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The lesssons of the credit crisis are not being taken seriously by markets

I have been following the matter of bank leverage, and the improvements that are required to deal with current bad debts and more importantly future bad debts that will arise from credit card and mortgage defaults. Sadly no lessons have been learnet judging by the reaction from the investment analyst community to the small improvement in capital ratio at Goldman Sachs.

Banks still need bigger cushions | Reuters – Rolfe Winkler

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Clearly the relationship to recent TCE (Tangible Common Equity) levels is hardly the point. What ought the TCE level be now based on the expectations for the next few years?

Yes, leverage is down, but only relative to the obscene levels reached a year ago. Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

In fact this little tidbit is interesting.

A nickel of equity for every dollar of assets is a pathetically small capital cushion. When the Federal Reserve system was founded, the required cushion was 18 cents. Ever since, we’ve been marching toward zero, pumping more credit into the marketplace than can be prudently managed.

At 18 cents leverage would be 4.6 :1 … that is still excessively high relative to coorporate leverage but perhaps it could be argued based on strong profit margins of banks. In any event it is hard to argue for anything less. Then we must layer on the continued practise of off-balance sheet debts which are not incluuded in TCE calculations, and which of course mean leverage is actually worse than shown.

In the meantime, banks are using various accounting gimmicks to hide leverage. For instance, Citigroup and JP Morgan Chase have $165 billion and $145 billion of off-balance sheet assets, respectively, that will have to come back on their balance sheets next year. Taking account of them now would reduce their TCE ratios by 8 percent and 7 percent, respectively. Bank of America has $470 billion of off-balance sheet assets, though they haven’t disclosed what will end up on the balance sheet.

Written by Colin Henderson

July 30, 2009 at 11:44

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