Why Doesn't Insolvency Equal Bankruptcy?

Includes: BAC, C, JPM, WFC, XLF
by: Balance Sheet Future
Another terrible day for financial stocks with the sector down more than 9%. Even the institutions once considered stronger by some; JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and US Bancorp (NYSE:USB) led the sector lower with declines of 14%, 16% and 18%, respectively. Citigroup's (NYSE:C) shares fell below the $1 mark before closing at $1.02. The market has voted and considers Citi (in terms of its common stock) insolvent. For some reason the government feels that with more taxpayer money and time the company's solvency problem will resolve itself. For the government, insolvency does not equal bankruptcy.

Bernanke Says U.S. May Need to Expand Bank Rescue

Federal Reserve Chairman Ben S. Bernanke said policy makers may need to expand aid to the banking system beyond the $700 billion already approved and take other aggressive measures even at the cost of soaring fiscal deficits.

“Without a reasonable degree of financial stability, a sustainable recovery will not occur,” the Fed chairman said today in testimony prepared for the Senate Budget Committee. “Although progress has been made on the financial front since last fall, more needs to be done.”

Financial stability occurs when assets trade from weak hands to strong hands. The government's solution to expand aid bailout funds to the financial system is delaying the recovery. The Fed and Treasury cannot guarantee or buy every asset in the US financial system. Losses must be realized and weak institutions let fail so the strong can survive and eventually grow.

The government instead focuses on the lack of lending by institutions to businesses and consumers. Businesses and consumers are not borrowing because they do not need to borrow more money. Businesses are cutting expenses and focusing on cash flow. Consumers, who overspent coming into the downturn, are tapped out and now focus on saving.

Promote Recapitalization

The massive asset price bubble that took place due to freely available credit and leverage has burst . We will not see the previous price levels for decades. Asset owners throughout the world must recapitalize based on new prices and leverage ratios. This recapitalization will result in additional losses in the banks, commercial real estate and insurance companies. Those institutions without the cash needed to recapitalize will sell assets to the institutions with stronger balance sheets and the system will be strong again.

How the Bush and Obama administrations missed this point is beyond me. The government should not give bailout money to institutions that need to plug holes on their balance sheets while they wait for asset prices to come back. The answer is not a suspension of mark to market accounting. Balance sheets must be reset with weak institutions left to market forces. To achieve financial stability the government needs to promote recapitalization.