America's Banks: Are They Really Insolvent?

Several well-respected economists have gone on record over the last few weeks and discussed the likelihood that our country’s financial institutions are all insolvent. Two particularly heavy hitters - Paul Krugman and Nouriel Roubini - have gone as far as to advocate nationalizations on a wide scale. It seems that just about everyone and their moms have jumped on this idea as the perfect way to “punish irresponsible shareholders” and “hold management teams accountable.” Interestingly enough, very few of these people ever acknowledge two very important questions that must be answered before we, as a nation, embark on a campaign to nationalize our financial institutions and radically alter the course of American economic policy. Is our financial system truly insolvent? How will nationalizing solve our financial woes? After all, are we looking for a scapegoat for the current recession or are we trying to get our economy back on solid footing?

What exactly is insolvency?
Insolvency is when a business has insufficient assets to cover liabilities. When CNBC refers to banks not having enough of an equity cushion, it refers to natural equality set up by a balance sheet - assets = liabilities + shareholders’ equity. Thus, assets - liabilities = equity cushion. A business uses its assets to pay back liabilities as they come due. When this is not the case, the business becomes “insolvent.” In a normal environment, businesses can increase assets by raising new debt (liabilities) or equity. Given the frozen credit markets and the number of firms licking their wounds from asset deflation, new debt (known as refinancing) is not an option and, as a result, we see the increased focus on equity capital.

Equity capital can be generated in a few ways. A lot has been made of preferred and common equity capital raises this year. Many of the nation's banks have received TARP money in exchange for preferred equity. Goldman Sachs (GS) gave a sweetheart deal to Warren Buffett in exchange for preferred equity and warrants. Morgan Stanley (MS) recently sold $9 billion in common equity to Mitsubishi. These capital raises were all made in hopes of shoring up the asset base in order to cover potential liabilities.

In addition to equity raises, assets themselves can also generate return. In fact, the bank business model is predicated exactly on this oft-ignored phenomenon. Banks take on liabilities at low interest rates and then lend these assets out at higher interest rates. This means that strictly speaking having fewer assets than liabilities is not necessarily insolvency. Provided assets generate a reasonably fast return and liabilities mature slowly, it’s possible that the simple passage of time could rectify such a mismatch. A quick check on big banks (Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), and JP Morgan (JPM)) on Yahoo! Finance shows that they all remain significantly free cash flow positive despite accounting losses due to asset writedowns.

Are banks insolvent today?
It’s hard to say whether or not the likes of Bank of America, Citigroup, or Wells Fargo are truly insolvent. The arguments of Krugman and Roubini are predicated on the likelihood that many banks have not properly “marked to market” their assets. So, even if they are showing positive asset-to-liability coverage, it’s likely not reality given how illiquid most assets are these days. Taken to its logical extension, Krugman and Roubini make the point that most banks would be insolvent if there were a run on the bank - depositors demanding money back, debt holders accelerating amortization, etc. Truthfully, all banks would be insolvent in such a situation. That’s why we created the Federal Reserve System and it’s why the Fed and Treasury have worked so hard to prevent a Great Depression style run on our banks. It is also why the Fed operates as a lender of last resort, guaranteeing liquidity even in markets like the ones we face today. And, no, Fed lending is not a use of taxpayer dollars. The Fed is capitalized by the banks, which participate in the reserve system.

In the end, a true bank insolvency is not as simple as assets < liabilities. Because of ample liquidity avenues, banks typically can maneuver any impending needs to service liabilities. Insolvency, instead, is usually a subjective decision made by regulators. These decisions are generally made by the FDIC, which makes its criteria public. We see here that generally, they look for a Tier 1 capital (equity + cash) to Liabilities > 4%. Since the report is readily available, looking at Bank of America’s most recent investor presentation, we see the bank currently with more than twice this level of asset coverage. It would seem that calls for nationalization are still somewhat premature by traditional regulation standards.

What’s the point of nationalizing?
This is the big question that I’ve been wondering about. Honestly, I don’t know enough about economic policy and financial regulation to really explain so I’ll direct you to this terrifically written article by Edward Harrison of creditwritedown.com. He’s actually been writing about impending insolvency and the appropriate government intervention through bank nationalizations since August, so he’s not just some bandwagon pundit. In fact, if you read his blog, you may notice that Roubini’s recent post on the need for nationalization is significantly “borrowed” from Harrison. I’ll do my best to summarize.

