Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor. This is his first piece for Minyanville.

The declaration that US banks are “insolvent” has been repeated so often, so emphatically, and by so many, that it’s practically considered a truism, requiring no explanation.

And it’s creating very negative consequences for financial markets (as a quick look at the current shareprices of Bank of America (BAC), Citigroup (C), Wells Fargo (WFC) and JPMorgan (JPM) will attest) and the economy as a whole: It’s been used to rationalize both massive bailouts and, more recently, outright nationalization of the banking system.

But I have yet to see a single commentator present a model of a bank’s balance sheet that demonstrates that a particular bank is in fact insolvent and/or unable to lend. Of course, the arguments of the Cassandras do contain a grain of truth. But they lead to dangerous falsehoods.

I believe that the current misunderstanding stems from a fundamental lack of knowledge about how banks work. It’s true that many US banks may have negative book value if their assets are marked to market or even if they are marked to their hold-to-maturity value. However, that is very different from the claim that the common equity of banks have no value and that private banks need either to be bailed out at taxpayer expense or be nationalized.

Let me be clear:

1. It is categorically false that the intrinsic equity value of banks with negative book value is zero.

2. It is categorically false that it is necessary for taxpayers assume the burden of losses created by private banks.

3. It is categorically false that nationalization is a necessary step to “clean up” bank balance sheets and free up credit.

Let's take an example of a bank that, due to poor investment decisions and/or systemic economic conditions, has become “insolvent” - if we understand that term to mean an entity with negative adjusted book value.

It's assumed here that the bank is forced to immediately write down the full “hold to maturity” (or HTM) value of losses from troubled assets.


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As can be easily observed, given the leveraged nature of a bank, significant losses in its portfolio of assets -- in this case, 11% of total assets -- can very quickly result in negative equity. However, does this mean that the value of the common equity is worthless? Or that the bank should be bailed out and/or nationalized? 

But a bank can have negative book value and a highly positive Net Present Value (NPV) of equity.