If you want a metaphor, let’s call these assets vampires. They are draining the life out of the banks that have too many of them in relation to their capital. The euphemists can complain all they want about the unrealistic, unfair accounting, but for far too many of these bad investments, the economics WILL (I love not being a regulated analyst anymore so I can use promissory language) catch up with the accounting, the liabilities will suck more cash than the assets can throw off and the hapless holder will have to be closed.
It follows that asking the government to own them is to risk bankrupting the government.
More sharp analysis from Linda Lowell on PPIP. She shows why the Geithner plan may help with price discovery, but is not anything like a silver bullet for banks capitalization.
Selling distressed securities permanently consumes capital
So let’s talk about why PPIP won’t induce banks to sell their troubled assets. They will realize a loss that will reduce earnings and capital. Right now, according to FDIC call report data for q4 2009, in aggregate, US commercial banks categorize a bit more than 90 percent of their debt securities as available-for-sale (AFS). In the FDIC’s standard large bank cut of the data (511 institutions with assets greater than $1 billion), 93% of their debt securities are classified as AFS.
Quick accounting refresher: AFS securities are measured at fair value. A change in fair value does not affect earnings, but gains or losses over amortized cost are accumulated in a component of equity called Other Comprehensive Income (OCI). This running cumulative total is also referred to as unrealized gains or losses. Unrealized losses reduce equity capital and are taken into account by equity investors, BUT they are not included in calculations of regulatory capital.
It doesn’t matter if PPIP pushed up the bid for distressed assets. Schmidt’s illustration should convince you they will not push the bid back up to amortized cost. So, if the bank sells a security that currently has an unrealized loss, the loss is realized – it reduces earnings, shareholder’s equity and regulatory capital. Good old-fashioned prudence should be the first capital constraint on lending, but regulatory capital would be the second. If the goal is to get banks to lend more – and at more liberal terms than the current downturn implies – the last thing policy makers should do is encourage banks to destroy capital.
See here for a surefire solution to bank capital.
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