The belief is that one way to stabilize our markets is just to force our way down to the bottom and start over. Bank nationalizations would allow this as the government could provide its own guarantee to counterparty obligations and then write down assets to their most draconian values, which allows the easy management and resale of “toxic assets” at a reasonable market value. This strategy raises a few concerns.

First and foremost, with the estimated need to write down in excess of $3.6 trillion in value (Jeremy Grantham recently estimated as much as $10-$15 trillion), is it really worth taxpayer dollars to guarantee these debts simply to punish shareholders and management of our nation’s banks? Why not spend a little less money and make bank shareholders pull themselves out of this mess?

Second, the highly pessimistic view of our nation’s banks’ solvency is built on the assumption that market value is the true value of the assets they hold. Unfortunately, this couldn’t be farther from the case. There is a significant argument to be made that the long-run recoverable value of many “toxic” loans is probably significantly more than the 10 or 20 cents on the dollar that we seem to be all too willing to assign them these days. An economic policy, which can help to rectify the market dislocation, would go a long way to shoring up balance sheets throughout the nation, not just at banks.

In the end, I see the merit in the desire to quickly expose the extent of asset writedowns and get back to putting our economy in drive. However, I don’t think that many people calling for nationalizations understand the real results of such actions. Nationalization of our nation’s banks will require either trillions of dollars (not just hundreds of billions) and will bring about significant asset devaluation across all sector and securities. If I came to you today and gave you two choices:

1. The market can bottom tomorrow and we’ll jump right back to growth, but you have to give up 20-40% of your asset values.
2. The market will bottom tomorrow, but won’t reappreciate for decades.

Which would you choose?

Full Disclosure: The author bought shares of Bank of America last year, but no longer has any positions in the stocks mentioned in this post.

Comments

[Lin:]

Richc , sentinal,

you are both correct ! Just wait for the commercial real estate implosion , skyrocketing unemployment , with even more foreclosures . We aren't even 1/2 way thru this yet . Don't forget the ' student loan ' defaults when millions of these college grads can't get jobs or become unemployed .

Feb 13 01:55 AM

[MaineLobster:]

Don't forget to list the banks exposure to other derivatives.

Bank of America: (as of Sep 30, 2008)
Total Assets:1.8 Trillion
Total Derivatives: 39.98 Trillion

www.occ.treas.gov/ftp/...

Flip to page 23 and feast your eyes! There is nothing like taking all your assets, flying to Vegas and putting it all on Black.

Feb 13 08:27 AM

[CaptainJJack:]

Even though there are a lot of comments here, I feel compelled to add my own solution:

I think the banks should be required to mark to market each quarter, BUT it should be in a footnote and not part of the actual balance sheet. This IS a distinction with a difference because the capital adequacy ratios and the ability to lend should be based on the balance sheet and not the footnote numbers.

The numbers that go on the balance sheet should reflect the ECONOMIC reality as the bank knows it at the end of each quarter, and that speaks to the question of WHEN and how much cash flow the bank is truly expecting from the asset.

If the bank expects that it will only receive 50% of the cashflow from the asset that it had been expecting to receive, it should market the asset down to 50% and put THAT amount on its balance sheet.

Yes, this IS mark to model, and yes, it is subject to manipulation, but that is why the true market value is in the footnote. The bank could play some games, here, but in the end, the analyst, and regulator, can see both numbers.

In other words, it should be based on the bank's expected cash flow.

I believe you will see that the "stress testing" outlined by Geithner is designed to effectively move from market to market to expected cash flow as the basis for evaluating the bank's creditworthiness and solidity.

I guess Geithner feels he cannot avoid mark to market balance sheets, so he is doing the next best thing to what I am suggesting.

Finally, I predict that Geithner will wait until the stress test is pretty far along before starting the auction market, but that needs to be set up to get the true market values to keep everybody honest, and it will.

Feb 13 08:35 AM

[HChang:]

If some banks are nationalized, ti will only benefit those who are not. The so-called toxic assets will be bought by those not naitonalized but at fire sale prices. In the end the government still has to cough out billions if not trillions to recapitalize them as i doubt selling the assets will get good prices now. If nationalization happens, taxpayers will be crying again (always crying) and say those money belongs to them. Instead why not take a small pain now and wait for the banks to recover, which they will. Nationalizing the big banks has very wide implications, not just for America but also many big banks around the world. The world financial system is already in a mess and don't need another round of crisis. Who knows how much it will costs to recapitalized the banks? Things are stabilising, it will take some time before we are back to normal. I would rather take the medicine of time than the risks. You don't have to agree but think again, it will cost more if the big ones are nationalized.

