Why the banks are broke

Wondering why banks like Bank of America or Citigroup are technically broke after $165 billion in bail-out funds to the nation's eight largest of them and *may* need to be nationalized until they can be re-sold to investors? A story in Time magazine summarizes:

Since October, the government has deposited $165 billion into the accounts of the nation's eight largest banks. Yet those same financial firms are now worth $418 billion less than they were four months ago, and the Congressional Budget Office estimates that the government's preferred shares are worth at least $20 billion less. In Wall Street terms, that's throwing good money after bad. All told, the government's annualized rate of return on its investment in the nation's largest banks is -1,096%. That's well beyond Bernie Madoff territory; he topped out at a mere -100%. (See pictures of the demise of Bernie Madoff.)

So how could $438 billion — $418 billion of their money and $20 billion of ours — go poof, just like that? Here's the easiest explanation: our banking system has sprung a leak..

To understand why nationalization may be inevitable, you have to get a handle on the true source of the banks' problems. The banking business — at least the way George Bailey practiced it in It's a Wonderful Life — was all about deposits and loans. You take in deposits, on which you pay a relatively low interest rate, say 2%. Then you lend that money to other people at a higher interest rate, say 7%. Pocket the difference. Repeat.

But starting in the early 1970s, banks began funding less of their lending with old-fashioned deposits. Bank deposits backed 90% of all loans four decades ago; today they back 60%. Where does the rest of the loan money come from? From the bank's past earnings and the money given to it by its investors. Using the house's money has generated higher profits — with significantly higher risks...

Another way banks sought to boost their profits — at least those available to shareholders — was through stock buybacks. Investors cheer buybacks, because they shrink the number of outstanding shares, boosting a company's profits per share and usually its stock price. But corporate stock purchases also decrease banks' capital, because their earnings are used to purchase shares rather than being retained as cash.

Worse, sometimes banks borrow money in order to buy back shares, upping their leverage and lowering their capital at the same time. In the past four years alone, the nation's largest banks, as defined by Standard & Poor's, have spent $300 billion buying back stock...

TARP does nothing to patch the hole in the banking system. And it certainly doesn't do anything to encourage banks to make more loans. Yes, banks have gotten nearly $300 billion in money from the government, and that's a lot of dough. But it's not free dough. In return for federal cash, the government has taken preferred-stock shares as the firm's markers. Unlike common stock, which is the kind you or I would buy from a broker, preferreds have to eventually be paid back, so they are really loans, not additional capital. (See which country has the best bailout plans.)

Say a bank has $5 in capital and $100 in loans. Now the government gives the bank an additional $100 in preferred shares and says, "Go make more loans." Well, the bank might then have $200 in loans, but it still has only $5 in common shareholders' equity. The result: if just 2.5% of its loans go bad, the bank's shareholders are wiped out. Wisely, the largest banks in the nation lent less in the fourth quarter of 2008 than in the previous three months — a strategy that has drawn some complaints.

But that hasn't removed the pressure on their shares. That's because the banks have had to continue to take loan losses. And banks don't have the option to pass those losses off on the new money they got from the government. They have to write down their common stockholders' equity first. And as that capital falls, so go the bank's shares. Some are alarmingly close to zero...

Nouriel Roubini, the New York University economics professor who was famously early in predicting that the end of the housing boom would cause a financial crisis, estimates that continued loan losses will force U.S. banks to come up with an additional $1.4 trillion just to stave off bankruptcy. And since the banks aren't likely to earn much money or attract new investors anytime soon, much of the money will have to come from the government.

Regulators are split on what to do next. The Federal Deposit Insurance Corporation is backing a plan to create what it calls an aggregator bank, which would buy up the loans of BofA, Citigroup and the rest of our now troubled system, theoretically putting an end to the escalating losses eating away at the banks' capital. But if the government buys those assets at current market rates, banks would be forced to take immediate losses on the sales, doing more harm than if the government just left the troubled loans where they are. Sources say the Federal Reserve would prefer to let the banks keep the loans and troubled bonds for now and instead provide the banks with insurance policies guaranteeing that the government will swallow a good deal of future credit losses. But a similar deal that the Fed struck with Citi did little to boost that company's stock or stave off fears that it may soon go under.

That's why a small but growing number of people are starting to talk about nationalization. Speaker of the House Nancy Pelosi recently said nationalization, or something close to it, is a better solution than just buying bad assets, because if the government takeovers succeed, then taxpayers get to keep the profits when they eventually resell the banks. But if the government doesn't turn a nationalized bank around, it could be very costly to taxpayers...

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