Bank Capital Problems

Lost amid the ruckus over Arlen Specter’s switch to the Democrats is the continuing negotiation between the administration and those big banks deemed to have failed the recent stress tests. That’s inflammatory language on my part: apparently no one officially ‘failed’, but some seem to have passed ‘less well’.

In particular Citibank and Bank of America, who now lead the pack as banking weaklings are locked in furious talks about what their capital levels should be. A quick look at B. of A. suggests that they are about $70 billion short at the moment, while Citi is so messed up it’s very difficult to gauge how much they need. Suffice to say it’s a lot.

Both banks are pushing back very hard and attempting to build the case that they can re-establish satisfactory capital ratios through ‘normal’ means.

In Citi’s case this implies convincing holders of some $52 billion of preferred stock to convert their holdings into common equity. I would guess this will be difficult to do since the preferred stock produces a reliable dividend and Citi’s common stock has been anything other than a good investment recently. Still, the bank may stand a chance to go part of the way: the government is one of its biggest preferred stock investors and may cooperate. Meanwhile Citi’s proposed sale of some of its Japanese business could produce another $5 plus billion.

Even after tossing all these huge numbers around it looks as if Citi will be forced to downsize itself in order to bring its ratios in line. So we should expect to see a sale of some of its larger businesses here in the US: some of which it argued were untouchable even as recently as January.

B. of A. is also floundering. Its entire strategy of aggressive expansion over the past few years has left it not only capital poor, but also chock full of rotten assets. Earlier this week it announced that it was retiring the much tarnished Countrywide brand, for which it had paid over $4 billion last year. Whatever is left of the old Countrywide business is now wrapped up safely within B. of A.’s own mortgage business, which now owns one in ten of all home loans in the country.

There is no question both banks are in parlous shape. Their capital ratios are extremely thin now and would not be able to withstand any fresh uptick in loan losses. The stress tests that exposed their problems included what I regard as a moderate to tough scenario based upon rising unemployment, which would cause credit card losses to rise sharply. Since both Citi and B. of A. are huge credit card lenders they would be hit quite hard in such a scenario.

I imagine that the talks between the banks and the government will be tense. Neither bank wants the markets to look askance at their odds of survival. At the same time it is reasonable to expect potential investors to be leery: neither bank looks like a safe place to invest at the moment.

Meanwhile, the situation in Europe is even worse. The IMF now expects European banks to lose an additional $750 billion over the next two years with British banks losing $200 billion over the same period. Obviously losses of this enormity will have to be replaced with fresh capital even for the banks to get back to today’s capital ratios. This is without the expected increase in capital cushion that most country’s regulators are now pressing for, and it leaves little or no room for fresh lending.

So the banking crisis goes on relentlessly. The damage to worldwide wealth is staggering. By the end of the cycle, which seems to be at least two years away, we will have lost between $2 and $3 trillion from our collective balance sheets. those losses and any additional voluntary de-leveraging [a.k.a. reduction in debt] by businesses and consumers throughout the world economy will severely dampen worldwide growth prospects for years to come.

So permit me to repeat: the number one issue facing governments the world over is how to get the banking system back on its feet. Unfortunately whatever they do it will cost taxpayers a whole bunch of money.

That means the really big lesson we should all have learned is to rein those banks in. They cost a lot to fix.