Feb 13 10:53 AM

[HChang:]

And part of the problem are due to the short-sellers (or gamblers). They had caused the stock prices of banks to drop so low that reduce equity in a big way and lead to insolvency. When will America ban short-selling? It's illegal and punishable by law in many asia countries because of the damage it caused previously.

Feb 13 10:57 AM

[I-investor:]

This article hits the nail on the head! BTW, nationalization fans, the constitution of the USA requires just compensation in such cases. The courts would be inudated with lawsuits if such events took place. Ultimately, nationalization would likely shake the confidence in the financial system. It's way too problematic a solution.

But it does make for good fear-mongering, if you are banging on the SKF.

Feb 13 12:47 PM

[Henry Buttal:]

Did I see that Whitehawk is concerned about projected cash flow distortions, but that he trusts Mark-to-Market! Wow.

Having run several small to medium businesses, in both exec and CFO slots, I can tell you that:
- Cash availability (whether as flow from business operations or from lending/ equity offering resources) is always the life blood of the business
- Accounting is good at providing operational indicators, but is lousy for an actual representation of value of a)underlying assets b)the business
- Attempting to assess the long-term health of your business, or its long-lived assets, by pricing on a short term basis is a recipe for disaster

If MtoM was the definitive measure of business viability, ALL BUSINESS would be shutdown. At some instance in time, MtoM would make any business unviable.

The sad truth is that recent FASB practices have put form over cost/benefit for years. American businesses of all sizes, and ultimately the U.S. markets as a whole, have paid the price for the increasingly restrictive and unreasonable policies put in place.

157 is the most visible faux paux, but is only a small part of the overall burden.

My view of this as it relates to the banks is if they have the cash flow, and there is a reasonable assessment based on historical or current performance that can define LONG TERM IMPAIRMENT of the long lived assets, then that should be the measure, not Mark to Market/ 157. If we are talking about balanced loan tranches, then they would be viable.

Feb 13 01:23 PM

[bindlepete:]

The writer is dead wrong in raisin money by debt has no impact on the " solvency issue" as for each dollar one raises one increases liability buy the same dollar.

Second, The Basel II agreement/treaty was approved by the Senate so it is US Law. That agreement required full transparency of financial institution assets. with all being market to the lower of cost or market.

Paulson tried to side step this legal issue with SIV and failed when his scam was pointed out. So Bernanke let itr slip as did the Dept of Justice, the Comptroller of the Currency and the FDIC and SEC. They all dodged the issue and buried it.

The Banks have yet to expose of account for their full liabilities and Barney Frank has and had the chance but he won't do it.

I can thus conclude that they are insolvent and should be in receivership. I recognize this is painful but integrity, the law and our future demands we wake up and be honest with ourselves. Continued denial is criminal.

Feb 13 03:58 PM

[a believer:]

Cash will be the best investment until inflation or hyperinflation kicks in - then commodities will be the best investment.

Here is something interesting: I was on a street in Raleigh the other day and I counted 10 different banks in a 3-block stretch. 10! Most were in new buildings; some had just opened their doors.

The American people have all watched the absolutely reprehensible behavior of the banks over the past 1.5 years and the banks have shown their "true colors" to us all.

Here is a trend: Alot of the young people are starting to develop a NEW monetary system that freezes out banks because they realize so many banks are run by greedy crooks - the banks are destroying individuals and our country. They also realize the effect of "interest: (usury) on money supply growth is ruining the world's economy. Who can afford to pay back the ever-expanding interest? No-one.

Those young people are SMART.

Here is another trend I've recently noticed: More and more people are storing their money at home and are paying their bills with cash and money orders.

My prediction, therefore, is that most banks will disappear. Avoid loans, credit, banks, crooks, shills and the Wall St. thieves at every opportunity.

Minimize your business with banks; avoid them if possible. Our economy must go back to conducting business with cash and savings, NOT credit and loans, and it will.

Feb 13 05:08 PM

[Kinabalu:]

"Krugman and Roubini make the point that most banks would be insolvent if there were a run on the bank - depositors demanding money back, debt holders accelerating amortization, etc. Truthfully, all banks would be insolvent in such a situation."

That's why economists aren't accountants. In the long run (an economic concept if there ever was one) the accountants will be right. Allocation of costs and revenues to individual accounting periods is the hardest thing accountants do. But they know that at the end of the companies life, whenever that is, they will have the final answer. In the meantime economists can kibbitz all they want.

