Yes, that’s 1 trillion, on top of, or taken from, the $700bn already contained in the Tarp.
FBR Capital Markets has written a 15-page note arguing that the US financial system needs at least that in tangible common equity to restore confidence and improve liquidity in the fractured credit markets. This would be different from the Tarp, proceeds of which come to banks mostly in the form of preferred stock. Why the need for tangible common equity specifically? FBR explains:
The straight-forward “tangible common equity to tangible asset” ratio is the only true measure of leverage and the only capital ratio that should matter to common shareholders. Tangible common equity is in the first loss position in the capital structure (allowance for loan losses aside). Any losses reduce tangible book value, which is a primary driver of a company’s stock price performance. If the reduction to tangible book value is significant and the company’s stock price falls, the company loses financial flexibility, which increases the possibility of failure, regardless of preferred equity levels.
Put simply, when losses come or common dividends are paid out — they come from tangible common equity. (In jargon, it’s a measure of net worth relative to assets, or common shareholders’ equity minus intangibles and goodwill).
Tarp, as FBR notes, has boosted Tier 1 Capital (the core measure of a bank’s strength from a regulator’s point of view) but it has done nothing to boost tangible common equity. In fact it’s made it worse.
One goal of the Treasury’s plan is to encourage banks to increase lending in order to prevent excessive economic contraction, but TARP capital will not increase lending by banks because banks will not view TARP capital as something that can be levered. The greater the leverage to common equity, which ultimately determines stock price, the riskier the institution. Exhibit 8 illustrates the pressure on tangible equity if a banking institution decided to fully leverage TARP capital. As shown, a bank choosing to fully leverage up TARP capital will shave roughly a percentage point from its tangible common equity ratio, putting further pressure on the first lost position, which will result in pressure on the bank’s stock price. If the government wants to increase lending, then the Treasury needs to make the TARP capital real tangible capital and get rid of the notion that the government can fix the U.S. financial system through inferior preferred stock insurance.
So we need an injection of $1-1.2 trillion of tangible common equity, according to FBR’s calculations, below, and based on eight of the US’s biggest financial institutions (Bank of America, JP Morgan, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, AIG and GE Financial Services). That would result in tangible equity of 8.5 per cent of assets, or 12x leverage. The current ratio, FBR says, is tangible equity at 3.4 per cent of assets and a whopping 29x leverage.
But where exactly is this money to come from?
As realists, we understand that there is not $1 trillion sitting on the sidelines waiting to recapitalize the financial industry. The most practical solution is for the U.S. government to inject the capital into the financial system as quickly as possible. The government needs to take the initial steps to begin the process, and private capital and earnings can finish the job. It will likely take three to five years for the financial system to fix itself completely, with adequate capital and appropriately priced interest rate and credit risk.
Three to four years recovery at a cost of 1 trillion? That’s a bargain $250,000,000,000 per year, we guess.
Related link:
Tier 1 tyranny - FT
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