(Under)Capitalized?

The recent announcement from the powers above, that the nation's financial institutions would soon be subjected to a series of "stress tests" has prompted much discussion concerning the proper methods of measuring capital adequacy. We have of course been bombarded by statements from bank executives throughout the course of the Crisis, who have assured us that, according to Tier 1 Capital Ratio's, their banks are well-capitalized. Although these statements are true, the CEO's were unable to convince the Market, which deemed Tier 1 to be an irrelevant measure at this point in time. Under the TARP program capital injections, the government received preferred equity stakes in the receiving institutions. The Tier 1 ratio treats these preferred stakes as capital, however the Market came to interpret this new money as simply a form of long term financing. 

Alas, the measure of Tangible Common Equity has emerged from exile, and claimed the senior most role in determinations of banking system capital adequacy. Immediately following loan loss reserves, Tangible Common Equity is the first part of the capital structure to withstand losses. Unfortunately, the Crisis has intensified by orders of magnitude, the bank's losses have blown through all loss reserves, and Tangible Common Capital has been decimated. To put the matter in perspective, the eight largest US Financial Institutions have combined assets of $12.17T(GAAP reported) and only $405B in Tangible Common Equity. 

We have assessed scenarios of de facto nationalization whereby the Government converts its preferred TARP stakes into Tangible Common Equity, and submit that at this point, there is little else to do. However, in the end we see this as measure that does little more than reduce the severity and speed of the decline, while ultimately prolonging the pain.

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