Feb 13 09:27 PM

[Jgregory:]

Is it just me, or do most of the people who want to close or nationalize the banks speak English with an accent (and their writing is no better)


On Feb 13 03:58 PM bindlepete wrote:

> The writer is dead wrong in raisin money by debt has no impact on
> the " solvency issue" as for each dollar one raises one increases
> liability buy the same dollar.
>
> Second, The Basel II agreement/treaty was approved by the Senate
> so it is US Law. That agreement required full transparency of financial
> institution assets. with all being market to the lower of cost or
> market.
>
> Paulson tried to side step this legal issue with SIV and failed when
> his scam was pointed out. So Bernanke let itr slip as did the Dept
> of Justice, the Comptroller of the Currency and the FDIC and SEC.
> They all dodged the issue and buried it.
>
> The Banks have yet to expose of account for their full liabilities
> and Barney Frank has and had the chance but he won't do it.
>
> I can thus conclude that they are insolvent and should be in receivership.
> I recognize this is painful but integrity, the law and our future
> demands we wake up and be honest with ourselves. Continued denial
> is criminal.

Feb 13 11:53 PM

[Jgregory:]

Well done


On Feb 13 08:35 AM CaptainJJack wrote:

> Even though there are a lot of comments here, I feel compelled to
> add my own solution:
>
> I think the banks should be required to mark to market each quarter,
> BUT it should be in a footnote and not part of the actual balance
> sheet. This IS a distinction with a difference because the capital
> adequacy ratios and the ability to lend should be based on the balance
> sheet and not the footnote numbers.
>
> The numbers that go on the balance sheet should reflect the ECONOMIC
> reality as the bank knows it at the end of each quarter, and that
> speaks to the question of WHEN and how much cash flow the bank is
> truly expecting from the asset.
>
> If the bank expects that it will only receive 50% of the cashflow
> from the asset that it had been expecting to receive, it should market
> the asset down to 50% and put THAT amount on its balance sheet.<br/>
>
> Yes, this IS mark to model, and yes, it is subject to manipulation,
> but that is why the true market value is in the footnote. The bank
> could play some games, here, but in the end, the analyst, and regulator,
> can see both numbers.
>
> In other words, it should be based on the bank's expected cash flow.
>
>
> I believe you will see that the "stress testing" outlined by Geithner
> is designed to effectively move from market to market to expected
> cash flow as the basis for evaluating the bank's creditworthiness
> and solidity.
>
> I guess Geithner feels he cannot avoid mark to market balance sheets,
> so he is doing the next best thing to what I am suggesting.
>
> Finally, I predict that Geithner will wait until the stress test
> is pretty far along before starting the auction market, but that
> needs to be set up to get the true market values to keep everybody
> honest, and it will.

Feb 13 11:58 PM

[NITRAM:]

SELLINH SHORT AND BUYING LONG IS GOOD. GREED IS BAD. UNFORTUNATELY THE SHORT SELLERS HAVE BETTER OPTIONS THAN THE LONG BUYER. ENFORCE ALL THE RULES SHORT AND LONG.


On Feb 12 08:25 AM James Wilson wrote:

> Get control of the Shorts and then watch the market recover.
>
> People are not going to buy in only to be placed in a long position
> by Shorts.

Feb 14 09:52 AM

[Madrid:]

And how do they expect to buy a house or start a business? Or will all these young people choose to live in a homeless shelter or the street?


On Feb 13 05:08 PM a believer wrote:

> Cash will be the best investment until inflation or hyperinflation
> kicks in - then commodities will be the best investment.
>
> Here is something interesting: I was on a street in Raleigh the other
> day and I counted 10 different banks in a 3-block stretch. 10! Most
> were in new buildings; some had just opened their doors.
>
> The American people have all watched the absolutely reprehensible
> behavior of the banks over the past 1.5 years and the banks have
> shown their "true colors" to us all.
>
> Here is a trend: Alot of the young people are starting to develop
> a NEW monetary system that freezes out banks because they realize
> so many banks are run by greedy crooks - the banks are destroying
> individuals and our country. They also realize the effect of "interest:
> (usury) on money supply growth is ruining the world's economy. Who
> can afford to pay back the ever-expanding interest? No-one.
>
> Those young people are SMART.
>
> Here is another trend I've recently noticed: More and more people
> are storing their money at home and are paying their bills with cash
> and money orders.
>
> My prediction, therefore, is that most banks will disappear. Avoid
> loans, credit, banks, crooks, shills and the Wall St. thieves at
> every opportunity.
>
> Minimize your business with banks; avoid them if possible. Our economy
> must go back to conducting business with cash and savings, NOT credit
> and loans, and it will.

