Intro to TARP: Banks have two problems

The big banks (and some large non-banks like AIG, Fannie Mae, and Freddie Mac) have two problems, not one:

  1. They don’t have enough capital.
  2. They have on their balance sheet downside risk that is creating uncertainty about how much the firm is worth and is scaring away investors.

I will use a simple example constructed by former Council of Economic Advisers member Donald Marron.

Imagine that you run Large Bank. You collect deposits and you borrow on the debt market, and you use both sources of funds to make loans. Here is what your balance sheet looked like three years ago when you made these loans.

Assets Liabilities and Equity
Loans 1,000 Deposits 600
Debt 300
Equity 100
Preferred 0
Total 1,000 . . . . . . . Total 1,000

To keep it simple, let us assume that all 1,000 of loans were for home mortgages.

We measure the health of your bank in three ways:

  1. You have 100 of capital — the equity from the shareholders who invested in your bank.
  2. Your leverage ratio is 10 to 1 — you are supporting 1,000 of loans with 100 of capital.
  3. Can you roll over your debt and issue new debt when you need/want to? Do creditors have enough confidence in your bank that they are willing to loan you money?

A healthy bank is one with a lot of capital, with a leverage ratio that is not too high, and that can borrow when it needs to at reasonable interest rates. Of course, the higher the leverage ratio, the more profit you make on each dollar of capital.

Now let us assume that you screwed up three years ago. 200 of the 1,000 of loans you made were “no documentation” loans.Some (many? most?) of those 200 of loans are going to default, or at least be late with some of their payments. They are clearly not worth the 200 of face value. First let’s separate out the good and bad loans.

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 200 Debt 300
Equity 100
Preferred 0
Total 1,000 . . . . . . . Total 1,000

Now in present day, you estimate that 80% of those bad loans will default, with a 50% recovery rate, so they are worth only 120 (60% of 200). You write down the value of the bad loans to 120, losing 80 on the assets side. This means the value of your equity has dropped from 100 to 20.

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 120 Debt 300
Equity 20
Preferred 0
Total 920 . . . . . . . Total 920

Writing down these loans has wiped out 80% of your capital. Problem #1 is that you only have 20 left of capital. This also leaves you with a very high leverage ratio of 46:1 (920 of loans divided by 20 of capital). Large Bank is clearly not in good shape.Creditors will start charging you higher interest rates for new debt (or to roll over existing debt), and any uninsured depositors may get nervous and pull their money out.

If you can raise more capital by selling more equity, you can give yourself more protection against insolvency and reduce your leverage ratio. Your existing shareholders will be upset, because before they owned 100% of the profits, and after raising more capital they will own a much smaller share. If you raise new private capital, you will be “diluting” your existing shareholders. This is one possible explanation why some banks have not raised capital so far.

You have a second problem, however. As you try to raise more capital and sell equity to new private investors, they are questioning the value of those bad loans. Sure they might be worth 120, but they might be worth only 100, or 80, or even 60.A private investor thinking of putting 60 of his own capital into Large Bank could see that get wiped out if the bad loans are only worth 40 rather than 120. The downside risk associated with those bad loans may deter private investors from putting in their own capital.

So Large Bank has two problems. You don’t have enough capital, either to satisfy your regulator or to reassure yourself that you won’t soon go insolvent if things get even worse.

You also have downside risk which makes the health of your bank even shakier than the above balance sheet suggests, and which scares away private investors.

Tomorrow we will look at three different ways to address your problems, aka TARP I, II, and III.

By | 2017-11-04T17:40:20+00:00 Tuesday, 28 April 2009|