Monday, February 23, 2009

Are banks insolvent?

Bronte Capital does a good job of going through the various flavors of "insolvency" and declaring that US banks are not, necessarily insolvent.
* Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
->Not right now. And even if they were, it would not matter as that capital is just a buffer and should be used...now.

* Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
-> Probably not, under GAAP. (If you believe YTM).

* Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
-> Yes, if access to capital was normal.

* Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
-> Nope.

* Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?
-> Depends on Government action.

My own answers are "No", "No", "No", "No", and "No". Look at how capital requirements are set, it's a hoary mix of accounting judgement, and pro-cyclical regulatory requirements:
Tier 1 (core) capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200.
So, after large losses, Tier 1 capital gets eroded, which worsens all the ratios tied to tier 1 capital. Banks need to raise more capital and reign in lending, just when lending is needed and capital is scarce. Let's pass over the question of whether this is sound financial regulation and agree, at least, that it is profoundly pro-cyclical. This pro-cyclical nature means that the US will not exit the economic recession it is in through sound banks, because sound banks do not create sound borrowers. It is the other way around. If the Obama administration had thrown the money they have given to banks at households, helping them save, the economic situation would be much better.

The cry for nationalization has hit the NYTimes, so political reality cannot be far away. It's amusing to hear Geither talk about how the US does not want its finance system to be a branch of the Government. We crossed that bridge a long time ago. My favorite description of the current system is a Potemkin market.

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