How Banks Work 3: More Elephant Poop
February 17, 2008
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.
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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?
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:
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.