Painful but necessary: how banks rebuild capital

There are four ways banks can rebuild capital following a crisis. But, whether it's just the shareholders who lose out or the economy as a whole, someone's going to suffer.

Banks and other financial companies operate with lots of leverage. This is good for bank shareholders when times are good, but very bad when loan losses start impairing assets.

If a bank were to invest its capital 6% in mortgages on an "unlevered" basis, its return on equity would be 6% the same return you'd get if you invested your equity, or savings, in a Treasury bond yielding 6%.

But banks invest shareholder capital in a way that multiplies returns and risk by 10- or 15-fold. A bank can multiply the size of its balance sheet when it borrows money from depositors. Banks shareholders use depositors' money to buy new assets, which generate the cash that pays depositors back a fixed return.

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Then, these shareholders keep any returns over and above the returns paid to depositors. Shareholders face more risk, but can enjoy big returns if management invests bank assets in a wise manner.

Remember this formula when you hear the endless stream of news about write-offs, SIVs, CDOs and asset-backed commercial paper. To understand what's going on, just plug these exotic instruments into the asset and liability accounts of banks like Citigroup.

Among bank assets, mortgage-backed securities now play as big a role as plain vanilla mortgages. Among bank liabilities, commercial paper and derivatives have grown in importance relative to old-fashioned deposits. This creates the potential for bank equity, or capital, to vanish when assets turn out to be unexpectedly risky, or even worthless.

An article in The Economist explains:

"All this turmoil is focusing attention on banks' capital ratios, the amount of money they set aside as a percentage of assets to cover unexpected losses. This cushion is being squashed in a number of ways. First, net losses eat directly into capital. Second, since capital ratios are typically calculated on the basis of how risky a bank's balance sheet is, the ratings downgrades add to the amount of rainy-day money banks need to set aside. Third, assets are growing as banks take on the financing of more off-balance sheet vehicles, which again adds to the capital they need."

Banks and other financial companies that find themselves on the wrong side of this financial crisis must rebuild capital. There are a number of ways they can accomplish this, but all are unpleasant.

1. Issue new shares

This hurts because it dilutes existing shareholders when stocks prices are already depressed. It's especially embarrassing for companies like MGIC Investment Corp. and MBIA, Inc. These insurers were buying back gobs of stock at much higher prices. Now they'll probably have to sell this stock back to the market at low prices, resulting in hundreds of millions in economic losses for shareholders.

This is a painful move for these companies, but they must cover their liabilities, which include paying for the impending wave of insured losses in structured credit and mortgages.

2. Cut dividends

When a bank pays a dividend, this transaction reduces both assets and equity, resulting in a slightly diminished ratio of equity to assets. When this ratio falls below a certain level, a bank can count on receiving more regulatory scrutiny. Cutting the dividend may be painful for shareholders, but it's often the least painful way to rebuild capital.

3. Sell 'noncore' assets

Financial conglomerates like Merrill Lynch have the option of selling their interests in a wide range of businesses to raise cash. Merrill owns almost half of publicly traded money manager BlackRock. Merrill could sell this interest in order to rebuild capital in its division that's getting pounded by CDO losses.

4. Slow down lending

Finally, this hypothetical financial company could slow the growth of its loan portfolio. This would allow the cash that normally flows in from older loans to remain on the balance sheet, instead of funding new loans.

On a company level, this may be a good thing, but on an economy-wide level, it's not. When banks slow down lending, it makes credit harder to get even for those with good credit.

Citing Goldman Sachs estimates, The Economist article notes, "If banks suffer a $200 billion loss on subprime mortgages but want to keep their capital ratios at an average level of 10%, that would stifle lending by a whopping $2 trillion."

Government-sponsored entity Freddie Mac spooked the markets last week when it announced it must raise capital amid rising losses. This will involve some combination of the unpleasant choices listed above.

It's not good news for housing market finance because it means Freddie will be less aggressive in buying mortgages from banks at a time when Congress has been pushing to allow Freddie to become more aggressive.

Washington, D.C., politicians are in the process of concocting some type of tax- and inflation-financed housing bailout, but it could take longer than expected. Financial stocks are oversold, and may be due for a bounce, but they are not out of the woods yet.

By Dan Amoss for Whiskey and Gunpowder

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