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We've been looking at how
banks work:
February 10, 2008: How Banks Work 2:
Shitting Like an Elephant
February 3, 2008:
How Banks Work
This week we'll talk more
about what happens at banks when people don't pay their loans back.
We saw that banks are
highly leveraged, such that a relatively small loss, in comparison to total
assets or loans outstanding, can lead to a meaningful loss for the bank. Our
example, Wells Fargo, had a pretax return on assets of 2.64% ($12.7 billion
in pretax profit), plus it had provisioning of $2.204 billion, plus it had a
bit of leftover provisioning such that it ended 2006 with $3.764 billion of
provisions. Thus, its pre-provisioning profit was $14.9 billion, plus there
was $3.764 billion to start the year.
From this we see that
Wells Fargo has enough profits to cover the first $14.9 billion of losses in
2007, or about 3% of assets, assuming that base profitability stays about the
same. As long as losses didn't exceed this figure, the net profit, as reported
by accountants, would be disappointing to equity investors, but the bank
would basically be OK. The problem for banks arises when losses exceed
profits, or in other words there is a net loss.
(This also describes why
banks like to spread their losses over several years, if possible.)
The shareholders' equity,
remember, was $45.9 billion. So let's say Wells Fargo takes a loss of 5% of
assets. Not real big, right? Just 5%. Since there were $481 billion of
assets, that would mean $24.05 billion. The pre-provisioning profit of $14.9
billion would be completely consumed, leaving a net loss of $9.15 billion.
That loss would come out of the bank's capital base, leaving $45.9 billion -
$9.15 billion = $36.75 billion. That $9.15 billion loss leads to a 20% decline
in capital. Ouch!
Losing money is a bummer,
but it is especially perilous when an entity is highly leveraged, like a
bank. Remember, there were $481 billion of assets, $435 billion of
liabilities (mostly deposits), and $45.9 billion of capital. Now, there are
$481b-9.15b=$472 billion of assets, $435 billion of liabilities, and $37
billion of capital. The leverage of the bank has gone up from $481:$46 or
10.4x to $472:$37 or 13x. Or, to put it another way, the depositors are
looking at the bank, which had a $46b "cushion" to pay back the
depositors' $435 billion, and the "cushion" is now only $37
billion. If the capital base becomes too small, there could be a run on the
bank as depositors want to get paid back while the bank is still able to pay.
Thus, a bank that is
making losses and has a shrinking capital base is at risk. What happens if
there is another loss next year? Because of this, the Bank for International
Settlements requires that a bank that is operating internationally (like most
big banks) maintain an 8% capital ratio. If the bank falls below this ratio,
then no international settlements. No international settlements = no
international business. They compute the capital ratio a little differently
than the simple assets:capital ratio, but it is similar (it is actually risk
assets:capital, which leaves out some supposedly "no risk" assets
like government bonds held to maturity). Wells Fargo's
BIS capital ratio is on .pdf page 116.
We see here that the
computed regulatory capital ratio is 12.50%. This is above the 8.0% required
for capital adequacy.
An international bank
simply cannot allow its capital ratio to fall below 8%. It would have to
cease all international operations. A catastrophe. So, the risk is not really
that the capital goes to zero, the risk is that the capital goes to 8%. We
see here that Wells Fargo has $51.4 billion of capital (as it is calculated
for regulatory purposes), and the 8% limit is $32.9 billion.
Let's think about this.
In our example, we had a loss of $9.15 billion. So, if you take $51.4 billion
- $9.15 billion, you get $42.25 billion. Which is only a bit above the $32.9
billion at which you have real problems.
However, not only can a
bank not fall below 8%, it can't even get close to 8%! That's why, on the far
right side, there is a requirement "to be well capitalized under the FDICIA
prompt corrective action provision". In other words, if there is even a
risk of falling below 8%, you gotta start coming up with some
solutions quick! This level is set at a 10% capital ratio. Although it
applies only to the Wells Fargo Bank N.A. subsidiary (about 79% of the
consolidated bank by capital), we see that this level is hit at $33.7 billion
(from $40.6 billion), which is a decline of only $6.9 billion! So,
considering our $9.15 billion loss for the consolidated bank, we see that
this one single loss -- a mere 5% decline in asset values --
could put Wells Fargo in a rather perilous financial position.
(Proportionally speaking, 79% of $9.15 billion is $7.22 billion.) Especially
with today's capital requirements, there is only a little teeny cushion
between normal operations (12.50% capital ratio) and an emergency (10%
capital ratio).
That explains why so many
banks have been running around for capital recently.
The BIS capital ratios
were imposed in 1988, and are widely thought to be an attempt by
U.S. banks to suppress the international expansion of Japanese banks.
Japanese banks were doing very well in the late 1980s, while the US (and some
European) banks were buckling under huge losses in Latin America. The
Japanese banks tended to have rather low capital ratios. Why not? There were
no capital requirements in those days. The BIS et. al. terrorized the Japanese
banks for years in the 1990s, and indeed one major Japanese bank (today's
Resona) decided to withdraw from international activities.
* * *
At this point, I'd like
to address a little different subject, which is "bad debts" at
banks. Once a loan has become an issue -- for example, because some payments
were missed -- it becomes a "bad debt." We see from the example of
a simple home mortgage that it can take years to fully work out a bad debt,
going from delinquency to default to foreclosure to the sale of the
collateral asset. Or, maybe the loan is restructured. "OK, I can see you
really can't pay the original loan, so let's make a deal. I'll give you a
special, fixed-rate loan at a low interest rate. We can agree that you can't
pay $4,000 a month, but you can pay $2,000 a month, so let's make that the
loan payment for now until the balance is paid off." Banks can do this.
