Bank Failure Accounting 101

Let's return to the basic balance sheet of a typical financial company before the writedowns:

FRED’S BANK & TRUST
BALANCE SHEET

Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100

Assets are equal to liabilities plus equity, as they must by the principles of accounting. Or, in other words, equity is assets minus liabilities. Government regulations and private contracts between banks require some small amount of equity to remain on the balance sheet. That’s a form of leverage, which helps Fred’s Bank & Trust do more and make more with their depositors’ money.

Now let's write down [mark-to-market] the questionable assets—not all the way to zero, but to $2:

FB&T BALANCE SHEET (after write-down)

Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

Now Fred’s Bank has zero equity and is in violation of those regulations and private contracts. The debtholders can compel Fred’s Bank to sell some its good assets in order to meet those private contract requirements.

For example, the private contract might allow zero equity, IF bondholder debt is brought below $10 and ordinary bank operations remain profitable. Then FB&T could sell $7 in good assets to pay down bondholder debt, meeting the private contract requirement.

This touches on the notion of a “credit crunch”. Much of FB&T’s bondholder debt is short-term, from just overnight to a few months. If Fred’s Bank has a weak balance sheet, it can’t pay off yesterday’s bonds with tomorrow’s new borrowing. The private contract terms get tougher as the balance sheet gets weaker. FB&T will probably have to sell good assets. But the asset market is weak and the forced sale might further reduce equity, to below zero. And with negative equity, the bondholders and depositors might not get all their money out. So they run to the bank to get their dough before FB&T runs out of cash.

But the Federal Reserve will not accept zero equity, no matter what. They want to stop the run before before the equity gets negative, so the FDIC will not have make good on deposits with no equity behind them. Fred’s Bank is failing. It has raise equity somehow, or the government will close it down.

Keep in mind, though, FB&T still holds $95 in good assets. And is probably still making positive income on them. Fred’s Bank is failing according to its balance sheet, but it is far from worthless.

The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here's the result:

Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

Fred’s Bank gets its share of the $700 billion bailout, but is still failing. It can use the cash proceeds to reduce bondholder debt. This might persuade the bondholders to relax their terms, renew those short-term loans, and not force FB&T to sell good assets. So the bailout money might help Fred’s Bank stay liquid. But it does nothing to help the bottom line.

What FB&T needs is some new equity. A bigger bank, for example, buying Fred’s Bank would add equity. Or, even before the bailout, if the accounting rules had been changed (from what is called “mark-to-market”), the questionable assets might have been $3 or $4 instead of $2. FB&T would not be strong, but it would have still been solvent. Profits from normal operations—making good loans—would have shored up the equity, and we would all be worrying about some other crisis in a year or so.