Buffett's Unmentionable Bank Solution

Buffett's Unmentionable Bank Solution, by Holman W Jenkins, Jr
WSJ, Mar 11, 2009

Last week's post mortem on the Fannie and Freddie takeover was received better than we might have expected. A few readers assumed Eddie Lampert and Bill Miller, fund managers who lost money when Fan and Fred were seized, and whose letters to their own investors we quoted, were engaged in special pleading.

In fact, the nationalization of Fannie and Freddie is water over the dam. The men's perspective may be one of pain, but it is historical pain.

Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other banks, who, during his marathon appearance on CNBC Monday, clearly called for suspension of mark-to-market accounting for regulatory capital purposes.

We add the italics for the benefit of a House hearing tomorrow on this very issue. Mark-to-market accounting is fine for disclosure purposes, because investors are not required to take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but can dictate actions that make no sense in the circumstances. Banks can be forced to raise capital when capital is unavailable or unduly expensive; regulators can be forced to treat banks as insolvent though their assets continue to perform.

What happens next is exactly what we've seen: Their share prices collapse; government feels obliged to inject taxpayer capital into banks simply to achieve an accounting effect, so banks can meet capital adequacy rules set by, um, government.

(This sounds silly, but has been a big part of government's response so far.)

CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions."

Depressing bank stocks today, he said, is precisely the question of whether banks will be "forced to sell stock at ridiculously low prices" to meet the capital adequacy rules.

"If they don't have to sell stock at distressed prices, I think a number of them will do very, very well."

He also proposed a fix, which CNBC duly omitted from its loop, namely to "not have the regulators say, 'We're going to force you to put a lot more capital in based on these mark-to-market figures.'"

Mr. Buffett obviously understands where we are today, though it seems to elude many of those kibitzing about "nationalization," "letting banks fail" and other lagging notions. Since last year, our banking system no longer rests on capital, but on government guarantees. With those sweeping guarantees in place to protect their depositors and bondholders, banks now are able to earn princely spreads above their cost of funds, however questionable their balance sheets.

Banks will "build equity at a very rapid rate with the spreads that exist now," Mr. Buffett said. With the possible exception of Citigroup, he added, "the banking system largely will cure itself."

Notice he didn't call for subsidizing hedge funds to buy toxic assets. He didn't call for more government capital injections -- which are not merely redundant when comprehensive guarantees are in place, but positively destructive of the ultimate goal of moving back toward a system based on private capital.

Mr. Buffett didn't utter the unstylish words "regulatory forbearance," but letting banks earn their way out of trouble under an umbrella of government guarantees is precisely that.

Hank Paulson started down just this road last July. Bank stocks soared. Then he turned on a dime. Washington needed somebody to punish and felt it couldn't impose haircuts on uninsured depositors and bondholders. That left only shareholders, who have been allowed to face vast dilution and/or government takeover based on mark-to-market regulatory capital standards.

Yet the truth is, you get little or no moral hazard bang from punishing bank shareholders. Equity investors, by definition, accept the risk of losing 100% of their stake in return for unlimited upside. Go ahead and wipe out shareholders: Markets will turn around and create the next 50-to-1 leveraged financial institution as long as the potential return outweighs the risk.

The only real fix for moral hazard, in some future regulatory arrangement, would be truly to dispel the belief of bondholders and uninsured creditors that they will be bailed out.

That's a subject for another day. The recent devastation of bank equity values wasn't inevitable but was a choice (an addled and perhaps not entirely conscious one) by policy makers trying to make sure bank shareholders didn't benefit from the massive safety net rolled out for banks.

As strategies go, it was a terrible one. It greatly increased the toll the banking crisis imposed on the economy, and the cost that fixing the banks will impose on taxpayers. But there's still a chance to avoid a disastrous, taxpayer-financed government takeover of the banking system. The alternative, just as Mr. Buffett spelled it out, begins with forbearance on capital standards.