The View From 1776
Tuesday, October 21, 2008
Bank Balance Sheet Primer
Understanding basic aspects of the $700 billion Wall Street bailout requires some familiarity with balance sheets and bank equity capitalization effects.
To most voters, the $700 billion bailout seems like an unnecessary giveaway to Wall Street, the guys who created the mess. Without taking a position on that aspect, let’s try to get a simplified picture of what’s being done with the $700 billion inflationary expansion of the money supply.
Two of the basic initiatives by the Treasury and the Federal Reserve are buying bad loans (at presumably fire-sale prices) and purchasing preferred stock in banks. These are closely linked actions.
The problem, if not the prescribed corrective action, is much the same as what befell the S & Ls in the 1980s. Banks’ asset values are shrinking, because of bad loans (the subprime meltdown), which simultaneously reduces their equity capital. Without a sufficiently high ratio of equity capital to total assets, the banks become insolvent and must be shut down by the FDIC.
Picture the process as a balancing act, a set of old fashioned scales with two weighing pans. One pan contains the banks’ assets. The other, their liabilities (such as customers’ deposits) and their equity capital.
To maintain a balance between the two pans, equal amounts must be removed or added to each.
So, when asset values drop, the balance is maintained by a reduction of equity capital (net worth) in the other pan. The banks’ liabilities, unfortunately, don’t change.
In the credit squeeze resulting from the collapse of the subprime mortgage market and other derivative securities, the market value of those assets on banks’ balance sheets fell sharply. Accounting regulations compelled the banks to mark to market, that is, to reduce the asset values carried on their balance sheets. Doing so necessitated an offsetting decrease of the equity capital (net worth) on the other side of their balance sheets, driving them toward insolvency.
That’s the origin of the multi-billion losses reported by banks.
Initially banks sought new equity capital from other institutions and from overseas investors. As market conditions continued to deteriorate, those investors pulled out of the market, closing that avenue to increasing sound assets (cash from outside investors) and ipso facto raising the equity capital amounts on the other side of the balance sheets.
Treasury and Fed’s first move was to create an auction market in which banks could sell bad loans to the government, in this case at small percentages of the asset amounts originally booked. The auction market was needed, because nearly all of the banks, here and abroad, were simultaneously in bad shape and unable to buy bad loans, at any price, from other banks. Investors with sufficient cash (reputedly hedge funds and other non-bank financial institutions), uncertain about how much worse the situation might become, decided to sit on the sidelines.
But, remember the need to balance both sides of the scale. When a bank sells its bad loans at any price less than the originally booked amount, it must adjust the balance by reducing its stated equity capital. This leaves us still pushing banks toward insolvency, as their equity capital starts to fall below statutory minimums.
Hence the government’s latest move: buying new preferred shares to be issued by the banks. This will shore up the banks’ equity capital bases by putting a good asset - cash - on the asset side of the balance sheets and adjusting the equity capital upwards on the other side of the balance sheet.
If the plan works satisfactorily, the credit freeze/squeeze will ease, and banks will begin again to lend to each other, to other financial institutions, and to businesses. If so, the current recession will be lessened.
On the negative side, all of the $700 billion to be employed in the program is literally phony money, created out of thin air by bookkeeping entries on the Fed’s books. That imparts a huge inflationary bias to the economy, which may partially be offset by the shrunken value of bad loans.
The bailout, however necessary, is still knee-jerk, liberal-progressive, Keynesian economics, which dictates Federal spending as the remedy for every economic ill.