Archives for October 2011

Uwe E. Reinhardt is an economics professor at Princeton.

In a recent lead editorial, “Will Mrs. Merkel Wake Up This Time?” The New York Times lectured Chancellor Angela Merkel of Germany on her and her citizens’ duties toward nations that have lived for years beyond their means and now need financial aid, and toward European banks that through their lax and myopic loan policies aided and abetted the living beyond means.

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These banks, the editorial said, need “European-financed recapitalization,” which apparently Chancellor Merkel opposes, fearing that German taxpayers would have to contribute directly and heavily to a “bank recapitalization.”

I doubt that German citizens are quite as ignorant as the editorial suggests. One can at least sympathize with their reluctance to run what looks like a giant charity for improvident fellow Europeans. After all, I do not see the rest of America rushing to bail out California or sundry municipalities whose governments lived much beyond their means in years past. And did not President Ford tell his fellow Americans in New York City that he would not support a bailout of the city from its financial straits – an event that The Daily News captured with the memorable headline “Ford to City: Drop Dead”?

Leaving that issue aside, I wish the editorial writers had explicated precisely what form their recommended “recapitalization” of the banks would take. In the agreement hammered out in Brussels on Thursday morning, European leaders “invite” the banks to join in a “voluntary” write-down of 50 percent of the face value of Greek debt owed to them, forcing them to book a loss of the other 50 percent, making recapitalization even more urgent.

As part of their agreement, European governments therefore will force their banks to “raise new capital,” presumably from private investors. If the latter do not show up, then whose money would do the “European recapitalization,” and on what terms?

Citizens of any country have reasons to smell a rat when the country’s elite speaks to them of “recapitalizing” banks. In this regard, for example, the United States bailout of its troubled banks, and Ireland’s bailout of its banks, are hardly reassuring. The Occupy Wall Street movement appears to be fed in part by this suspicion.

Recapitalization is a generic term. It can be done in different ways, some more unseemly than others. My inquiry among a nonrandom sample of educated adults suggests that many people do not actually know exactly what recapitalization means. Can we blame them, given that financial experts speak mainly to one another in opaque jargon, and government shuns transparency in these matters?

To see clearly what is involved, it is helpful to start with a simple accounting identity that describes a business company’s financial position, at market values, at any moment in time as “t.” It is

A_t – L_t = E_t

Here A_t denotes the total, realistically realizable dollar value of assets to which the firm has legal title; L_t denotes the total dollar value of the company’s liabilities, if it paid off all of that debt at time t; and E_t denotes the company’s net worth or “owners’ equity” – all as of the point in time t.

A business is solvent as long as the realizable value of its assets exceeds its debt (A_t L_t). Even such a company, however, may find itself illiquid if it does not have on hand enough cash or liquid assets that can quickly be converted to cash to meet short-term debt coming due within the next month or year. An illiquid but solvent business can easily be helped through a short-term bridge loan secured by other assets or an open credit line at a commercial bank that can be tapped in such cases. For solvent banks the central bank is a short-term lender of last resort.

Prudent executives manage the balance sheet of their enterprises so that, at any time t, the realizable dollar value of the company’s assets are enough, under most foreseeable future contingencies, to repay all of the company’s debts and, it is to be hoped, leave some positive net worth for the owners. They and their companies’ owners get nervous when the leverage ratio, L_t/A_t, rises north of 50 percent, or when cash earnings do not cover interest due by some multiple.

Unfortunately, the leaders of our and Europe’s banking sector either never knew this or, if they did, forgot it when they lapsed into what the economists George Akerlof and Robert Shiller call “animal spirits” in their book of that title, employing a term first used by John Maynard Keynes. The banks’ directors, ostensibly elected to advise and supervise these managers, seem to have been caught up in the euphoria, as were the banks’ owners.

