The big reason that Hank Paulson pushed a government takeover of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) is that he concluded, after Morgan Stanley (NYSE: MS) scrubbed their accounting, that the $84 billion in capital stated on their books was really worth $50 billion less. This made me wonder what would happen to the capital of other big banks if they took a similar 60% haircut.
The answer? Eight large U.S. investment banks would lose $372 billion worth of capital -- putting them all well below the minimum required capital ratios -- with an average ratio of equity to assets of 2.5% ($248 billion in capital to $9,788 billion worth of assets). My conclusion is that these banks lack capital to support their level of risk. So it should be no surprise they are reluctant to lend. The government and other sources of capital don't want to step in. And the challenge of recapitalizing them will be left for the next president.
Here are the four most vulnerable banks based on how low their ratio of equity to assets would be if they took a 60% capital haircut which marked their balance sheet more to market than to model:
- Morgan Stanley. Equity falls from $34 billion to $14 billion --> equity/assets from 3% to 1.3%
- Merrill Lynch (NYSE: MER). Equity falls from $35 billion to $14 billion --> equity/assets from 4% to 1.4%
- Lehman Brothers (NYSE: LEH). Equity falls from $26 billion to $10 billion --> equity/assets from 4% to 1.6%
- Goldman Sachs (NYSE: GS). Equity falls from $45 billion to $18 billion --> equity/assets from 4% to 1.7%
I am not sure if these other banks were as aggressive about their accounting as Fannie and Freddie. But I would welcome any thoughts on how much they may be overstating their capital. When management's survival depends on reporting good numbers, it appears humanly impossible for them to go out of their way to err on the side of conservatism.
But if taxpayers are going to have to bail out every one of these banks, we are not going to have enough money to do the job. And today's paltry 178 point rise in the Dow only goes 52% of the way towards reversing the 345 point loss from last Thursday. And it seems like an awfully slim equity market payoff for what could be $800 billion in taxpayer's money.