Nov 8th 2007 From The Economist print edition
Illustration by Satoshi KambayashiSINCE the barbaric “breaking wheel” was replaced by the guillotine in 18th-century France, methods of execution have increasingly sought to end life speedily rather than inflict long agony. There can, however, be few decapitations less painful than those at big American banks. On November 4th Chuck Prince left the boss's office at Citigroup, the world's largest bank, with the “tremendous support and respect” of the board ringing in his ears, even though the firm had to write down $8 billion-11 billion in October alone (see article). A week earlier, Stan O'Neal lost his job at Merrill Lynch after leading the investment bank to a loss with $8.4 billion of write-downs. He too entered retirement not on a tumbril but in a limousine, with $160m to soothe his discomfort.
However churlish you may feel about Wall Street's new axiom—“the higher they fly, the bigger the parachute”—the departure of two of America's most senior bankers in a week is a good sign. Accountability, after all, is a step towards clarity, and there are few more coveted resources in today's fog-strewn and stormy banking industry. Both departures were accompanied by revelations of much steeper losses from American subprime mortgages than either Citi or Merrill had owned up to just weeks before. That attempt at honesty may have spooked the market because it showed how unsure the banks remain about how to value their subprime-related assets, but that is no reason to shy away from such disclosures.
One worrying lesson for bankers and regulators everywhere to bear in mind is post-bubble Japan. In the 1990s its leading bankers not only hung onto their jobs; they also refused to recognise and shed bad debts, in effect keeping “zombie” loans on their books. That is one reason why the country's economy stagnated for so long. The quicker bankers are to recognise their losses, to sell assets that they are hoarding in the vain hope that prices will recover, and to make markets in such assets for their clients, the quicker the banking system will get back on its feet.
Understanding your debts Coming clean will be difficult, because for the time being the disclosures have provided more questions than answers. First, just how much do banks stand to lose? The latest confessions show that a whole new constellation of credit instruments, known as collateralised-debt obligations (CDOs), are far less secure than had been assumed even at the end of September. These include supposedly impregnable “super-senior” and AAA-rated tranches of CDOs that a short time ago were prized by the world's banks, insurance companies and mutual funds. In some cases their values have shrunk to a sliver of their original price since a series of downgrades by rating agencies last month. Citi, one of the biggest issuers of such CDOs, estimated this week that the losses on CDOs and other assets at other banks could reach $64 billion—to which its own potential write-downs must be added. Others estimate that overall losses linked to subprime could exceed $200 billion.
Second, do banks have enough capital to survive the crisis? At some institutions, mounting losses are making the cushions of capital held for times of crisis look increasingly threadbare. Wall Street firms and European banks use a special accounting provision for securities they consider hardest to value, which appears mainly to involve educated guesswork. On Wall Street the amount of securities in this category has ballooned and could easily wipe out the big firms' core capital if they were written down to zero—which is improbable but no longer thought impossible. To make matters worse, bond insurers, which rate America's $2.5 trillion municipal-bond market, are also up to their necks in CDOs. They were told this week that they might lose their coveted AAA ratings unless their shareholders provide more capital, which would cast a cloud over municipal bonds.
Third, how hard might the broader economy be hit? The flimsier the banks' capital base, the less freely they can lend to firms and households, putting both consumer spending and corporate investment at risk. Already there is evidence that credit conditions are tightening well beyond the housing market. A survey this week found that American banks have been tightening lending standards on everything from mortgages to commercial property to business and industrial loans. In Europe too, credit conditions have tightened. In Britain the withdrawal of a bid for J. Sainsbury, a supermarket chain, by a Qatari-backed investment group was the latest sign that life has almost been squeezed out of the buy-out business.
Batman and Rubin So what is to be done? The main task is to restore honesty, clarity and credibility as quickly as possible. Citi has turned to Robert Rubin, a former American treasury secretary once dubbed a member of “The Committee to Save the World”, to become chairman. Mr Rubin's star is a little tarnished now—he had advised Mr Prince since the latter became chief executive in 2003. The temptation for Mr Rubin and others will be to hold back from revealing the full extent of the banks' exposures to CDOs, subprime mortgages and other wilting assets. After all, there is no benefit in banking to be the first bearer of bad news, and many chief executives will be justifiably nervous of following the same route as Messrs Prince and O'Neal.
But if the banks do not come clean, regulators should push them. Auditors will apply pressure when the banks produce year-end reports. Meanwhile, those who would be screaming down a megaphone for full disclosure if the problem banks were Argentine or Brazilian should apply the same discipline closer to home.
The risk is that, as in Japan, tinkering will be easier than acting decisively. The incentives to continue pussyfooting are clear. Undue haste could cause panic. And it is comforting to believe that everything will work out all right in the end, especially if the Federal Reserve keeps cutting rates at every whiff of trouble. The higher oil and food prices go, however, the harder it will be for the Fed to respond so generously. The longer the wait, the harder the economy may fall.