it may be to believe, shares of beleaguered Citigroup are on fire.

The stock of the de facto U.S. government-owned bank is up some 300 percent after it cratered at around $1 back in early March.

The over-caffeinated stock maven Jim Cramer keeps calling Citi a "buy, buy, buy" on his nightly CNBC television show. Even the more sober-minded writers at Barron's are pounding the table a bit, predicting Citi shares could double in price in three years."

Time out! It's far too soon for anyone but stock flippers and fast money hedge funds to buy Citi right now.

That's because there's still a world of hurt for Citi in the $83.2 billion in subprime mortgage-backed securities, corporate loans, home loans and commercial real estate mortgages that the bank's finance team has stuffed neatly into something called the "Special Asset Pool."

But there's nothing special at all about these assets. This cesspool of toxic securities and floundering loans is the worst of the stuff that's been stinking up Citi's balance sheet.

And these rotting securities and loans represent a good chunk of the $300 billion in problem assets the federal government is guaranteeing under its bailout of the giant bank.

Yet what the cheerleaders for Citi sometimes forget is that the struggling bank must absorb up to $39.5 billion of the "first loss" on those troubled assets. To date, Citi says it has incurred $5.3 billion in losses on this pool of toxic assets -- meaning the bank has another $34 billion in losses to soak up before the taxpayers start footing the bill.

And the way things look today, Citi is looking at a good deal more losses to come from its Special Asset Pool.

For starters, Citi still sits on a rather sizable portfolio of subprime-backed collateralized debt obligations -- the dubious securities that helped spark the financial crisis.

At last count, Citi valued its CDO portfolio at $9.6 billion, a 56 percent decline from the value the bank placed on those securities last summer. To protect itself against a potential default on those CDOs, Citi has hedged its exposure with some $4.5 billion in credit default swaps.

But unfortunately for Citi, it didn't buy those insurance-like derivatives from American International Group, another big bailout recipient.

If Citi had been shrewd enough to have done business with AIG, it would have been able to sell its CDOs at face value to an entity set up by the Federal Reserve, just like Goldman Sachs, Deutsche Bank and Merrill Lynch and other big banks did. In a flash, Citi's CDO problem would have disappeared.

Citi, however, had the misfortune of purchasing its CDS from Ambac Financial Group, a bond insurer that many see as being on its last legs. The bond research firm CreditSights says Ambac "may run out of capital sometime in 2013."

Many others think Ambac's demise could come much sooner. On August 7, Ambac, which trades around $1, reported a larger than expected $2.4 billion second-quarter loss.

A collapse of Ambac would render the CDS that Citi holds on its CDOs all but worthless. (For related news click here).

To date, Citi, which declined to comment on its CDO exposure, has written down the value of those insurance-like derivatives by more than $1 billion, according to regulatory filings.

Even if Ambac survives in some fashion, Citi is likely looking at additional write-downs on those contracts, and potentially on the underlying CDOs they are supposed to insure.

Citi also could take more hits on some $6.2 billion in private equity investments and $8.5 billion in loans that financed debt-laden buyouts. The bank also reports having some $10 billion in Alt-A mortgages -- a home loan that's a step above subprime -- and $8.3 billion in still largely untradeable auction-rate securities.

To be fair, Citi has been aggressive in writing down the value of its $10 billion in so-called Alt-A home loans to $1.7 billion. The bank has been equally aggressive in reducing its exposure to commercial real estate loans. The bank has marked down the bulk of its $28 billion in commercial real estate-related assets to $5.1 billion.

So it would require substantial defaults in both categories of loans for Citi to incur large losses.

But to say Citi isn't going to suffer any more losses in this pool of toxic assets is way premature. And none of this analysis has focused on the $183 billion in loans to cash-strapped consumers on Citi's books that could still go bust.

In short, the safest bet on Citi shares is still a short one.

