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John Hempton has 5,155 words on bank insolvency today, and makes the good point that "insolvency" is not well-defined. So what do I mean when I say that some big banks are insolvent? I mean that when you look at assets you shouldn't include things like goodwill, and instead concentrate only on concrete things like cash and retained earnings; then, value loans on a held-to-maturity basis. If you do that, those assets are worth less than the face value of total liabilities.

Hempton makes the good point that mark-to-market values are significantly lower than held-to-maturity values because the buyers of distressed loans want much higher returns (on the order of 15%) than the discount rate (on the order of 5%) that you'd use to value a held-to-maturity value.

So how do you work out a reasonable held-to-maturity value for an asset book? As Hempton says, you can't trust the banks themselves to tell you, because they will lie: the downside to telling the truth is death. His idea is to use TARP funds to capitalize ten different funds, each of them mixing public and private capital, and each of them buying banks' assets using cheap money as funding. That should give a good basis for a vaguely realistic valuation.

But is that really necessary? We already have such funds (capitalized with public funds, with access to cheap liquidity): they're called banks. No one trusts Citigroup when it takes a bunch of nuclear waste on its trading book and suddenly reclassifies it as being held to maturity and therefore exempt from mark-to-market requirements. But if JP Morgan was to buy the stuff on Citi's trading book, and Citi was to buy the stuff on JP Morgan's trading book, then at that point the prices would be much more believable. And these big banks have a very low cost of funds indeed, thanks to a Fed which is more than willing to provide them with essentially unlimited liquidity.

Hempton is also convinced that given a few years, banks will be able to recapitalize themselves all on their own, out of operating profits:

The pre-tax, pre-provision income of the banking system normally funded is probably 300 billion. It is probably much larger if the funding costs were reduced to near Treasury levels. If you haven't noticed interest rate spreads and hence pre-tax, pre-provision profits of the banking system should (presuming normalised funding) be way way up. 300 billion is an underestimate. So if there are 2 trillion of losses and 1.4 trillion of starting capital then four or five years and we are back to fully capitalised. We would get back there faster than that - because the banks have raised considerable capital on the way down and not all the 2 trillion of end losses are born within the banking system.

I'd take issue with some of these numbers: $300 billion a year is $3,000 per US household per year. That's real money. We're entering a world where households have lower borrowings, higher savings, and much greater awareness of the banking system; we're also entering a world of much stricter bank regulation, which means less opportunity for banks to gouge consumers when it comes to fees. So do I believe that the banking system will be making something like half a trillion dollars a year in operating profits if and when it gets back to some kind of steady-state sustainability? No.

I'm also dubious about the $1.4 trillion in starting capital -- that's regulatory capital, which is a very different animal from something like tangible common equity, and importantly it includes preferred shares, which I, for one, consider much closer to being liabilities than equity as far as a bank is concerned.

Hempton thinks that on this basis the system is "brimming with solvency"; if I had to point to one place where I clearly disagree with him, it would be here. I think that on a snapshot basis the system is worse than he calculates, and I also suspect that going forward the ability of the banking system to recapitalize itself is much weaker than he thinks.

Still, he's indubitably correct on the subject of the "Geithner plan" -- which is one of those phrases that genuinely belongs in scare quotes:

As far as I can see there is no detail - and if you don't have detail you don't have a plan.

This is one of the reasons I'm becoming increasingly convinced that we're turning Japanese: given how hard it is to do something bold, it's always easier to faff about and do something woefully insufficient. Unless and until Geithner announces a plan worthy of the name, we'll have to assume that to be the base-case scenario.

Disclosure: No positions

Source: America's Insolvent Banks