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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 (NYSE:GS) gave a sweetheart deal to Warren Buffett in exchange for preferred equity and warrants. Morgan Stanley (NYSE: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 (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and JP Morgan (NYSE: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.

Source: America's Banks: Are They Really Insolvent?