What about the impact of the toxic assets on the balance sheet? Many may worry that allowing banks to carry negative book value (in HTM value terms) will create a “zombie bank” situation, such as that which existed in Japan. But the Japanese analogy isn’t apt. In Japan, the government forced banks to continue to lend to unprofitable companies, effectively preventing Japanese banks from being able to dig themselves out, since they were forced to throw good money after bad.

This isn’t what’s happening to the US, nor should we expect it to happen. The US isn’t forcing banks to make new lows to borrowers in default.

So is allowing the banks to operate with negative equity in HTM terms a free lunch? No. Carrying the non-earning toxic assets on their balance sheets will cause US banks to earn a lower return on assets over the next few years; this reduces the NPV of their common equity.

There should be no free lunch for the common equity shareholders of banks, nor need there be. That’s the point. In the example provided, bank equity holders are paying for the full value of their losses. However, they’re doing so over a number of years. There’s no need for dilutive equity offerings, and absolutely no need for government subsidies that socialize the banks’ losses. As long as banks are allowed to value their assets at acquisition cost and gradually charge them off over a period of, say, 15-20 years (similar to depreciation), the banks can continue to operate normally by collecting deposits and extending new credits to credit-worthy customers.

In the example, the portfolio losses are in essence paid gradually by suspending dividend distributions for 13 years, while earnings applied to charge off legacy assets represent roughly 50% of annual earnings. This charge-off rate essentially takes the place of a 50% dividend pay-out ratio. Again, no free lunch here.

The example can even work if banks are allowed to make some dividends payouts to common shareholders along the way, though it would take longer for the bank to repair its tangible book value and achieve an acceptable equity capitalization level. But if the government were to allow banks to charge off the toxic assets over a 20-30 year period, then dividend payments to common shareholders could be accommodated.

How realistic is this example provided?

First, there are many precedents in Latin America and Asia in which distressed banks have repaired their tangible book value and generated intrinsic value to common shareholders in precisely this fashion.

Second, the assumptions in this exercise are pessimistic, if anything. In particular, it seems certain that the government will be absorbing some of the banks’ losses, one way or another. This could happen either by the government directly sharing in the losses, or by providing the bank with very low funding rates through the Fed’s discount window or similar facility. In this case, the present intrinsic value of bank equity would be even greater than forecasted by the example.

Finally, the whole process of balance sheet healing can be sped up though equity offerings over time. As long as the equity offering is made at an “after the money value” equal to or in excess of its “before the money” NPV, no dilution to current shareholders will occur.

At the P/BV multiples in the example, and based on historical precedent, it’s highly likely that equity offerings ultimately accretive to shareholders can be made.