September 26, 2008

"The long-winded version"

Here's Mike Plaiss's follow-up....

Since you invited me, you've opened yourself up to the long-winded version. First, I'm afraid, it is important to understand the role of capital in a bank. Here's the short version. A bank must maintain a certain percentage of their assets in capital. So if a bank has $1 billion of assets (loans, investments, etc.) then they have to have, say, $50 million in capital -- their own money, not borrowed funds. This is a gross oversimplification, but you get the idea. So a shareholder group could raise $50 million in capital (real money), borrow $950 million, and they'd be fine running a $1 billion bank. Understand that a lot of that $950 million would be in the form of good old fashioned savings accounts, CD's, etc.

You may be surprised at the amount of leverage (borrowing) that banks are allowed to employ and this is the first of two problems that the financial sector is facing right now. Banks have never been more leveraged, especially investment banks. They can leverage even more, and it is no accident that they were the first to die.

The second problem is that banks have suffered a very real decline in asset quality. Nearly every bank is struggling with an increasing number of bad loans. Imagine a developer who borrowed money to build a new subdivision in 2006 with plans on having the first phase complete in 2008-09. He is likely bankrupt-- and the value of that land, the collateral, to the bank now? Not good.

Asset quality issues inevitably impact capital. Bad loans have to be written off, investments that have depreciated significantly in value have to be written down, etc. All of this decreases capital. Let's use the numbers in the example above and assume that the bank is looking at loan losses (or investment write-downs) of just 1.5% of those $1 billion in assets. Well, that's $15 million in capital that's gone, but remember they are required (by some quite determined regulators) to have $50 million in capital.

The bank now has two choices. Raise $15 million in capital (In this environment!? Good luck), or shrink the balance sheet. If they shrank their assets from $1 billion to $700 million, they'd be OK with only $35 million of capital.) So the bank in this example is looking to sell $300 million worth of loans or securities -- preferably by the end of the quarter.

If it were only a few banks in this predicament, it would be no big deal, but the reality is that many if not most banks are in this same boat, and that is the crux of the problem. Everybody is looking to de-leverage, to shrink their balance sheet by selling assets, at the same time. It only takes a moment of thought to realize where that gets you.

And if it were just the banking world it might not be such a big problem. But nearly everybody is looking to de-lever (sell assets) right now. Hedge funds? They borrow money to buy their assets too. Who's going to lend it to them now? They are under even more pressure than the banks to sell. Private equity? Yes, that's coming on line (and what a great time to have access to private equity) but frankly it's a drop in the bucket. Thus, we have maybe 5 sellers (of all assets) for every one buyer and therein lies the "opportunity" as Kessler sees it.

None of this is really a defense of the plan, only its cost. If the government buys these assets they aren't "out" $700 billion. The treasury can borrow at, say 4%, buy assets that are going to return north of 8% (even with the losses factored in) and make a killing. It is certainly reasonable to argue that this is simply not something that the government should be in the business of doing. I have thoughts on that, but again I'll save them for later.

Posted by John Weidner at September 26, 2008 9:23 AM
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