The declaration that US banks are “insolvent” has been repeated so often, so emphatically, and by so many, that it’s practically considered a truism, requiring no explanation.
And it’s creating very negative consequences for financial markets (as a quick look at the current share prices of Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM) will attest) and the economy as a whole: It’s been used to rationalize both massive bailouts and, more recently, outright nationalization of the banking system.
But I have yet to see a single commentator present a model of a bank’s balance sheet that demonstrates that a particular bank is in fact insolvent and/or unable to lend. Of course, the arguments of the Cassandras do contain a grain of truth. But they lead to dangerous falsehoods.
I believe that the current misunderstanding stems from a fundamental lack of knowledge about how banks work. It’s true that many US banks may have negative book value if their assets are marked to market or even if they are marked to their hold-to-maturity value. However, that is very different from the claim that the common equity of banks have no value and that private banks need either to be bailed out at taxpayer expense or be nationalized.
Let me be clear:
- It is categorically false that the intrinsic equity value of banks with negative book value is zero.
- It is categorically false that it is necessary for taxpayers to assume the burden of losses created by private banks.
- It is categorically false that nationalization is a necessary step to “clean up” bank balance sheets and free up credit.
Let's take an example of a bank that, due to poor investment decisions and/or systemic economic conditions, has become “insolvent” - if we understand that term to mean an entity with negative adjusted book value.
It's assumed here that the bank is forced to immediately write down the full “hold to maturity” (or HTM) value of losses from troubled assets.
As can be easily observed, given the leveraged nature of a bank, significant losses in its portfolio of assets -- in this case, 11% of total assets -- can very quickly result in negative equity. However, does this mean that the value of the common equity is worthless? Or that the bank should be bailed out and/or nationalized?
But a bank can have negative book value and a highly positive Net Present Value (NPV) of equity.
In the example provided, tangible book value is currently reported as $30 but would actually be -$80,00 if all assets were marked down to HTM value. However, under the relatively conservative assumptions illustrated in the model below: If the bank is simply allowed to carry its assets at acquisition cost and to charge the troubled assets off over time -- say 15-20 years -- the tangible book value of the bank will grow organically to $118,302 by 2021 - without any intervention or subsidies by the government whatsoever.
Applying a discount rate of 10%, the net present value of this 2021 book value is $34,268. US banks have historically traded at multiples well in excess of 4 times book value. Applying a conservative multiple of 2.5x book value would yield a market capitalization of $85,670. This is well over 100% above its current value in the stock market, which is at a mere $40,000. The regulatory uncertainty and the talk of cram-downs and/or nationalizations have caused an over-reaction in the market that has caused the market to value many banks well below their intrinsic NPV.
As a check to the reasonableness of my NPV calculation, I determine what would have happened if, with perfect foresight, the losses resulting from the 2007-2009 debacle could have been anticipated. In such a circumstance, what should the pre-crisis value have been? Would this fully discounted value been higher or lower than the current market valuation?
In order to do this, I calculate the NPV of the charge-offs over the 13-year period. This NPV is then subtracted from the pre-crisis value. In addition, an estimate is made of the NPV of the efficiency drag of having to carry non-earning assets on the balance sheet. The resulting residual value is still 200% above the current market capitalization. This confirms that the market, in this instance, has overreacted and is assigning a value well below what it should be.
(Click to enlarge)
In the example provided, it would take the bank approximately 10 years to charge off the losses incurred from the 2007-2009 financial crisis and rebuild tangible book value capitalization to pre-crisis levels of 3.00%. It would take approximately 13 years for the bank to achieve the desired tangible common equity capitalization ratio of 5.00%.
How does this happen? Simple. All troubled legacy assets are placed in a special portfolio of non-performing, non-earning assets that have to be charged off over time. An ROA of 1.1% is applied to the performing earning assets, after charge-offs from delinquencies in these assets. The ROA on earning assets is conservative, given that many US banks have historically achieved ROAs of 1.2%-1.4%. Earnings, asset and book value growth in the example is fully organic and a function of capitalization of earnings and a leveraging of assets at a gradually increasing common equity capitalization ratio. The resulting earnings growth and ROE are in line with or below the typical historical performance for US banks.
How can one be sure that the bank can generate the earnings to dig itself out of the hole? There is every reason to expect it will, as long as the bank is reasonably efficient.
Banking is a unique industry. Unlike virtually any other industry on earth, banks deal in a product that never goes out of style - money. As long as a bank maintains adequate technology and human capital to compete in the marketplace, long-term profitability is virtually assured, because demand is assured. As long as a bank can generate positive cash flows, and as long as the NPV of these cash flows exceeds the NPV of the losses from the defaulted assets, then the present intrinsic value of that bank’s common equity is positive. A bank can therefore have a very negative net worth and still have a highly positive net present value.