– Mark T. Williams, who teaches finance at Boston University’s School of Management, is a former Federal Reserve bank examiner. The views expressed are his own. –

The market has anxiously waited over two months.  With the stress test results in, we now have our work cut out for us.  Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One.  They were problem banks before the tests and they continue to be.  But this painfully drawn-out process has spawned four tangible benefits worth discussing.

First, the stress test results raise an important policy question:  Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry.  In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.

Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards.  Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.

It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities.  Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.

Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table.  Doing so will help to separate higher risk-taking banks from lower risk-taking banks.

Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking.  Not long ago, the term “stodgy” was used to describe a bank or banker.  Today it’s more accurate to use “risky.”

Fundamentally, banks attempt to make money only three ways — interest loans, fee-based products and services, and proprietary trading.  Each has a varying degree of risk.  What makes one bank willing to take more risk than another is driven by management risk appetite, the perception of risk being taken, and the amount of capital to support such risk taking.  A bank with lower capital is a boat that needs to stay close to shore.  Banks with higher capital have greater ability to go out to sea, take risks, and weather a financial storm.

As expected, some bankers see an inherent conflict with large capital reserves as this can reduce their perceived returns.  While bankers have no control over the economy, they have absolute control over the level of risk that they take and the capital levels they deem as adequate.  Ideally, bankers should take these factors into account as they continue to recalibrate their risk-taking activities to match the level of capital needed.

Fourth, the government’s very public stress-testing blitzkrieg elevated general awareness of the benefits of using such risk-management tools in evaluating and planning around possible adverse financial outcomes.  And while stress testing has been used for decades by banks and regulators, the fact that banks overdosed on risk over time and not overnight suggests that such tools were infrequently used or ignored in the pursuit of seeking excessive profits. Also, more aggressive model assumptions can and should be applied. Going forward, with elevated awareness of stress testing, bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.

Some banks have a greater propensity to overdose on risk, regardless of the initial size of their boats.  Many, such as BofA, Citigroup, Wells Fargo, and Capital One, are out to sea in a financial typhoon and now must be brought (or towed) back to safe harbor.  Stronger capital requirements, better regulatory risk oversight, and bankers with a stronger handle on fundamental risk-management principles should help reduce the chance of another banking meltdown.

– James Saft is a Reuters columnist. The opinions expressed are his own –

A look at credit insurance prices for U.S. banks shows that market thinks the government’s mouth is writing checks its body can’t or won’t cash.

Despite a blistering rally in bank shares and Herculean efforts by the U.S. to build confidence in its financial sector, the price of insuring some leading banks’ debt against default has increased markedly in recent weeks.

That tells us that bond investors have serious doubts about the popular perception that the United States won’t allow systemically important institutions to fail, or in saving them in some form won’t make bond holders take substantial losses.

Since the KBW index of bank shares began a 65 percent rally on March 6 the cost of insuring Citigroup for five years via a credit default swap has risen to an annual payment of 627 basis points from 470, meaning it costs 6.27 cents to insure every dollar. Wells Fargo 5-year CDS stand at 292.5 basis points, as against 240 on March 3 and 120 at the end of December, while Bank of America’s ended last week at 355, exactly where it was on March 6 but 50 above its March 3 level.

The people buying this insurance fear if a big bank fails over the coming five years, or needs further buttressing with public money, the bill will be too large for the U.S. to bear, either politically or otherwise. That implies that there could be burden sharing by creditors, either through some sort of divvying up of the remaining assets or through forced or government orchestrated conversions of debt into equity.

OPTIONS

The options for the U.S. aren’t particularly attractive. As pointed out by Tyler Cowen in the New York Times here for the U.S. to simply fess up and say it stands behind all bank debt is to take on a gargantuan liability and to effectively neuter bond holders as a force for market and company discipline.

If the U.S. were to allow someone big to go down and make bond holders suffer too, there is a legitimate fear that creditors to the banking system would stage a disorderly wildcat strike which could bring down many healthy institutions.

