Are U.S. Banks Really Worthless?

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 (BAC), Citigroup (C), Wells Fargo (WFC) and JPMorgan (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:

1. It is categorically false that the intrinsic equity value of banks with negative book value is zero.
2. It is categorically false that it is necessary for taxpayers to assume the burden of losses created by private banks.
3. 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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.

Comments

[ironpants:]

Thankk Roubini, Whitney, Soros, Einhorn et al for the poison and vitriol contaminating the market and jeopardizing the country.

They need muzzles.

SEC?

Feb 25 06:22 AM

[Steven Hansen:]

this was a good presentation, and is food for thought. i have thought about letting the banks lay in their own crap - retaining their toxic assets and taking years to become healthy.

however, dispite your contention that the banks could operate in a healthy manner - each knows that the other is not healthy. there will never be an economic recovery until the banks get healthy. and that is the rub.

Feb 25 06:29 AM

[Pj568:]

If the hedge funds and billionaires of the world aren't buying this argument then I'm not either.

Feb 25 07:28 AM

[Mad Hedge F...:]

So nationalize the banks already! Get it over with! Call it whatever you want: partial nationalization, temporary nationalization, socialization, liverwurst, or rutabaga. Just get it over with! This tortuous slow drip of on again, off again, stop gap measures is going to cost us more than if we executed the politically incorrect “N” word. Of course, a government takeover is the worst nightmare for many Republicans. But now that former Fed governor Alan Greenspan and many fiscal conservatives are on board, this shouldn’t amount to political suicide for Obama. The FDIC’s Sheila Bair already does this on an almost daily basis with smaller regional banks, like Washington Mutual, but for some reason the top nine “too big to fail” banks are sacrosanct. Their deposits have been effectively nationalized with government guarantees since last fall. The market is already selling us that many of these once hallowed institutions are now worthless. This is what Citigroup (C) at $1 and Bank of America (BAC) at $2 are telling us. Just wipe out the pitifully little the common shareholders have left, clean them up, and resell them in five years after the credit markets are restored. Every government that ever did this, like the UK in the eighties and Hong Kong in 1998, made a fortune. I was involved with both, and serious coin was made by the sellers and the buyers. Not to drive a stake through the hearts of these de facto “zombie” banks really would risk a Great Depression II and an “L” shaped lost decade. The markets would love decisive and surgical action like this and rocket.

Feb 25 07:44 AM

[wassercom:]

U.S. banks are worth what the short-sellers say they are worth. Until the SEC and Obama figure this out, our markets are doomed.

Feb 25 08:10 AM

[Andy So:]

The idea is sound, but in practice it would be difficult to implement such a plan. I see two issues in your article. The first is the degree of leverage. In your sample bank you wrote:

"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"

We only know an approximate degree of how leveraged banks are.

There is already a problem of transparency in the products held by banks. There is a fear of what else might be hidden. You have to remember that many of these products were spawned by a structured products industry that simply didn't exist. These packaged derivatives have all kinds of clauses that can very quickly lead to cash calls and erosion of your NPV.

So the first problem is how to absolutely quantify the total value of these bad assets. Do you use the last mark-to-market value? Average historical prices? Also not every bank wants to come clean about these assets since some of the risks they took are borderline illegal. Full disclosure will involve government intervention and assuredly something bad is bound to come up. Just look at the very simple example of hidden expenditures tied to structuring fees for these products. Which bank wants to get their name out there? That's why this is taking so long to sort out.

So your theory states that "All troubled legacy assets are placed in a special portfolio of non-performing, non-earning assets that have to be charged off over time." In my comment above, it's never going to be "All" but rather "Some". That figure is never likely going to be fully trusted either.

The second problem with your idea is the backbone of your article.

"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%."

What if there were flat to negative ROA figures? Banks will never be what they were for the past twenty+ years. If you take away or minimize structured products, investment banking and broker/dealer operations, what you are left with is the brunt of earnings dependent on consumer and commercial lending. Remember twenty to thirty years ago we didn't have structured products or investment banking operations on the scale that we've had in recent decades. Some of these things (CDS, ABS etc.) didn't exist 10 years ago.

Assuming there is government intervention and forced lending to the public. Your comparison to Japan becomes increasing valid since we are throwing good money after bad. You are lending money to an American public that has a savings rate of 1% and no driving industry or growth in sight. There's no biotech boom like the 80's, .com boom like the 90's, or structured finance boom of our current decade around the corner. We are likely to face Japan like conditions of flat growth.

Feb 25 08:31 AM

[James Wilson:]

LOL TOXIC ASSETS !

Like the ones built with Chinesse Sheetrock with all the chemicals in it ?

The insulation on the electrical wiring breaking down, cooling coils springing leaks in new Air Conditioning System, chemical oders in air ducts, and people getting sick.

Since 2001 many homes built with Chinesse Sheetrock !

Feb 25 08:49 AM

[kelm:]

What I have come to understand from my other readings (I am no expert in this) is that the analysis above is correct if the bank held the original loans. I am told that the regulations work differently when the bank holds a collateralized security comprised of hundreds of loans and that may be linked to indexes of home price. Depending on the structure of the security, many have been rendered worthless by drops in the underlying indexes that they are tied to, not just by the degree of performance of the loans that they include.

Feb 25 09:09 AM

[henarl:]

Why would the common shareholders be willing to go thru many years with no dividends just to hopefully come out slightly ahead at the end when there are better investments available, Maybe the government might be willing to do this in order to "save the financial system" but I doubt that private investors would be on board.

Feb 25 10:45 AM

[Maklo:]

I agree with the basic premise of the author that this "adjusted negative common equity" (calculated by taking all expected losses all at once and applying it to the book equity) as reported by the press may not mean a bank is worthless because those losses will be realized over time in a relatively predictable manner. These can be offset by the future earnings of the bank. Or said differently, the bank will see higher provisions against its income in the coming years, until these assets are worked out of the system.

