More Blather From the Times

Gretchen Morgensen's Column, The Worst Misstep: Geithner Added to the Doubt, is fundamentally dumb. I have the feeling that she doesn't know if loans are assets or liabilities, and ditto with deposits. However, the half hearted attempt to discuss the arithmetic of bank financial strength isn't the point.

Rather the point is that we need to quit lying and get at a higher truth.  To start with the conclusion: 

But it will also require transparent, rigorous analysis; candor with the public and investors; and a recognition that lots of debt heaped upon a pile of dubious assets has created a financial nightmare — it’s no more complicated than that.

If you can parse the sentence to determine what is debt and what is a dubious asset, and assume that debt refers to the bank's leveraged capital structure, which includes junior debt (preferred shares) and capital, and dubious assets are the loans and securities that earn interest, then maybe it makes sense.

However, the way to get to this transparent, rigorous analysis is the following:

So here’s a strong first step: the Treasury Department needs to hire out-of-work bankers to conduct what investors call a “burndown analysis” of banks’ financial positions. This is what private investors do as they go foraging for gems hidden amid the wreckage in the banking system.

A burndown analysis, because it is a worst-case exercise, typically requires very pessimistic estimates for loan performance early on and higher-than-average loss estimates for loans in later years.

And then:

A bank’s prospects also derive primarily from its deposits, not its loan book, in such an assessment. To reiterate: Any examination of a troubled financial institution needs to determine what its assets are truly worth, how much can it earn and how much capital it needs to operate at a profit.

But she had already asserted that:

it involves knowing where the economy will be in six months or a year

So, this rigorous analysis involves knowledge of the future, which is inherently unknowable. It also requires knowing short and long term interest rates. I suppose that it is reasonable to assume that the Fed can keep short term rates -- the borrowing costs of banks, low for a while. But what happens if we get some inflation and interest rates on short term rates climb? The banks earn zero or less, since they lend "long" and are funding with deposits.

Meanwhile, the "burndown analysis" tells us that the assets are worth enough less to make the banks insolvent.  Banks tend to have capital ratios of about 10% of assets, and need to maintain these levels.  Write down the assets by 10% and the capital is gone.  

Here is a simple model:  Take the peak unemployment rate - 8% times 2 times the bank's assets.  If peak unemployment is 15%, then take 15%-8% = 7% ------- multiply by 2 to get 14%.  Then multiply that by the bank's assets to get losses.  

They are all insolvent under these absurdly simplistic assumptions.  This isn't much different then Mr. Roubini's estimates published yesterday in the Times.  14% of the $14 trillion of bank assets gives you about $2 trillion vs. Roubini's $1.7 to $1.8 Trillion.  

There is no hidden "truth" that needs to be disclosed.  The only thing the markets want to know is how badly the share holders are going to be punished.  The markets learned that any new capital was going to come with a high cost, so that sliced the already modest value of financial shares.  

Constant repetition of the idea that there is a hidden, true value for assets is idiotic, simplistic, and maybe even dangerous.  People may want to know the future of the economy, but it isn't honest and transparent to pretend that you know.