It is very similar to the situation last year when the U.S. took Fannie Mae and Freddie Mac into government conservatorship and did everything short of explicitly guaranteeing the two mortgage lenders’ debt. But that wasn’t enough for the markets, specifically the Chinese, who lightened up on Fannie and Freddie bonds, making mortgage rates higher than they otherwise would have been and hampering monetary policy. Ultimately the U.S. was forced to use the Federal Reserve to buy up Fannie and Freddie debt directly as a means of keeping mortgage finance flowing.

BURDEN SHARING

Remember too that these are 5-year credit default insurance contracts, so the same cast of characters might not even be in charge when the bills come due. The range of outcomes is pretty wide and so it’s no surprise people want insurance.

It is possible too that the CDS market is distorted or deluded; after all these might be the same people who are paying good money to insure against U.S. sovereign default, an event that might happen but would surely leave very few counterparties with the ability to make good claims.

To be sure, this doesn’t create funding problems for banks at this stage. They are able to sell bonds backed by the Federal Deposit Insurance Corp’s rather hopefully named Temporary Liquidity Guarantee Program. If those CDS spreads don’t come down it isn’t going away any time soon. It has already been extended into 2012 and I’d expect more in due course.

So, the U.S. is likely to continue to make soothing noises to bank creditors while saying nothing too specific or legally enforceable, all the while hoping that something, anything, turns up. That might work.

COSTS

However, the current fudge imposes its own costs. Banking is a long-term business built on trust. The very existence of concerns among creditors will breed them among clients and will tend to undercut a bank’s ability to get new business and hold on to the old. Lack of trust is a vicious cycle.

So should the U.S. force creditors to pay their share if a major bank needs rescuing? My heart says people should bear responsibility for their decisions and pay the costs. But even the most puritanical capitalist should be extremely worried about what holding this particular group of vested interests responsible for their mistakes might mean for the rest of us.

Remember too that the rather successful Swedish bank bailout made creditors whole, but hit equity holders and management. I’d settle for that.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– James Saft is a Reuters columnist. The opinions expressed are his own –

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

The KBW bank index has enjoyed a blistering rally, rising 51 percent from its March 8 low, though it is still down almost 40 percent from where it ended 2008.

To be comfortable with that, you have to believe two difficult things; that investors will value the earnings banks are now making as if they were sustainable and that banks won’t be swamped by credit losses and potential forced dilutions of shareholders.

“We are unconvinced that the banks have turned a corner,” FBR Capital Markets analyst Paul Miller wrote in a note to clients. “Investors who believe that the recent financial rally is here to stay expect that most banks will remain profitable.

We expect that profitability at these banks will be driven by favorable fixed-income trading revenues, as well as mortgage banking revenues.”

In some ways, balance sheets aside, it’s a pretty good time to be a bank in America. Competition has thinned out and margins should fatten commensurately.

U.S. bank profits from trading and mortgage banking are both problematic. Trading income, because it varies wildly, is hard to predict and hard to value.

If the past two years has taught us anything, it’s that paper profits can evaporate and risks can be hard to spot.

On the positive side, the fact that banks are now putting less balance sheet to work as market makers means that those banks which still operate can make considerably more on the difference between where they buy and sell securities. But given the huge uncertainty about who will be around in a year’s time, especially given the by its nature unpredictable role of government, its hard to know how much competition there will be or even how much capital banks will be forced to hold against trading activities.

LOAN COLLECTING BLUES

Mortgage banking is also going to be bigger this year. The Mortgage Bankers Association predicts refinancing will total $1.96 trillion and purchase loans increase $821 billion, which could make it the fourth-biggest year on record. This is mostly because the Fed has driven interest rates down in a bid to reflate the economy. That makes it profitable for many Americans to refinance their mortgages and is luring a much smaller number back into the house purchase market despite falling prices.

But again mortgage banking is a notoriously tough business, and though a scarcity of lending capital has driven fees up, the record of banks in the U.S. engaging in it profitably is not good.

