Thursday, February 19, 2009

Bank Solvency

Arguments are raging for or against nationalizing part of the banking system. John Hempton at Bronte Capital (H/T econbrowser) has a long but excellent post on the topic.
His main points are: we first need a proper diagnosis, second solvency can be defined various ways (regulatory solvency, positive networth under GAAP, positive liquidation value, etc) hence the solvency meant needs to be specified and clarified by the arguing parties and finally the right policies may involve some selective nationalization after due process.

Bank's assets sits on banks' balance sheets with a value after markdowns or provisions (90 cts/$) that is higher than both market value (50cts/$) and "held to maturity" basis (75cts/$). Banks are hence under-reserved.

For the United States he then explains:
"Reasonable numbers are that:
The system starting capital (ie pre-crisis) was 1.4 trillion dollars

Banks have raised about $500 billion along the way

Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS

That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and

That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion."

He then notes the various definitions of solvency and goes about testing the system against these:

Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators? (his answer: not likely)

Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)? (his answer: a bare pass)

Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital? (his answer: definite yes)

Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value. (his answer: no way)

Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis? (tough to answer as it depends on government policy, hence the importance of a consistent plan)

His conclusion overall "if you believe these numbers - and he does - then there is no need to nationalize the banking system in the US provided you can get the confidence back" and adds that it can't be done without a strong plan.

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