- The assets sit on the bank’s balance sheet with a value of 90 – meaning they have either being marked down to 90 (say mark to mythical market or model) or they have 10 in provisions for losses against them.
- The same assets when they run off might actually make 75 – meaning if you run them to maturity or default the bank will – discounted at a low rate – recover 75 cents in the dollar on value.
- The same assets if sold in the market (which does exist if you wish to discover the price) trade at 50 cents in the dollar.
Before you go any further you might wonder why it is possible that loans that will recover 75 trade at 50? Well its sort of obvious – in that I said that they recover 75 if the recoveries are discounted at a low rate. If I am going to buy such a loan I probably want 15% per annum return on equity.The loan initially yielded say 5%. If I buy it at 50 I get a running yield of 10% - but say 15% of the loans are not actually paying that yield – so my running yield is 8.5%. I will get 75-80c on them in the end – and so there is another 25cents to be made – but that will be booked with an average duration of 5 years – so another 5% per year. At 50 cents in the dollar the yield to maturity on those bad assets is about 15% even though the assets are “bought cheap”. That is not enough for a hedge fund to be really interested – though if they could borrow to buy those assets they might be fun. The only problem is that the funding to buy the assets is either unavailable or if available with nasty covenants and a high price. Essentially the 75/50 difference is an artefact of the crisis and the unavailability of funding.
- The system starting capital (ie pre-crisis) was 1.4 trillion dollars,
- Banks have raised about $500 billion along the way
- Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS (such as Norwegian local government authorities), indeed the whole point of securitisation was that it took the loans and losses out of the banking system,
- That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and
- That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion.
- Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
- Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
- Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
- Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
- Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?
Now I have a metaphor for how you might think of Test 2. In the centre of the road are double lines. You are not allowed to cross them. Crossing them is dangerous (you might crash and you might cause injury to others). When you cross them you should get back to your own side of the road quickly. However there are times of driving stress when you would cross them and that crossing is considered normal and acceptable. A child runs out on the road – and under stress you swerve over the double lines. Nobody will confiscate your car and lock you up for that. However if you stayed over the double lines you would expect the government to come down on you. Breaching regulatory capital buffers is normal in times of stress – but staying at very low to zero levels of negative capital – that is suicidal.