Subprime Crisis Background Information - Understanding Financial Institution Solvency

Understanding Financial Institution Solvency

Critics have argued that due to the combination of high leverage and losses, the U.S. banking system is effectively insolvent (i.e., equity is negative or will be as the crisis progresses), while the banks counter that they have the cash required to continue operating or are "well-capitalized." As the crisis progressed into mid-2008, it became apparent that growing losses on mortgage-backed securities at large, systemically-important institutions were reducing the total value of assets held by particular firms to a critical point roughly equal to the value of their liabilities.

A bit of accounting theory is helpful to understanding this debate. It is an accounting identity (i.e., an equality that must hold true by definition) that assets equals the sum of liabilities and equity. Equity consisted primarily of the common or preferred stock and the retained earnings of the company and is also referred to as capital. The financial statement that reflects these amounts is called the balance sheet.

If a firm is forced into a negative equity scenario, it is technically insolvent from a balance sheet perspective. However, the firm may have sufficient cash to pay its short-term obligations and continue operating. Bankruptcy occurs when a firm is unable to pay its immediate obligations and seeks legal protection to enable it to either re-negotiate its arrangements with creditors or liquidate its assets. Pertinent forms of the accounting equation for this discussion are shown below:

• Assets = Liabilities + Equity
• Equity = Assets - Liabilities = Net worth or capital
• Financial leverage ratio = Assets / Equity

If assets equal liabilities, then equity must be zero. While asset values on the balance sheet are marked down to reflect expected losses, these institutions still owe the creditors the full amount of liabilities. To use a simplistic example, Company X used a $10 equity or capital base to borrow another $290 and invest the $300 amount in various assets, which have fallen 10% in value to $270. This firm was "leveraged" 30:1 ($300 assets / $10 equity = 30) and now has assets worth $270, liabilities of $290 and equity of negative $20. Such leverage ratios were typical of the larger investment banks during 2007. At 30:1 leverage, it only takes a 3.33% loss to reduce equity to zero.

Banks use various regulatory measures to describe their financial strength, such as tier 1 capital. Such measures typically start with equity and then add or subtract other measures. Banks and regulators have been criticized for including relatively "weaker" or less tangible amounts in regulatory capital measures. For example, deferred tax assets (which represent future tax savings if a company makes a profit) and intangible assets (e.g., non-cash amounts like goodwill or trademarks) have been included in tier 1 capital calculations by some financial institutions. In other cases, banks were legally able to move liabilities off their balance sheets via structured investment vehicles, which improved their ratios. Critics suggest using the "tangible common equity" measure, which removes non-cash assets from these measures. Generally, the ratio of tangible common equity to assets is lower (i.e., more conservative) than the tier 1 ratio.

Banks and governments have taken significant steps to improve capital ratios, by issuing new preferred stock to private investors or to the government via bailouts, and cutting dividends.