With bad loans tripling and leveraged loans looming, banks need $1 trillion in new capital

It sure is hard to be a banker these days. It used to be that all a banker had to do to get millions in bonuses was to close some big deals and at the end of the year, the bonus cash would roll in. Every ten years or so, bankers are reminded that it's easy to lend out money and hard to get it paid back -- particularly when a recession puts the kibosh on cash flow for everyone at the same time.

Why this musing on the woes of banking in a recession? Before answering this, I must apologize for the string of acronyms I am about to unleash. Because today the 19 financial institutions (FIs) that the Treasury forced into what I think are bone-headed stress tests will find out the results.

And with their bad loans -- known as non-performing assets (NPAs) -- tripling on average, this will lead to big write-offs down the road that will require the banks to raise more capital. More specifically, at 13 of the largest U.S. banks, bad assets increased 169 percent from the first quarter of 2008 and according to KBW, the 19 largest banks will need to raise $1 trillion to cushion the losses from their bad loans.

And, regrettably, there is another shoe about to drop -- the $300 billion market for so-called leveraged loans (LLs) about which I posted in February 2008 and again last September. LLs are used to finance leveraged buyouts which were all the rage until their 2007 peak.

Those LLs were in turn securitized -- packed into so-called Collateralized Loan Obligations (CLOs). Last August, the default rate on those LLs had risen from 0.24 percent in August 2007 to 3.3 percent. But now that default rate is expected to soar far higher -- to anywhere between 15 percent and 24 percent, which is twice the old peak.

Those CLOs bought two-thirds of the LLs between 2005 and 2007 and now billions of those LLs are going to need to be refinanced in the next several years. Specifically, in 2009 $26 billion in LLs will try to refinance, $44 billion in 2010 and $120 billion in 2011.

It's a shame that so many of them will not be able to refinance and will then default. This will spell big trouble for the FIs that originated the LLs in the first place. And it will increase their total NPAs and the amount of capital they need to raise.

I'd like to think that we can come up with a better strategy to fix what ails the financial system today. I've suggested six principles for that here.

But I regret to say that the current strategy will need to fail -- probably after it becomes apparent that FIs can't raise $1 trillion in private capital -- before there is hope of a new one emerging.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.


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