In that cerebral mode, American bankers calmly let the leverage ratios of the enterprises entrusted to them rise above 95 percent, in spite of the fact that the realizable value of a bank’s assets tend to be sensitive to economic conditions.

These assets consist mainly of the right to cash flows inscribed in financial contracts – Treasury and corporate bonds, short-term commercial loans to businesses. In the United States, the banks’ assets also included so-called “structured loans” secured by mortgages (increasingly subprime mortgages) and other derivative securities, including rights to cash flows implied by in bond-insurance contracts (credit default swaps).

European bankers, too, invested in such risky securities – often sold to them by their American colleagues. In addition, they loaded up on loans to governments living way beyond their means (Greece) or loans to real estate developers thriving in a real-estate bubble (Ireland, Spain).

I have described this sorry saga in a tongue-in-cheek after-dinner speech, “Why the French Are to Blame for the Banking Crisis.”

Toward 2007, the statement for A_t-L_t=E_t — also called the balance sheet – of a typical bank looked like the sketch in Figure 1 below. The growth of the banks’ assets side was wholly financed with debt from many sources, much of it very short term.

For a real example, see Figure 2, taken directly from a paper by Tobias Adrian and Hyun Song Shin. That graph shows the composition of the liabilities and equity side of the balance sheet of the British bank Northern Rock, whose failure heralded the banking crisis in Europe. (For similar charts of other European banks, see slides 33, 36, 39 and 42 from a recent presentation by Professor Shin, “Global Banking Glut and Its Consequences.”

By mid-2007, news had penetrated all the way to the banks’ executive suites that a good many of the structured securities on the asset side of their balance sheets were secured by dodgy mom-and- pop mortgages that had been extended to people unlikely ever to earn enough to be able to make their monthly mortgage payments on time. The market value of these securities began to shrink.

In Europe, on the other hand, it became clear that some governments – especially that of Greece — would not be able to pay debt service on the sovereign bonds they had sold as investments to European bankers.

Eventually, then, it dawned on everyone, even bankers, that, realistically, the balance sheets of the typical bank looked more like Figure 3. The banks were not just illiquid, which could easily have been fixed by central banks. Many of the banks were effectively insolvent, if all assets were realistically marked to realizable values.

We can think of the generic term “recapitalizing the banks” simply as “restoring the balance sheets of the banks to financial health.” It requires that somehow the banks’ debt-to-asset ratio L_t/A_t be reduced to more prudent levels, which is the same thing as saying that its complement, the equity-to-asset ratio, E_t/A_t, also known as the “capital ratio,” provide a robust enough cushion for possible future declines in asset values (L_t/A_t and E_t/A_t add up to 1, of course).

In calculating these balance-sheet ratios, not all assets are treated equally. Cash on hand, for example, does not have a risk of declining on dollar value (not to be confused with declining in real value through deflation). There is no need to hold an equity cushion for cash. Similarly, high-grade bonds like United States Treasuries or German government bonds (bunds) face only a low risk of declines in dollar values and, realistically, might require at most a very small equity cushion. On the other hand, dodgy sovereign bonds, derivatives and structured securities – e.g., mortgage-backed securities – may very well decline in value and require a higher equity cushion. In short, the sum of the dollar value of assets (A_t) used to calculate the balance-sheet ratios is risk adjusted.

As noted earlier, part of the agreement hammered out by European leaders is to force or coax continental banks to increase their equity cushions, i.e., their E_t/A_t ratios. Ideally those new equity funds — about $150 billion — are to come from private investors. But with two-thirds of the total needed by banks in Greece, Italy and Spain, private investors may not step up to the plate. Then what?

I know some approaches that would do the trick. My colleagues in Princeton’s Bendheim Center for Finance, who specialize in banking and financial markets, know even more of them. I will pursue these approaches in my next post, hoping that some readers will now describe how they would would like the task accomplished.

Article source: http://feeds.nytimes.com/click.phdo?i=f5d802d1b03f7026933ce8024c8c45bd