Big Banks: Under-Capitalized, Overexposed, Opaque

08-24-2011 • Ritholtz.com

The US banking sector is not healthy. There is a fundamental misunderstanding about the Wall Street bailouts amongst the public, and quite a few policy makers at Treasury and the Federal Reserve: Somehow, they “fixed” the banking system. All it took was few trillion dollars in liquidity and a few $100 billion dollars in recapitalization, and all is now fine (I suspect some people at the Fed know the Truth). In fact, they did nothing of the sort. The banking system was not saved; The massive injection of liquidity temporarily salved the day-to-day operations of banks, but they did not repair what ailed our financial institutions. Indeed, pouring billions into nearly identical management teams that mismanaged the risk, over-leveraged exposure, and drove banks off the cliff in the first place was an invitation for another crisis. And that crisis now appears to be arriving. And, its our own fault. Consider what was actually done in 2008-09, and you will understand why none of the underlying problems have been repaired: • Bank holdings: Remain stuffed with declining assets, primarily in Housing and Derivative holdings. Another leg down in Housing could be nearly fatal. • Transparency: Balance sheets are unnecessarily Opaque; Eliminating Fair value accounting via FASB 157 did not fix balance sheet problems, but instead allowed banks to hide them. • Capitalization: Remains too thin; leverage should be mandated back to the pre-2005 rule change of no more than 12 to 1; As we have learned, management does not keep adequate capital unless mandated to do so (sufficient capital reserves cuts into profits); • Misaligned Incentives: Compensation and bonus schemes were not significantly changed after bailouts, except during loan repayments. Thus, management and traders still have the same upside to roll the dice, but do not have the downside risks, which remains on shareholders and taxpayers;