How Much Money Will It Take to Save the Banks?

Earlier this month, NYU economics professor Nouriel Roubini did what he does best: He came out with a prediction so dire and so intimidating that some couldn't help but write him off as an educated Chicken Little. He's been here before: Most ridiculed him back in 2006 when he predicted Fannie and Freddie would eventually collapse, too.

His latest forecast: Banks still need at least $1.4 trillion of new capital to get back on a sustainable path. "[This estimate] suggests the U.S. banking system is effectively insolvent in the aggregate," he warned.

Another $1.4 trillion? Really?
Sure. As disgustingly huge as those numbers are, Roubini's estimates hardly seem far-fetched.

The total amount of capital needed to right the financial system is the sum of two parts:

• The total amount of future writedowns.
• The total amount needed to recapitalize after those writedowns are absorbed.

There are a zillion ways you can measure capital-adequacy levels, but the most popular these days is the tangible common equity ratio (TCE). Using TCE ratios, the latter of the two calculations is easy: We can just look at a bank's current TCE ratio, and calculate the amount of money required to recapitalize itself back to historically normal levels.

The historical norm for TCE ratios is about 6%. Needless to say, most banks are light-years below that today. For the six largest banks, here's how much capital each needs just to get back on par with historical averages:

Source: TMF calculations based on optionARMageddon.com data.

For the largest six banks (we have thousands, by the way), it would take over a quarter trillion dollars to recapitalize them back to sane levels.

Since banks' common share prices have been shredded over the past year, most of the capital has to come from the government in one way or another -- either by converting existing preferred shares into common equity like Citigroup is set to do, or by more injections from taxpayers, such as the Treasury's new plan to buy convertible preferred shares. Since Uncle Sam's willingness to throw money at banks seems utterly insatiable these days, filling a $276 billion hole hardly seems problematic. TARP still has some $350 billion at its disposal, after all.                                              

If only it were that easy
Recapitalizing banks from today's levels is hardly the biggest worry: The biggest worry is surviving more writedowns, as the self-reinforcing cycle of unemployment leads to credit losses, leads to more unemployment, leads to more credit losses, and on and on. Recapitalizing as a long-term solution is only effective if major writedowns are over -- which not even the most optimistic analyst would suggest.

So how severe will future writedowns be? No one has perfect foresight -- Roubini's own estimates of losses tripled over the past year -- but using some logical trends, a few analysts have created a ballpark estimate of what the impending pain might look like.

Independent credit research firm CreditSights, for example, estimated the amount of future losses banks could face based on estimates of continued chaos in the housing market and an unemployment rate of 10% -- about the same level the Treasury is now using for its stress test as a "more adverse" scenario estimate.

Under CrediSights' estimates, here's what banks could be facing:

Source: The New York Times.

Add 'em up
Between impending losses and the amount needed to recapitalize banks after losses are absorbed, we get an admittedly rough estimate of what it'll truly take to bring our largest banks back to life: About $800 billion more.

Since this only includes the six largest banks, Roubini's estimate that we'll eventually need something like $1.4 trillion suddenly seems pretty reasonable.

Bottom line: TARP 1 did its job of preventing the financial system from collapsing in the middle of hysterical panic last fall. Unfortunately, to actually begin repairing the damage, banks -- by almost any estimate -- need much, much more capital. I think nationalization is the answer. Some disagree. At any rate, it's pretty clear that the current path banks are on is completely unsustainable, and something spectacularly large -- free market or otherwise -- will be in store sooner or later.

For related Foolishness:

• When Will It End?
• Socialism Isn't What I'm Worried About
• This Bailout Is Great!