Mortgage banking, as distinct from mortgage lending, is the business of originating loans, these days almost exclusively for Fannie Mae or Freddie Mac in exchange for a fee and the right to earn more fees by collecting payments in exchange for servicing the loan for the lender.

But the mortgage servicing right that a bank gets when it makes the loan is usually recognized as income based on the current value of the cash it is expected to generate over time.

That means that banks that originate lots of mortgages show huge gains in income during refinancing booms. It does not mean, however, that they necessary make money out of the deal. Servicing rights can go wrong in many ways.

First, people can stop paying their loans back. The servicer usually has to advance the first few payments if a borrower is late and doesn’t get the money back until the loan is resolved. It’s also a lot more expensive to service bad loans than regular payers, making the economics of the business particularly tough right now.

Banks can also lose out if loans are refinanced sooner than they expect, robbing them of the future fees they were counting on.

And what about credit losses? Unemployment, which drives losses on commercial loans, on mortgages and on consumer loans, will be going up for some considerable time.

For example, the baseline forecasts released by the Organization for Economic Cooperation and Development (OECD) this week were considerably more bearish than even the “more adverse” numbers being used to run the U.S. stress tests now being run on banks.

Blog Calculated Risk does a nice job running the numbers here, but the highlight has to be the third q here, but the highlight has to be the third quarter, where the OECD is predicting an economy shrinking by 1.9 percent, as against a rather miraculous recovery to minus 0.2 percent in the “tough” scenario used by Geithner et al. Similarly, the unemployment rates predicted by the severe stress test are lower than the OECD base case all the way out to the end of 2010.

So then, it won’t be the stress test that undoes many banks, it will be reality.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —

– Alexander Smith is a Reuters columnist. The opinions expressed are his own –

People are up in arms about bankers receiving bonuses when the banks they worked for have gone down the pan. But isn’t it just as shocking that so many state-backed financial firms still subsidize the eye-popping wages of sporting superstars through rich sponsorship deals?

It’s the same story on both sides of the Atlantic. Citigroup, which received $45 billion from the U.S. government, is sticking with a $400 million marketing deal from 2006 which includes the naming rights for the new home of the New York Mets baseball team, which will be called Citi Field.

Meanwhile Royal Bank of Scotland announced it had renewed its sponsorship of the 6 Nations rugby competition last month, only 10 days after reporting the biggest loss in British corporate history. And it continues to sponsor the Williams Formula 1 team, a sport known for eating up tens of millions a year.

There is indeed a strange correlation between failed companies and sporting sponsorships.
Manchester United sponsor American International Group (AIG), Newcastle United supporter Northern Rock and failed British bank Bradford & Bingley, which sponsored not one but two soccer clubs, Bradford City FC and Barnet FC, have all crashed spectacularly since during the credit crisis.

And it isn’t just financial firms which have run into trouble and seen their names stripped from team shirts and hoardings. English premier league club West Ham United lost their sponsor when tour operator XL Leisure Group folded.

But this shouldn’t really be a big surprise. Some have even made a direct link between sporting sponsorship and corporate underperformance. A recent report by U.S. fund advisory firm Advisor Perspectives crunched the numbers for U.S. companies that entered into so-called “naming rights agreements” and believes it has established a statistical connection.

Its study of 69 U.S. naming deals shows the performance of companies that purchase such rights trails the S&P 500 index by 4.7 percent over the course of the deal. If you invested in a company the day it announced a naming agreement and sold when the agreement was done (or still held onto it for current name holders), your portfolio would be down 9.1 percent, versus a fall of 4.5 percent for the S&P 500.

Advisor Perspectives argues that poor corporate governance, leading to risky or bad decisions on capital allocation, is to blame for this underperformance and points out that three of the top five largest bankruptcies in history, Worldcom, Enron and Conseco all sponsored major U.S. sports venues.

They also point the finger at executives who benefit from the luxury boxes, hospitality packages and privileged access to sporting celebrities, all at the expense of shareholders.