What about the impact of the toxic assets on the balance sheet? Many may worry that allowing banks to carry negative book value (in HTM value terms) will create a “zombie bank” situation, such as that which existed in Japan. But the Japanese analogy isn’t apt. In Japan, the government forced banks to continue to lend to unprofitable companies, effectively preventing Japanese banks from being able to dig themselves out, since they were forced to throw good money after bad.
This isn’t what’s happening to the US, nor should we expect it to happen. The US isn’t forcing banks to make new lows to borrowers in default.
So is allowing the banks to operate with negative equity in HTM terms a free lunch? No. Carrying the non-earning toxic assets on their balance sheets will cause US banks to earn a lower return on assets over the next few years; this reduces the NPV of their common equity.
There should be no free lunch for the common equity shareholders of banks, nor need there be. That’s the point. In the example provided, bank equity holders are paying for the full value of their losses. However, they’re doing so over a number of years. There’s no need for dilutive equity offerings, and absolutely no need for government subsidies that socialize the banks’ losses. As long as banks are allowed to value their assets at acquisition cost and gradually charge them off over a period of, say, 15-20 years (similar to depreciation), the banks can continue to operate normally by collecting deposits and extending new credits to credit-worthy customers.
In the example, the portfolio losses are in essence paid gradually by suspending dividend distributions for 13 years, while earnings applied to charge off legacy assets represent roughly 50% of annual earnings. This charge-off rate essentially takes the place of a 50% dividend pay-out ratio. Again, no free lunch here.
The example can even work if banks are allowed to make some dividends payouts to common shareholders along the way, though it would take longer for the bank to repair its tangible book value and achieve an acceptable equity capitalization level. But if the government were to allow banks to charge off the toxic assets over a 20-30 year period, then dividend payments to common shareholders could be accommodated.
How realistic is this example provided?
First, there are many precedents in Latin America and Asia in which distressed banks have repaired their tangible book value and generated intrinsic value to common shareholders in precisely this fashion.
Second, the assumptions in this exercise are pessimistic, if anything. In particular, it seems certain that the government will be absorbing some of the banks’ losses, one way or another. This could happen either by the government directly sharing in the losses, or by providing the bank with very low funding rates through the Fed’s discount window or similar facility. In this case, the present intrinsic value of bank equity would be even greater than forecasted by the example.
Finally, the whole process of balance sheet healing can be sped up though equity offerings over time. As long as the equity offering is made at an “after the money value” equal to or in excess of its “before the money” NPV, no dilution to current shareholders will occur.
At the P/BV multiples in the example, and based on historical precedent, it’s highly likely that equity offerings ultimately accretive to shareholders can be made.
In this example, a bank that currently has a market capitalization of $40,000 in the stock market due to concerns about possible bankruptcy and/or nationalization probably has an intrinsic value of more than $85,000 -- more than 100% higher than the current quoted price.
Several important conclusions can be drawn here:
- The NPV of the vast majority of banks in the US is highly positive, with some exceptions. Absolutely no taxpayer bailout of common shareholders is needed. Current bank equity shareholders are, on the whole, perfectly capable of assuming the losses that were generated by them. All that’s needed is a set of accounting rules that allow banks to work off their losses over time.
- Nationalization isn’t necessary to a well-functioning banking system. The financial intermediation infrastructure in the US in terms of technology and human capital is intact. As long as banks aren’t forced to write down their assets all at once, the vast majority of banks can operate profitably, collecting deposits and expanding credit.
- Provided that the government doesn’t impair the intrinsic value of the banks through unsound policies such as nationalization or cram-downs at distressed prices, it might make sense to consider some limited investments in select bank stocks. Many of these banks are trading at values well below their intrinsic values. And we should be expecting Geithner and his team to be searching for ways to boost equity-market valuations, since wealth levels have a direct bearing on consumption, investment and overall economic activity.
- The problems that have arisen in the financial system can be solved with provision of adequate liquidity and by reform of bank accounting regulation. The Fed has already taken care of the liquidity problem. Now the authorities need to take care of the accounting issue so that banks can resume lending and rebuild their equity bases.
- The specifics of the regulatory provisions that would allow banks to charge off non-performing assets over a number of years need to be worked out by regulators - and there are so many viable approaches to resolve this issue that it’s really no obstacle at all. For centuries, banks have carried assets on their books at acquisition value. There’s no reason why they cannot be allowed to do so again.
In terms of the criteria and timing of how losses are recognized, this is also an eminently soluble problem. It’s regulators’ job to create rules to determine how companies value their assets - which may have nothing to due with their current market value. This is just one more such task.
- There’s still no such thing as a free lunch. Bank shareholders should be made to fully absorb the losses incurred by the banks they own. But there’s no need for taxpayer bailouts, and there is certainly no need for nationalization. The reality is that the future cash flows of most banks are so great they can cover all losses and still leave plenty of value for shareholders. In fact, the NPVs of such residual cash flows are so attractive, it makes sense to buy select bank shares at current prices.