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For Banks, Size Does Matter, Part 2

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Bigger they come, harder they fall.

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Editor's Note: This is the second part of a two-part series. Part 1 can be found here.

Last week I talked about how much it costs for many banks to raise money today. For weaker banks, the cost of new capital is prohibitive.

But regulatory requirements mean that you have to raise money or reduce your loan portfolio if you're found to have inadequate capital. Raising money in today's environment is going to be difficult for many banks. Lehman (LEH) has been shopping for capital for months; Merrill (MER) has had to sell some key assets.

Selling the best and keeping the rest is a strange philosophy - but that's what regulations require you to do. Merrill, for instance, recently sold $30.6 billion in poorly performing mortgage-related assets (which they valued at $11.1 billion) to a private equity firm called Lone Star for $6.7 billion - a 78% discount on the original face value. But Merrill had to finance 75% of the deal, which means they may only get $0.05 on the dollar.

And while I'm picking on Merrill, let me quote this paragraph from Shilling:

"To add insult to injury, Merrill Lynch recently announced plans to sell $8.5 billion in new common stock, which will dilute shareholders by 38%. Previously, in response to writedowns, which totaled $46 billion since June 2007, Merrill has raised $15 billion in common and preferred stock. And this new common stock sale will be even more costly to Merrill since earlier sales of $5 billion in stock at $48 per share to Temasek, a Singapore state owned investment company, required compensation for the difference if Merrill sold stock at a lower price within 12 months. The stock is now $27 per share, which will cost Merrill over $2 billion."

If there are more large losses in the next year, what will banks do? Raising capital is going to be tough, and will come at serious costs to current shareholders. We'll see some of that, and that's a reason to be very cautious about the stocks of large financial companies. The bulls would say that the problems are already in the price. Of course, that's what they said 6 months ago. Caution is advised.

The second thing the banks can do to repair their balance sheets is reducing their loan books, or selling off assets or loans. And that is happening. It's going to be increasingly difficult to get large new loan deals done, and that's going to put a damper on the economy. 60% of banks are tightening their lending standards. In the recent Beige Book, the Fed reported that all districts have seen a tightening of standards, which is unusual.

Leverage loans for mergers and buyouts have dropped 75% since last year. They were only $50 billion in the first quarter, and are almost certain to have dropped to even lower levels this last quarter.

And the leverage that was so helpful as it rose? It's now going to have the opposite effect. If you lose $1 billion and can't raise the capital, you're going to have to reduce your loan book or sell off assets by (using my analogy) $10 billion. If we have potential write-downs of several hundred billion more, that pain is going to be felt in both the corporate and individual worlds, as credit availability is going to decrease and rates are going to go up.
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No positions in stocks mentioned.

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