There are still many hurdles to the Treasury Department’s revised plan to get banks to sell unwanted assets from their balance sheets. Among one of the pieces of the plan that has received kudos – but comes with complications — is a component geared toward motivating banks to sell so-called legacy loans. Some analysts worry that banks will not be able to sell those loans, because it will impair bank’s tangible common equity ratios, an important measure of a bank’s health.
“With banks already having thin TCE ratios, the ability of most banks to move problem loans off balance sheet at substantial haircuts is likely limited,” writes Steven Alexopoulos, analyst at J.P. Morgan Chase & Co. “In fact, there are already several distressed asset funds vying for bank assets with little success tied to the required hit to TCE on bank balance sheets…for bank stocks to have truly marked a bottom tied to the plan, we believe pricing must ultimately be set at a level that does not further impair TCE levels—an unlikely outcome given the market driven pricing discovery mechanism associated with the plan.”
Due to the massive write-downs taken on assets, many banks are sporting slim tangible common equity ratios. According to SNL Financial, Citigroup Inc. was one of the shakiest, with a TCE ratio of 1.56% at the end of the year. Many banks hold substantial loan portfolios, and accounting rules stipulate that banks do not need to mark those loans to market values quarterly. Instead, they hold them at their “book value,” or historical cost. In their annual reports, the banks do disclose the difference between this value and the fair value – an estimated worth if they did mark down prices.
Regions Financial, for instance, had a tangible common equity ratio of 5.23% at the end of the quarter, according to SNL Financial. But that includes about $15 billion in loans that the company has elected not to mark to fair value. Add those loans into the equation, and the company’s approximate $13.5 billion in common equity is washed away.
Selling those assets at a severely reduced price would diminish the bank’s common equity, and there are plenty of assets that have not been marked down. “Approximately 15-20% of US and 10-20% European banks’ total assets are marked-to-market, the rest will have to recognize underlying impairments as the losses come through,” write analysts at Credit Suisse.
Other companies are in similar situations. Bank of America’s tangible common equity was $53.2 billion at the end of the year, and it sported a low TCE/TA ratio of 3.07%, according to SNL. Re-assessing those loans not held to value – and Bank of America had a difference of $24.6 billion between the book value of its loans and the fair value of its loans – and that TCE ratio drops sharply.
This issue is what would get in the way of banks offering up their loans for sale to private institutions. If the bank believes the loans are worth about 85 cents on the dollar, but private funds – even with Treasury equity and FDIC backing of debt sold – only wish to pay 50 cents, banks would take a big hit to their tangible common equity, making them less likely to take on more assets.
Some banks have been more conservative than others. Betsy Graseck, analyst at Morgan Stanley, noted in a report that those banks that would be the biggest beneficiaries would be those “who have taken conservative purchase accounting mark to markets on acquired portfolios,” naming J.P. Morgan Chase & Co., Wells Fargo, PNC, and Bank of America Corp., though to a lesser extent. J.P. Morgan’s loan portfolio was valued at $721.7 billion at the end of the year, but the estimated fair value was $700 billion. It had a TCE ratio of 3.83%.