They can work out any sort of arrangement they like. And, a bank may conclude
that this is a better course of action than going through the legal
foreclosure process. In other words, it gets more of its money back this way.
That's good, right? (In fact, banks are doing just this sort of thing right
now, with some encouragement from the US Treasury.)
However, in both cases
the loan is obviously an impaired loan, or a "bad loan." In the
first case, the bank may have the loan for a couple years, until the
foreclosure process is worked out. In the second case, the bank may have the
loan for the next 30 years. And then there is the example from the Japanese
case, of loans that are paid in full 100%, but are at some elevated risk of
default. This is true especially of corporate loans. Look, for example, at
the $240 billion or so of private-equity buyout loans on banks' books today.
I hear these have been recently priced at $0.85 or so. Which is well below
$1.00. Definitely impaired. However, as far as I know they have all been paid
in full. These sorts of loans are also often categorized as "bad
loans" as well.
Over time, there is some
reckoning of "bad loans" on bank's books, and it comes to some
colossal number like $300 billion. This is typically the face value of the
loans. It is NOT a measure of losses. These numbers are published in the
newspapers, and everyone poops their pants about the "bad loan
problem". What are we going to do about it?????
The first question is:
why do we have to do anything about it at all? The banks have already
provisioned against the problem loans. These provisions may prove to be inadequate,
but on the other hand they may be more than adequate. The bank may find that
it set aside $0.30 in provisions for a problem loan, but they eventually get
back $0.80 for the loan, so there is a $0.10 latent profit! There is nothing
wrong with letting banks work out their problem loans themselves. After all,
they are experts at this, right? This is their business. Indeed, there are banks
that own nothing but problem loans. They acquire problem loans
for $0.70 and work them out for $0.80. (These are generally known as
"asset management companies," but they do the same thing as regular
banks' problem loan departments.) The fact that these banks own 100%
"problem loans" is not a problem. They can be quite profitable.
Nevertheless, in the
newspapers, on TV, among politicans and public policy types, there is endless
talk about the "problem loan" problem. These "$300
billion" of problem loans are imagined to be some kind of financial time
bomb waiting to go off. We better do something before the "problem loan"
time bomb goes off!!! Aaaaack!!!! After all, the "problem loans"
must be the problem or they wouldn't be called "problem loans,"
right?
Wrong.
There is, at this point,
typically a great failure to identify the problem. The problem is usually not
"problem loans." That was the problem. That time bomb already
went off. Banks have already paid for that problem via
provisions. The real problem is usually ... loans that are not yet classified
as a "problem." These might include, for example, super-crappy loans
which will become a problem in the future, like last year's CDOs and subprime
lending. However, once "problem loans" become a headline issue,
nobody is making these kinds of "future problem loans" anymore. The
other problem is more-or-less OK loans, which would become a problem in
the future if the economy continues to deteriorate. To solve this
problem, you have to do what you can to foster a strong economy, which must
include:
Low Taxes
Stable Money
Also, this helps the
"problem loans" already existing. The "problem" of
problem loans is not really the face value, but the recovery. In an improving
economy, a bank might eventually get back $0.90 for its "problem
loan," while in a deteriorating economy it might get back $0.50 or even
$0.20.
It is often imagined that
this "$300 billion of bad debts" means that someone is going to
have to pay $300 billion to make the bad debts disappear. This is nonsense.
The real losses might be more like $300 billion * $0.20, or $60 billion, and
the banks have already paid this via provisions. Sometimes this myth assumes
such power that even bank stock analysts make this
mistake! "Ohhhh, Bank A is going to dispose of $10 billion in bad debt.
Bank A's book value will therefore decline by $10 billion!!!" Actually,
Bank A might have provisioned the debt at $0.30. Then, considering that the
economy is now recovering nicely, maybe it sells the debt for $0.80. So, it
then deprovisions by $0.10. On $10 billion of debt, that is a $1 billion profit!
Second, taking bad debts
"off banks' books" (often through the sale of a loan) doesn't make
the bad debt disappear. It just moves it to another bank's books, or to some
other owner. Whoever owns the loan, they will manage it in whatever way they
feel will bring the most overall profit or recovery. This might take many
years, even decades. It might make perfect sense to hold onto the loan for a
long time, until the economy and asset values recover. Consider, for example,
Wilbur Ross, who bought the bank debt on bankrupt auto parts maker Collins
and Aikman. He probably bought it for about $0.90 or so. Marty Whitman was a
big holder of the subordinated debt, which originally traded for about $0.60.
It may well turn out that Wilbur Ross will end up owning all of Collins and
Aikman, and it may well turn out that this investment will be worth not only
$0.90, but many multiples of that as the auto industry recovers. This process
may take many years.
It is also imagined that
this "$300 billion of bad debts" is some horrible drag on the
economy. Now, it is probably true that the "$300 billion of bad
debts" represents the effects of some horrible drag on the
economy, like tax hikes or monetary instability. Or, it might just be an
artifact of total financial silliness previously. It is often the case that
more stringent lending standards (which often follow the emergence of bad
debts) will result in some economic slowdown. However, "bad debts"
don't really cause a drag on the economy themselves. I mentioned that the US
banks had enormous bad debts from lending in Latin America in the 1980s.
Also, there were the S&Ls, which were very much loaded with bad debts in
the 1980s. Neither caused a drag on the economy, which did very well during
that time.
I mentioned that some
"bad debts" might be restructured loans. Is paying $2000 a month
rather than $4000 a month a "drag on the economy?" And how about
those loans that are paid in full but are considered to be
at some risk? How is that a drag on the economy? Remember, these "loans
at risk" can constitute the majority of "problem
loans."
We will talk more about
how banks and the broader economy interact in coming weeks.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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