Feb 14 04:01 PM

[Patriotgame:]

BAC appropriately mark to market their assets each quarter in one of the most heavily regulated industries in modern business. They currently have $140 billion of tangible equity with more than $60 billion of that in the form of common. And they have and additional $23 billion in allowance for loan losses.

Doesn't sound insolvent to me.

Feb 14 04:33 PM

[vaughn:]

The banking insolvency scare tactics is based on the worst case scenario ( ie, 50% housing default rate with 50% recovery rate, meaning a 25% loss) and that loss must be recognized now and right now. This ignores an important fact that default does not all happen at once: default happens over a period of time until the economy recovers.

It is likely that in 2009 a 5% default might happen, then banks will have to deal with that in 2009. However, given the actually zero rate of funding cost of banks, banks are in a position to earn huge spread to cover loan and credit loss.

For those argue that all banks must restart anew missed the point that banks, taken as a whole, are actually increasing lending. The current tight credit market is not banks' fault. It is the demise of the shadow banking system. Naturalization of all banks will not revive the shadow banking system and will make things even worse.

Shorts and vultures love the scare of naturalization. So far, Us has over 20 banks failure. Has any of the failed banks be naturalized? None, Nada, zero. It is clear that Us has no naturalized banks, only failed banks seized by FDIC.

Feb 15 12:14 AM

[Whitehawk:]

If you have access to the WSJ online, pull up "Denmark Offers a Model Mortgage Market" published on Oct. 10 2008; it is written by the controvert George Soros, so those of you into conspiracy theories might take it as him stealing the show after wrecking the train. A couple excerpts:

"Every [Danish] mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices."

"How [would the U.S. get to the Danish system]? It will involve modifying the existing stock of mortgages, so that the principal does not exceed the current market value of the houses, and refinancing them with Danish-style loans. The modification will have to be done by servicing companies that need to be properly incentivized. Modifying mortgages that have been sliced and diced into securitizations may require legislative authorization. The virtual monopoly of the GSEs would be terminated and they would be liquidated over time."

I like that last little bit about terminating the GSEs but I can see modifying mortgages within existing SIVs as a thorny issue and possibly expensive.

BTW, Soros has written several articles in the WSJ outlining multiple ideas for fixing the mortgage securitization and banking crisis in the U.S. Does anyone know if the current admin/congress is even listening to him? [Yes, I know conspiracy theorists will say he helped get them in there.]

Though I am quite skeptical of his motives and sincerity, and generally on the opposite side of his known politics, some of his ideas appear reasonable. (And note I said some, not all.)

On Feb 12 07:33 PM The Curious Investor wrote:

> @TERN
>
> This is a really interesting idea. Can you provide any links or further
> reading on the way the Danish handle home mortgages. I've never heard
> of the ability to buy back your debt on the secondary market. <br/>
>
> On Feb 12 06:15 PM TERN wrote:

Feb 16 02:11 AM

[Mad Hedge F...:]

Why don’t we accept the wisdom of crowds and accept the market’s judgment that the big banks are worthless? Let them all go bankrupt. With Bank of America (BAC) and Citigroup (C) down 95% from their peaks, shareholders have already been wiped out. All we are arguing about here is whether they should be allowed to come back in the next economic recovery. The Geithner bailout plan missed a golden opportunity to shock us all to our senses. Whatever happened to creative destruction? Let the weak banks go, and they will be replaced by stronger, better managed ones without any government involvement at all. Let the natural Darwinian survival of the fittest run its course. I watched with chagrin while Japanese banks pretended they were solvent for 15 years. Everyone in the country suffered as a result, and a whole generation’s worth of economic growth was lost.

Feb 21 08:57 AM

[The Curious...:]

For those still interested, I highly recommend this follow up article on the subject of bank insolvency. thecuriousinvestor.com.../

Mar 04 09:21 AM

[Near Retire...:]

I wonder if we can clean things out if we allow homeowners to buy out the mortgages at the written down value of the loan. I read that these packed loans are now on the books at 80% or 60% of the the face value. If we could buy these loans and get the refinanced at 4-4.5% payment would be reduced significantly and perhaps the face value of the new loans would be above the market value of home. There probably isn't much that can be done if the property values have been cut in half.

This assumes that somehow the owner of these loans can be tracked down of course.

Mar 07 10:24 AM