However, not all banks are "typical". Investors need to make a differentiation with the banks that operated this way, and the banks that did not.

-- Normal loan products originated with hold-to-maturity in mind will see heightened losses but these can be planned and reserved for. The toxic assets that sit on many banks balance sheets have and will cause the downfall of those that took them on.
-- Some banks had more aggressive funding sources and are less able to withstand strain on their portfolio. Others were more conservative and will be able to take losses and avoid a run on its deposits.
-- Some banks just happened to be in the areas that were the hardest hit.

There is always uncertainty because it is difficult to predict how the government is going to react. But I think there are a lot of things you can look for to separate the good ones from the bad ones.

Feb 25 10:47 AM

[hwood007:]

Hedge funds do not operate for our benefit, hedge funds make money going both ways. If they force the price down each day by selling large blocks then they make money each day. Using short selling bank ETFs each day, I assume that one could sell large numbers of shares and thus control market direction. If I knew market direction on a daily basis, I could make a pile of money.


On Feb 25 07:28 AM Pj568 wrote:

> If the hedge funds and billionaires of the world aren't buying this
> argument then I'm not either.

Feb 25 10:50 AM

[User 143167:]

The point is: you have to have another round of inflation to boost those asset prices above the value of the debt. While debt deflations kicking in now, it is downward spiral. To inflate or to die. The Fed and the Treasury Dept. are not even getting this, making TAFs or issuing trillions of t-bonds won't work. They have to double or triple the money in circulation to achieve it.

Feb 25 10:58 AM

[American in...:]

Well, I think the pessimists among us, which includes me, believes a lot of the bad losses are yet to be recognized. There were almost three trillion in subprime mortgages made, but total recognized losses are 1.1 trillion. Add on top that the adjustable rate mortgages that reset in 2009 and 2010 and the negative amortization loans and you have a perfect storm for the US banks.

Feb 25 04:10 PM

[Skeptical Ben:]

If anyone has Tim Geithner's email address, please forward this article to him.

Feb 25 05:10 PM

[James H. Wang:]

The problem isn't whether or not the banks "could eventually be profitable again."

This is why we have the policies we do on bank bankruptcies. Unlike other industries that run out of money and can do longer continue operations, banks can just dither.

It is NOT healthy for banks to be zombies in the economy, continuing to take money when they're underwater.

What seems to be not kept in mind for this article is that what you want is comparative advantage.

A "great" 5% ROE opportunity is not so great when everyone else is making 10%. Likewise, dead banks might still be able to perform some essential functions, but they sure as hell are not better than healthy ones.

Feb 25 09:51 PM

[pater_teneb...:]

my back-of-the envelope calculation shows that the losses they have admitted to so far (which are only a small fraction of the true losses, since a lot of stuff has been hidden under the level 3 accounting rug or remains off balance sheet) amount to more than twice the capital of the entire US banking system at the end of 2007. several large banks (such as C and BAC) are de facto insolvent, and would have been in chapter 11 proceedings for quite some time already if not for the treasury guaranteeing their losses and keeping these zombies on artificial life support with tax payer funded capital injections. shareholders continue to trun the risk to be diluted into oblivion as the losses continue to mount in the ongoing global depression. outright nationalization of the zombie banks down the road is practically assured. the collateral backing their huge exposure to mortgage debt continues to falter at accelerating rates of change. house prices are likely to fall anopther 20 to 40%, and the markit indexes show already that the entire sub-prime loan area is a COMPLETE write-off.
AAA rated debt pools trade for 35 cents on the dollar. leveraged corporate loans are likewise going down the drain, and so are increasingly credit card loans and other consumer loans. there's no mileage in pretending that things are not what they are. the system is kaput - which is why Bernanke announces today that he will print up another $1,1 TRILLION in new 'money'. good luck with that! ( oh , and the rubes all just got poorer again courtesy of the Fed diluting the value of their savings).

Mar 18 04:12 PM

[scooby_voo:]

Mad HFT,
You've obviously missed the whole point of this article: you don't need to nationalize!

Very insightful opinions from James Kostohryz. Thank you.


On Feb 25 07:44 AM Mad Hedge Fund Trader wrote:

> So nationalize the banks already! Get it over with! Call it whatever
> you want: partial nationalization, temporary nationalization, socialization,
> liverwurst, or rutabaga. Just get it over with! This tortuous slow
> drip of on again, off again, stop gap measures is going to cost us
> more than if we executed the politically incorrect “N” word. Of course,
> a government takeover is the worst nightmare for many Republicans.
> But now that former Fed governor Alan Greenspan and many fiscal conservatives
> are on board, this shouldn’t amount to political suicide for Obama.
> The FDIC’s Sheila Bair already does this on an almost daily basis
> with smaller regional banks, like Washington Mutual, but for some
> reason the top nine “too big to fail” banks are sacrosanct. Their
> deposits have been effectively nationalized with government guarantees
> since last fall. The market is already selling us that many of these
> once hallowed institutions are now worthless. This is what Citigroup
> (seekingalpha.com/symbol/c) at $1 and Bank of America (seekingalpha.com/symbo...)
> at $2 are telling us. Just wipe out the pitifully little the common
> shareholders have left, clean them up, and resell them in five years
> after the credit markets are restored. Every government that ever
> did this, like the UK in the eighties and Hong Kong in 1998, made
> a fortune. I was involved with both, and serious coin was made by
> the sellers and the buyers. Not to drive a stake through the hearts
> of these de facto “zombie” banks really would risk a Great Depression
> II and an “L” shaped lost decade. The markets would love decisive
> and surgical action like this and rocket.

May 30 04:21 AM