So when Royal Bank of Scotland struck its Formula 1 deal with the Williams team, Citigroup signed its Mets deal or AIG paid to have its name on the shirt of the world’s most successful soccer team

Manchester United, investors should have read these as clear sell signals for the stock.

Given the financial wall some of the banks have hit it is puzzling why they haven’t pulled the plug on these embarrassing deals. After all the CEOs of RBS, Northern Rock and Bradford & Bingley have all been jettisoned, as have the bosses of Citigroup and AIG.

But with some lengthy sports sponsorship deals, ending them would in most cases be counterproductive, wiping out any value left. And where banks have been nationalized, political factors come into play. In the case of Newcastle United, any damage caused by ending the sponsorship agreement with Northern Rock and alienating a fiercely loyal soccer fan base would have far outweighed the cost savings of scrapping the deal.

So for an early warning signal of a company with a vain or out-of-control CEO, a poor record of capital allocation, a likely share price underperformance and in the worst case scenario an above average chance of going bust, look no further than the big sports signings, not of players but of sponsors.

– At the time of publication Alexander Smith did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. The views expressed are his own. —

For every new president, campaign promises and inaugural idealism must give way to the hard choices that measure the mettle of their leadership.

Now Barack Obama must act pragmatically to fix the banks or the economy will sink under their weight.

Banks continue to suffer losses on bonds backed by failing mortgages, credit cards and auto loans, and questionable corporate debt. To assist, the Treasury has used TARP funds to purchase capital in healthy and deeply troubled banks alike; however, no one can calibrate how high bank losses will go, because no one knows how far housing prices will drop and how many loans will ultimately fail.

The Obama Treasury could put a floor under bank losses, through government guarantees on their bonds, or by creating an aggregator bank that purchases those securities from banks altogether.

Guarantees would give the banks profits on bonds whose underlying loans are mostly repaid, and shift to taxpayers losses from those bonds whose loans are mostly not repaid. That would require additional large subsidies from taxpayer to the banks.

An aggregator bank, however, could turn a profit. It could purchase all the commercial banks’ potentially questionable securities, at their current mark to market values, with its own common stock and funds provided by the TARP. Then the aggregator bank could balance profits on those securities whose loans pan out against losses on securities whose loans fail.

An aggregator bank could perform triage on mortgages. It could work out those whose homes can be saved with some adjustments in their loan balances, interest rates and repayment periods; foreclose on mortgages for homeowners who could not meet payments with reasonably concessions; and leave other loans alone.

Commercial banks acting alone cannot accomplish triage as effectively, because individually they can have little effect on how much housing values will fall. In contrast an aggregator bank, holding so many mortgages and working in cooperation with Fannie Mae and Freddie Mac, could have a salutary impact on housing values. It could put some breaks on falling home prices.

Beyond toxic securities, policymakers need to fix what got banks into this mess. The 1999 repeal of Glass-Steagall permitted the creation of financial supermarkets, like Citigroup, that combined commercial banks with investment banks, brokerages, and the bizarre universe of hedge and private equity funds.

Those nonbank financial firms are run by salesmen and financial engineers that don’t understand long-term commitments as bankers to borrowers with solid incomes and sound business plans.

Investment bankers, securities dealers and fund managers, essentially, get paid commissions on sales and for betting other peoples’ money on arbitrage opportunities. They put together people that have money with those that need money, and those people that can’t bear risk with those that can.

In contrast, commercial bankers, historically, had skin in the game—bank capital and a fiduciary responsibility to depositors. They were paid salaries, not commissions on the volume of loans they wrote or bought from mortgage brokers to package into bonds. They expected to be fired if their loans prove imprudent.

To investment bankers and securities dealers, it does not matter how risky a loan is, because they can always bundle it into a bond to sell it off or insure it with a swap. That’s nonsense, as we have learned. Adopting that thinking commercial banks got stuck with too many loan-backed bonds and buying swaps that were not backed by adequate assets.

