The Coming Bank Writedowns

Despite the gushing fire hydrant of liquidity that the US government has pointed at banks, a new wave of bank writedowns could cause a wipe out of these funds.

In the fourth quarter alone, banks are expected to incur $44 bn in write-downs and loss provisions, says Meredith Whitney, Wall Street's top analyst on the banking and brokerage sector at Oppenheimer Equity Research.

On top of that, bank capital reserves will also need massive backstopping as a result of credit rating downgrades on damaged securities concocted during the credit bubble, causing the banks to need more funds to maintain their required regulatory capital reserves.

What's more, due to new accounting rule changes going into effect late next year, banks will have to post an additional $25 bn in loss reserves over the next 12 months.

As a result, Whitney and her team have lowered their fiscal 2008 and fiscal 2009 earnings estimates for the financials by 17% on average. Worth noting is the fact that Whitney and her team do not have an outperform rating on any of the banks they cover.

Already, the International Monetary Fund has estimated that major global banks will need $675 bn in capital over the next several years in order to defrost the credit markets and to strengthen bank capital ratios.

At the same time, the IMF now backs "a greater degree of judgment" in the application of mark-to-market rules, which has forced massive, historic writedowns at banks around the world.

The accounting rules force banks to pricetag these assets as if they were to be sold in current quarters. Given that the markets are in blackout mode for these assets, the banks have been required to book "fire sale" prices of these damaged securities, turning them into Kryptonite and effectively creating landfill in portfolios around the globe.

As a result, the IMF estimates that losses on U.S.-originated loans and securitized assets could approach a total of about $1.4 tn, higher than the IMF's initial estimate in April 2008 of $945 bn.

Analysts now say that at an estimated $7 tn, the US bailout has now surpassed the estimated cost Japan incurred to fix its zombie economy in the nineties after the country's banking crisis.

Japan spent about 30% of GDP to fix its crisis. The US is now spending more than 50%. The costs do not include the current federal deficit, nor the unfunded costs for Social Security and Medicare, the latter two estimated to be anywhere from $55 tn to $90 tn.

The Bailout Grows

The Federal Reserve is now committing another $800 bn to unfreeze credit markets, increasing its balance sheet to $3 tn.

The US central bank will purchase as much as $600 bn of debt issued or backed by Fannie Mae and Freddie Mac. And the Fed will also set up a $200 bn program to support consumer and small-business loans.

However, economists say this is a necessary move as the securitization market, which has provided the liquidity to these markets, has dried up.

Now the question is, given the coming writedowns, what bailout sums will suffice?

TARP Resurrected

The government essentially resurrected the initial intent of the TARP plan just for Citigroup, a version of the first iteration of the $700 bn Troubled Asset Relief Program in which the government wanted at first to buy at auction bad securities built during the credit bubble. TARP will now instead invest in equity stakes of the financials.

On October 14, the Treasury shifted gears for TARP, creating a $250 bn facility available for direct capital injections in US banks, with 89 institutions getting funds, Whitney notes.

Of the program's budgeted $250 bn in disbursements, the Treasury has already given authorization for $238.5 bn, or over 95% of the program.

However, the government did an about face and will now backstop $243 bn or so in Kryptonite mortgage-backed and commercial real-estate backed securities at Citigroup.

The Federal Reserve already has quietly taken on $52.5 bn in toxic securities from AIG, along with the $27 bn in securities it inherited from the bailout of Bear Stearns.

The Citigroup plan does not include Citi's credit card assets, a portfolio which is at $118 bn. Delinquencies are rising here.

Stop Mark to Market Accounting Rules?

Accounting critics are hotly debating why the government won't stop the hammer blow of the mark to market rules which says companies must price and book securities as if they were to sell them today in a market that's as frozen over as the two moons of Mars.

Wall Street analysts have noted that the Treasury's turnaround for TARP came after it took a look at how damaged the banks' securities and loans were, with bureaucratics experiencing a lightening bolt realization that TARP money would not suffice to sluice through liquidity but instead would be needed to support solvency.

Tarpedo-ing the initial plan for TARP killed the potential floor under these securities that Wall Street had been looking for.

The massive writedowns triggered by the mark to market rules are triggering potential solvency problems. In prior crises, other countries such  have suspended these rules.

For example, during the Latin American debt crisis of the early 80s, (where countries like Brazil, Mexico and Argentina blew out their debt to industrialize), banks around the world hit the skids as market prices on debt from the region hit a dime a dollar. But regulators didn't force the banks to mark these loans to market, avoiding insolvencies.

Given that the TARP auction idea was tarp-edoed, the debate now is, why not kill the mark to market rules, even if temporarily? Already Congressmen such as Sen. Charles Schumer (D-NY) have asked during hearings whether the rules can be suspended on a temporary basis.

The Writedowns

Whitney believes that banks will book over $44 bn in write-downs and loss provisions in the fourth quarter alone.

And due to accounting rule changes effective over the next year, banks will have to post an additional $25 bn in loss reserves over the next 12 months.

"We believe that already, much of this TARP capital has been allocated to shoring up balance sheets and that many will return for more capital over the next 12 months," Whitney says.

