Federally insured banks are permitted to lend based on a multiple of how much real capital they have – from share value and shareholder investments, investor loans to the bank (bonds, preferred stock which is a hybrid between debt and equity, etc.), quality deposits and assets (like money lent to solid borrowers, investments, derivatives based on the foregoing, etc.) and, theoretically, the real value of remaining “not-so-wonderful” assets. Different assets and capital are measured/weighted differently, depending on which “metrics” you use, but some combination of the above list basically determines how solvent a bank is and whether it can really lend money and continue as a business.
The battle has been primarily over how to treat the huge pool of what most consider the “not-so-wonderful” asset on many banks’ books – derivatives based on subprime loans or commercial real estate that is crashing in value, for example. The banks say that they should not be forced to value such “legacy” (most call them “toxic”) assets in a market where it seems that no one wants to buy anything, but the government is trying to force some truth into the marketplace.
The “stress tests” applied by the feds to the first 19 banks (the largest) focused not only on the valuation of the above assets but on how well the banks are likely to fare going forward as the gross domestic product continues to shrink, housing values remain destabilized, credit card defaults rise, commercial real estate continues to fall and unemployment continues to rise. Banks will not be allowed to continue to operate without sufficient good capital on their books to continue as viable banks, but since these initial banks represent the majority of bank lending in the United States (an estimated 70%), the feds have been equally clear that the survival of all of these institutions is a clear governmental policy.
Adding additional capital would normally be accomplished in the private marketplace by taking deposits, selling shares or selling bonds and other debt instruments. Pricing and terms are always an issue, and the presence of “legacy assets” often creates a disparity between what the bank thinks it’s worth and how the marketplace actually views its value. The recent federal plan to guarantee the vast majority of loans used to buy “legacy” assets based on prices for these assets set in an “auction” format wasn’t found to be very appealing to many of the top banks; the auction price would objectively prove that the legacy assets could not be sold at anywhere near the price that such assets are carried on their books (“they will when the markets improve” cry the banks unconvincingly).
The alternative is federal investment – under the Trouble Assets Relief Program (but TARP has a little over $100 billion left) or some other de facto infusion of federal capital into the system (e.g., the feds take an additional equity or a convertible debt position in the company, perhaps even in exchange for some legacy assets). The government has made it clear that this alternative may be required for those banks unable to pass the stress test without such support. Critics cry “nationalization,” but banks have always been the subject of stringent federal regulation (obviously, not enough!), and both Republican and Democratic administrations have forced federal capital onto the balance sheets of banks they think need such infusion. Taxpayers take risk but presumably share upside in better times.
Funny how so many banks that were desperate late last year and early this year are now declaring often significant profits. They’ve had access to near zero percent Federal Reserve capital to lend, but for the most part, the credit markets are even more frozen than they were when TARP was created. The declaration of profitability, at least for some of these institutions, seems far-fetched given the economic reality around us. They are looking at ways to pay back the feds so that they can, pig-like, return to the trough of executive over-compensation. Thus, it seems that they are finding ways to declare profits either because they really want to get rid of the salary/perk restrictions that come with government investment (and hence “prove” they can repay their TARP money) or want the world to think they are just fine (which impacts stock price).
While some banks are truly capable of paying back the money through private stock/debt offerings (Bank of New York Mellon raised $1.5 billion in such private markets, and Goldman Sachs appears ready to repay the feds as well), there is a list of banks that clearly cannot continue under stress test guideline without raising capital somewhere, and the balance sheets of quite a few of these banks are not really susceptible to generating enough investment from the private sector. Further, the government is not letting banks who have TARP money, and the restrictions that go with such federal money, repay the feds unless it is really clear that they can without impairing the viability under that set of guidelines. Some banks will in fact be forced to take new federal money to be allowed to continue to exist.
For us mere mortals at the bottom of the lending food chain, this is only the beginning of an ultra-slow process that will seep loans to the biggest and most solid borrowers – probably the biggest corporations – sometime early this summer. The rest of the credit market will repair at a snail’s pace as residential and commercial real estate stabilize and the unemployment numbers (the last to reflect hitting “bottom”) stop rising.
American business is a long way away from the confidence necessary to begin “growing” and “manufacturing” at a scale that would seriously reverse the current economic meltdown, but you have to start somewhere. It’s too bad that all this is starting at the top of the economy, leaving those in the shrinking middle and swelling bottom wondering why they have to pay for it. It’s hard to justify by saying, “that’s how the American capital markets work,” but in reality, that’s how the American capital markets work.
I’m Peter Dekom, and I approve this message.
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