Commercial banks need to be separate and more highly regulated. The ongoing process of breaking up Citigroup and placing its banking activities into a separate entity should be replicated at other Wall Street and large regional banks.

Freed from toxic assets and the complications of affiliations with financial institutions having other agendas, commercial banks could raise new private capital and make new prudent loans as President Obama’s stimulus package lifts consumer spending and business prospects.

Such approaches would disappoint those who champion unbridled free markets but Wall Street’s financiers have abused the opportunities offered them by deregulation to the peril of the nation.

President Obama needs to craft solutions that address the world as he finds it not as intellectuals tell him it should be.

– James Saft is a Reuters columnist. The opinions expressed are his own –

Nationalization of weak banks in Britain and the United States may be preferable to current plans for insurance and soft “bad banks” schemes which risk being swamped by future losses as assets, especially real estate, continue to crater.

An insurance program, getting banks to identify their riskiest assets to the government which will insure them for a fee, is one of the main planks of a UK plan to bail out banks unveiled this week.

Both Citigroup and Bank of America have already received loss protection arrangements from the government. The betting is now that the United States will opt for some sort of a “bad bank” aggregator which will buy up doubtful assets from banks, with the emphasis on keeping as many as possible operating as publicly traded entities which, once shorn of their bad debts, would be viable and would lend.

Both plans keep banks in private hands, which is desirable, and insurance especially is attractive because it has a relatively low upfront cost. But both, and especially insurance, run a real risk of being too small and, by definition, only ridding the banks of assets that are bad now leaving them to founder on new bad loans later.

Commercial and residential real estate in both countries continues to head south at an alarming rate, with falls of as much as 20 percent or more possible in 2009. Those falls won’t be stopped by current lending programs; it is an ongoing crash that could probably be stopped only by some sort of economy-wide debt writedown which is very unlikely.

That means that we could find ourselves in six or nine months in exactly the same situation, but with banks crippled by a new wave of defaults and with the non-financial economy in a much worse state.

In other words, in order to work a bad bank plan must take into state control the weakest banks and probably needs to err on the side of taking the doubtful down along with the basket cases.

“They should probably nationalize now, but not blanket nationalization,” said George Magnus, senior economic adviser to UBS.

“It is by far the cleaner option, take on all the assets and take on all the liabilities and if you find out that in six months time commercial real estate, for example, has dropped 20 percent it is far less of a shock. You don’t have to treat it as a private vehicle which has to be viable.

“Sell the good bits recapitalized back to the market and you can have viable banks far more quickly.”

DEFINING FAILURE

Consultancy Capital Economics is predicting that British house prices will fall another 20 percent in 2009 and that land values contract by 70 percent peak to trough. British commercial property fell 27 percent last year and analysts in December were forecasting an another 16 percent fall this year. Goldman Sachs economist Jan Hatzius believes the U.S. Case-Shiller 20 City index will fall another 20-25 percent by the third quarter of 2010.

Nationalization is not a good outcome; it is failure defined in a word. And nationalizing banks raises the problem of re-privatizing. Who will want to buy banks from a government with a recent track record of what some will inevitably term confiscation? But few would commit capital to banking now, given that governments have been unable to explain how they will treat capital in the banking system.

If banks are to be taken into state control, there needs to be a process to deal with the rights of shareholders; any bank that stays in state control needs to be run at arm’s length; and the period it stays in state control should be as short as possible.

Easy to say, tough to do and no doubt nationalization will have its disasters.

Bank shares have fallen at an appalling rate on both sides of the Atlantic, with several UK banks trading as if they are in danger of being taken into state control. Royal Bank of Scotland, in which the government already has a 70 percent stake, has lost almost 80 percent of its value in January, while Barclays and Lloyds Plc have fallen precipitously. In the United States, Citigroup has more than halved in value in the month despite equity infusions from the government and an insurance wrapper on some of its assets.

But here is where things differ markedly between the United States and Britain. Britain may well need to do more for its banking system than the U.S. and sadly is less well placed to carry it off without nasty side effects.