The Triple Whammy

As noted, TARP has tarp-edoed the initial plan to buy at auction Kryptonite securities, which may create more writedowns down the road as the prices for these assets have since dropped.

Whitney also notes that banks face severe pressures on capital due to credit-rating downgrades on risky assets. A total of about $744.7 bn in real estate securities were downgraded in October alone by the credit rating agencies, 16 times the sum downgraded in August 2007, when the credit crisis began, Oppenheimer says. A total of $1.2 tn in real estate securities and mortgage assets have been downgraded to date in the fourth quarter.

The effect on banks of credit-rating downgrades on U.S. mortgage-related assets has been drastically underestimated, Whitney notes. As downgrades on these assets reached new highs in October, they have put heavy on pressure regulatory capital ratios, forcing banks to hold more capital against these assets.

That is a major reason why banks have not been lending again.

And proposed accounting rule changes set to go into effect for quarters after November 2009 will force the banks to put back onto their balance sheets securities now held in off-balance sheet entities, which will further force banks to hold onto more capital against these assets.

The New Accounting Rules Slam Banks

Citigroup has approximately $1.14 tn in off-balance sheet assets, Whitney estimates, adding JPMorgan's exposure is approximately $735.2 bn. Bank of America's is approximately $73.0 bn.

But what's really at stake?

The accounting rule changes affect what are called, in accounting jargon, qualified special purpose entities, or QSPEs and also unconsolidated variable interest entities, or VIEs.

Of Citi's $1.2 tn, $820 bn is in QSPEs. Under the new accounting rules, these QSPEs will no longer exist.

But not all of that sum will have to come back. The rules are complicated, but according to Whitney's read of them, Citi is expected to put back on the balance sheet $122 bn of credit card QSPE exposure, Whitney says.

However, Citigroup does not expect to put back on some $667 bn of mortgage-related assets now off the balance sheet because the banks says it does not bear the credit risk, Whitney says. The breakdown here: $578 bn of consumer mortgage loan securitizations and $89 bn of institutional client's mortgage loan securitizations.

However, on top of all this, Citigroup has $324 bn of unconsolidated VIE assets. Citi's maximum exposure here: $131 bn, Whitney figures. That's the sum Citi may have to put back onto its balance sheet. However, given the complexity of the rules, it is unclear to Whitney if or how much of these sums will need to be put back on Citigroup's balance sheet. So the potential total coming back on to Citi's balance sheet: $253 bn.

As for JPMorgan, it has approximately $735.2 bn in off-balance sheet assets. Some $645.3 bn of that sum includes securitizations picked up in its acquisition of Bear Stearns and Washington Mutual. About $128.6 bn is in credit card securitizations, which Whitney believes will have to be put back on JP's balance sheet.

But stuck in yet another off-balance sheet vehicle, JP Morgan does have about $89.9 bn. It is unclear how much of these sums would be stuck back on JP's balance sheet under the new rules.

It is not clear to Whitney whether or how much of the remaining $516.7 bn, which includes mortgages, commercial loans, auto loans and student loans, will be stuck back on JP's balance sheet under the new accounting rules. Another $170.6 bn in commercial loans and other securitized loans would not have to be put back on JP's balance sheet, Whitney figures.

Potential sums stuck back on JP's balance sheet: at least $218.5 bn.

As for Bank of America, it has about $73 bn in off-balance sheet vehicles. Again, it's unclear how much BofA would have to put back on the balance sheet.

Credit Card Time Bombs

Worth noting, says Whitney, is that Citi, Bank of America and JPMorgan have stuck the greatest portion of their credit card assets off-balance sheet, more than 55% of their total credit card assets.

Whitney believes that, at a minimum, the off-balance sheet credit cards exposures will have to be brought back on the balance sheet.

Based on Whitney's analysis of the three major banks (BofA, Citi, and JPMorgan), roughly 20% to 30% of the newly raised capital since the third quarter will be needed to build next year's credit card reserves alone.

The range zooms up to 20% to 42% if Whitney includes estimated write-downs for the fourth quarter.

It should be noted that Whitney says her team's estimates do not account for any potential reserves needed for putting back onto the off-balance sheet other securitiezed assets, like mortgage and commercial real estate securitizations.

What the Banks Got From TARP

Will the present TARP money be enough for the banks? Not likely.

Separate from the Federal Reserve facilities, Citigroup and JP Morgan received $25 bn from the initial TARP. Citigroup raised another $27 bn this week as part of a rescue package from the U.S. Treasury and FDIC (of which $20 bn was under the TARP).

Bank of America received $15 bn of initial TARP capital but may receive another $10 bn entitled to Merrill Lynch after the completion of the acquisition of the brokerage. In addition, Bank of America raised $10 bn in common stock.

Goldman Sachs and Morgan Stanley both received $10 bn of initial TARP money. Goldman Sachs raised another $10 bn with the Berkshire Hathaway preferred stock and the public common equity offering.

Morgan Stanley raised another $9 bn of capital placed with Mitsubishi UFJ Financial Group.

However, Whitney believes that much of this capital will be diverted to plug holes on the balance sheet.

TARP is about to get bigger.