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Tuesday, January 20, 2009

Is the U.S. Banking System Insolvent?

NYU Professor Nouriel Roubini says that it is, and believes losses could eventually exceed $3.6 trillion.

I think he's right that the banking system is insolvent, but likely only temporarily. When a financial institution is leveraged 10-1 and the total assets decline by 10%
, then there is no equity left. Even if all the assets declined by only 5%, the equity would likely be reduced to a level below the statutory minimums required by regulators. And according to FAS 157, financial institutions must mark-to-market its assets on a quarterly basis. While they have some discretion over how deeply they discount highly illiquid assets, they are required to mark the more liquid assets down.

With leveraged loans trading in the secondary market at between 60-70 cents on the dollar, banks must take a 30-40% haircut on that portion of its portfolio. More than likely, most banks have decided not to take huge marks on their mortgage portfolios since 1) they are performing and 2) it is very difficult to determine "market value" on each individual mortgage. But I think it's safe to say that, given the cost of capital today, banks would be very lucky to get 90 cents on the dollar for a performing mortgage.

So what is the solution? The only one I see is a huge market rally to increase the value of these securities overall. I think Obama should announce a capital gains holiday on all assets purchased within the next 6 months. I believe it would create a buying frenzy across all asset classes and increase the value of stocks, bonds, loans and even homes to a lesser extent (at least the declines would stop for a while). Other than a rise in asset values, I don't think there is enough capital in circulation to increase the equity of financial institutions to a level that gives confidence that they are solvent. And the existing $850B proposal would likely only draw nearer the day of reckoning, since the funds are essentially transfer payments that have very little stimulative value and a much larger hole to climb out of.