Don't Kid Yourself: Banks Can Still Be Insolvent

Earlier this year, global investors looked at banks and saw nothing but death. Their calculations were simple: Expected future losses exceeded total equity, and in some cases those anticipated losses exceeded the amount of equity that banks could probably raise. Hence, some were doomed for failure. This was the net opinion of thousands of investors who spent years plowing through banks' books to assess, value, and project their health.

Then a funny thing happened: Through the government's stress test, a small group of regulators and policymakers determined that, no, global investors had it all wrong: Banks were actually much healthier than almost anyone had assumed, and they had -- or could raise -- enough capital to make it through even the worst possible outcome. Nothing is wrong. Everything is fine. Trust us. All naysayers shut up and get back to work, please.

Color me skeptical
Amazingly, the masses have bought into the claim. Banking optimism is almost purely based on comments like "The stress test proves this," and "The stress test shows that." The irony is that the same people who (rightly) say the government is incapable of running private business now insist that the stress test is the holy grail of banking.

Common sense tells you that it probably isn't, and the facts bear out the assertion. Last month, I showed how blatantly optimistic its assumptions were, assuming a "worst case" unemployment rate of 8.9%, even though it's already 9.4%.

More examples of funny forecasting might be helpful.

See, the capital that banks need to cover losses doesn't all have to come from new equity. Losses, according to the stress test, will also be offset by future earnings. There's nothing inherently wrong with this approach: Banks can use future cash flow to plug leaks in their balance sheet. That's business as usual.  

What's interesting is the amount assumed: Fully 60% of expected losses for 2009 and 2010 are assumed to be covered by future earnings, not raised capital.

For the largest banks, here's how much dough we're talking about:  

Source: Federal Reserve, May 2009.

One takeaway is that since these earnings will offset losses, they won't be going back to shareholders in the form of dividends or buybacks. This point is incredibly important, because so much hope is being pinned on the belief that these banks will become earnings machines in the years ahead. And they probably will, but this table reminds us that most of those earnings could simply go right back into fixing black-hole balance sheets.

Another, more important takeaway: What if the government's earnings projections are too optimistic? Crazier assertions of skepticism have been proved correct, you know.

Now we're on to something
When a bank raises capital, the balance-sheet buffer is here and now. When it relies on projected future earnings, the benefits are far more uncertain. It's a projection. A guess. A hope. And if banks don't end up earning what the government assumes, they'll end up with a capital shortfall.  

Now, the stress test assumes that the 19 banks examined will produce a combined $362.9 billion from operations by 2010 to offset losses. Note that this projected source of capital is several times greater than the $74.6 billion of actual new capital they were asked to raise.  

How does that $362.9 billion figure compare to other, less-biased analysis? It's staggeringly optimistic, to say the least. An International Monetary Fund report titled "Stabilizing the Global Financial System and Mitigating Spillover Risks" projects that total retained earnings from all U.S. banks (and there are thousands of them, of course) will be $300 billion during the same time period. As NYU economist Nouriel Roubini points out, the IMF data translates into a forecast of $150 billion of retained earnings for the 19 assessed banks -- a far cry from the $362.9 billion that the stress test assumes.

Are the IMF's projections right? I have no idea. No one does. But the fact that two estimates can differ by $213 billion isn't reassuring. And it reminds us that these earnings forecasts are simply products of someone's opinion, not facts written in stone.

But what happens if, two years hence, the IMF's projections of profitability are more in line with reality? Where will banks find another $213 billion? What if it's $300 billion, or $400 billion? Will the market be as kind in raising new capital as it has over the past six weeks?

We can only hope.

For related Foolishness:

• If You Think the Worst Is Behind Banks, Read This
• Banks Are Selling Stock: Should You Be Buying?
• Here's How Messed Up Our Financial System Is

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express is a Motley Fool Inside Value recommendation. The Fool owns shares of American Express and has a disclosure policy.