The dollar is the world’s reserve currency, allowing the United States more leeway in financing its liabilities, and U.S. banks are smaller as compared to their economy. We’ve already seen sterling falling sharply and you can expect further falls as risk is transferred from the private sector to the state.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. –

– James Saft is a Reuters columnist. The opinions expressed are his own –

Just as every society has a creation myth, banking is now busily writing a destruction myth that seeks to explain and soothe in a world torn to its foundations.

The myth, as expounded by regulators, bankers and their various service providers, is that we were hit by a perfect storm, a 1,000-year flood so unpredictable that we can’t possibly be held accountable for it. An act of god, rather than the folly of man.

Or as the excellent financial blog Calculated Risk puts it: “Hoocoodanode?”

The implication of course is that now banks know these sorts of things can happen, banks will behave sensibly because it is their best interests to do so. It’s just that the data we put into the models only covered the boom years. Now that we are getting good data on a downturn, well, problem solved. No need for overly heavy-handed regulation, that will only stifle growth and recovery.

No need for intrusive compensation controls; this will simply drive risk takers out of banking and into less regulated areas, or will prompt a brain drain in which the best minds might go into, god forbid, industry.

There is a pronounced unwillingness to take responsibility and to recognize that many of the factors that went into creating and sustaining the bubble weren’t so much unknowable but more likely, for those in a position to do something about it at the time, either unprofitable, unpleasant or politically inconvenient to know.

Take, for example, Robert Rubin, former U.S. Treasury Secretary and current board member at Citigroup.

“Nobody was prepared for this,” Rubin told the Wall Street Journal. He has been paid $115 million, excluding stock options, since 1999 and was advising Citigroup when it decided to mimic its peers and take on more risk.

“… What came together was not only a cyclical undervaluing of risk (but also) a housing bubble, and triple-A ratings were misguided,” said Rubin, who believes he along with Alan Greenspan has taken an unwarranted knock to his reputation. “There was virtually nobody who saw that low-probability event as a possibility.”

There is simply no doubt that a number of people were raising red flags about risk, about the use of ratings, about issues around securitization, and most certainly about an emerging real estate bubble. But it proved impossible for those risks to get a proper hearing within a system that was throwing off so much life-changing money.

WHOSE MONEY, WHOSE RISK?

Rubin, when queried on his pay, answered that he could have make more elsewhere. True enough, no doubt.

But while everyone is free to take money that is on offer, that is different from saying that you have earned it, or that, in a system in which pensioners and taxpayers are the ultimate bag-holders, it is appropriate and should not be subject to regulation.

There is a similar argument on pay making the rounds: that since so many senior managers lost so much of their fortunes in the failure of companies such as Lehman Brothers and Bear Stearns, this demonstrates that there was not a misalignment of risks between employees, shareholders and the governments that ultimately must pick up the pieces when things go wrong.

It is very sad that so many people lost so much, but this is not even close to being an argument for continued light touch regulation. The issue is not so much that people in banking and finance have skin in the game, but that they are far from alone in having it, and that their ultimate cost of capital is in part a function of the fact that it is and has been understood that the state will step in if things
come to grief.

That argues, in my view, for stricter regulation of bank capital and of bank compensation so as to decrease the risks. That means tying compensation more closely to risks, including the risk that things that look good today go bad in three years’ time. The UBS scheme, under which bankers can “lose” money they “earn” based on various performance factors in subsequent years, is not a bad start.

Those who argue against more stringent regulation have one thing right: it is going to cost, and requiring banks to hold more capital will impose a ceiling on the speed at which the economy can easily grow. Of course, we are always regulating the last war out of existence.

One idea worth consideration is proposed by Paul Miller of FBR Capital Markets and would involve regulating assets and how they are funded, rather than just the institutions.

That would help to guard against the next shadow banking system and another highly levered and ultimately government-insured bout of speculation.

–  At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. –