Voodoo Banking Part 3

There are several areas of concern. Banks have benefited from hedging transactions (some of these are difficult to value Level 3 transactions). The exact nature of the hedges is not disclosed. The value of the hedge is based on models and estimates. The lack of disclosure around the value of the hedges, their nature and hedge counterparties make it difficult to gauge whether they will be effective in reducing losses.

A further area of concern is the practice of “circular asset sales.” Banks have sold risky assets where the seller has provided the buyer with favourable terms. Banks have sold leveraged loans on the basis that the bank lends the buyers 75-80% of the price at below market rates. Sellers have given undertakings that if future asset sales are at lower prices than that paid by the buyer then the seller will compensate the purchaser. These provisions have allowed banks to sell assets at prices that avoid the need to further mark down its positions.

This creates uncertainty about the value of bank assets. Further write-downs in asset values cannot be discounted.

...

Banks require re-capitalization. The capital required is in excess of $300-500 billion (15-25% of total global bank capital) to cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth.

Banks have raised a significant amount of capital but face increasing competition. Insurers, including the monolines, and the government sponsored enterprises (Fannie Mae (FNM) and Freddie Mac (FRE)) also need re-capitalization. This may limit availability and increase the already high cost of capital for banks.