Rate Watch #639 Why Treasury Has to Help Recapitalize the Banking System

October 10, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

Banking Capital

Last week's newsletter made the point that in addition to the $700 billion liquidity bill banks needed capital and that capital might have to come from Treasury. Treasury Secretary Paulson announced Thursday that he intends to do just this.

The details as to whether this could or should be part of the $700 billion or need Congressional approval for another few hundred billion are not known at present and will not have to be addressed for at least a few months.

I want to explain why this is needed.

I am revisiting, to some extent, last week's topic: bank capital. Let me make it clear that I am making this seem a lot simpler than it is. There are really 2 tiers of capital and a rather complicated set of rules for calculating capital. A fuller understanding may be ascertained here.

The mortgage mess has created losses for banks. That created a liquidity problem because banks had assets (mortgage and pools of mortgages) which they could not sell. That is illiquidity - having assets but not cash. The much discussed $700 billion liquidity bill helps solve liquidity by having Treasury buy those illiquid assets but has done little so solve the base problem which is capital. The already taken losses and losses on any other sales made will cause the capital of banks to diminish and that needs to be replaced.

This is also where the seize up in credit market is rooted. This is not simply about concern about making loans than will not be repaid. It has to do with how banks treat capital and assets.

There are International rules for bank accounting called Basel I & Basel II created by the Bank for International Settlements. A complete explanation is likely beyond my ability so I will present a simple explanation as to how this works.

Total capital must be at least 8% of total risk-weighted assets.

So you are a bank which has taken losses and your capital and assets are depleted. Now you are in a bad spot because of that risk-weighted assets thing. Remember that is you are a bank loans are assets and deposits are liabilities. You may no longer be in compliance with the 8% rule. You have essentially two choices: 1) bring your assets and liabilities (deposits) down or 2) increase capital.

This is a typical chart of risk by loan type:

Government Bonds = zero risk

Mortgages = 50% risk

FHLMC/FNMA paper = 10% risk (was 20% last week)

Unsecured Consumer loans 100% risk

Unsecured loans to businesses 100% risk

Secured loans to businesses 50% risk.

I want to emphasize that these numbers are for example only.

In short, if you are running a bank and your capital/asset ratio is close to the edge you are ill-disposed to make loans to businesses because doing say may take you "over the edge" regarding capital/asset ratio. You either hold cash or you put it in Treasuries. The effect of this on GDP is very serious.

Having Treasury help recapitalize banks helps solve the problem. Treasury should play no active role in management. It will be an equity holder (or probably a holder of warrants which can be exchanged for equity). Treasury and all of its parts such as FDIC, OTS and OCC must continue to act as the regulator and pay no regard to the fact that it has some sort of "stake" in any entity.

If you have something to add to this discussion please post a comment on the blog.

---

 

Dick Lepre
RPM - SF