Are principal writedowns bad for bank equity?

By Felix Salmon
July 13, 2011
Steve Waldman has a fantastic reaction to my post about principal reductions, saying that "accounting is destiny":

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Steve Waldman has a fantastic reaction to my post about principal reductions, saying that “accounting is destiny”:

If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.

Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.

But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla.

This is, basically, the muddle-through approach to troubled assets. If you keep them on your book at par, then you can claim to be well capitalized, and use all that capital to pay yourself well and expand into new businesses. Eventually, with luck, those businesses will be successful enough that they make enough money to cover the losses on the assets when they’re finally realized.

But the real world doesn’t always work like that. See David Reilly’s very good piece on Bank of America today:

BofA maintains it has ample capital and can grow into new, more stringent capital requirements by 2019. The trouble is investors might not be so patient…

BofA is juggling mortgage problems as the economy and housing again look shaky. Markets already have shown what they think: BofA’s shares trade at about 50% of book value and about 85% of stated tangible book value. This means investors think either its assets are overstated or liabilities understated.

BofA needs to put questions about its mortgage risks firmly to bed. Or it needs a thicker equity cushion.

In other words, there are two different ways of looking at bank equity. One is Waldman’s way, where you take the bank’s stated assets, subtract its liabilities, and are left with its equity. And then there’s the more common and salient way of doing things, which is just to look at the share price. While it’s true that regulators do worry about accounting equity, they pay attention to share prices too. (That’s one reason that they weren’t worried about banks during the subprime bubble: the shares showed very little risk there.) And when it comes to paying employees and opening new business lines, a healthy share price is in much more useful than any accounting fiction.

Investors know how much subprime junk is buried on the balance sheets of America’s biggest banks, and they take that into account when they value those banks’ shares. If the banks, through principal reductions, can increase the real value of that junk, Wall Street will likely reward them rather than punish them. Even if that means taking a write-down on assets which everybody knows are worth significantly less than 100 cents on the dollar.

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