Why Wall Street rescues are failing

Let's catalog the knights that have been eagerly anticipated and then failed so far:

• Bernanke and his power to lower interest rates. Cheaper money hasn't worked; banks are hoarding it by raising loan requirements.

• Buffett and his power to buy distressed banks and insurers. He's interested in only the most valuable casualties, leaving the worst and most dangerous institutions to dangle from nooses.

• Sovereign wealth funds and their ability to inject $10 billion-plus at a shot into battered banks. They're no smarter than the average investor, just larger. Even their sizable efforts so far amount to little more than a drop in the proverbial bucket, and they face mounting criticism and resistance at home.

• Treasury Secretary Henry Paulson and his ability to force bankers to the table. Every smart private businessperson who has entered the Bush administration has failed once inside; Paulson's winter program to rescue banks' structured investment vehicles went nowhere.

• Congress and its ability to write tax-rebate checks. The prospect of a $160 billion injection into the U.S. economy, amounting to 1% of gross domestic product, boosted stocks for little more than two weeks. The sugar high is over.

• President Bush and his ability to coerce lenders to freeze mortgage rates. Prospects of a work-out plan for overstretched private mortgage holders rallied home builders for two weeks before petering out; it's too limited.

• New York Gov. Eliot Spitzer and his ability to split up bond insurance companies, saving the muni bond business. The plan will be tied up in courts for years; it attempts to rescue states and cities at the expense of public shareholders and bondholders.

Each white knight offered hope that a few cough drops and slaps on the back would unclog the financial system's airways and send stocks on their merry way. Most have pushed stocks up for a week or two. Yet ultimately the folks with the most at stake -- and who really understand what's going on -- have re-entered the market as ardent sellers, pushing stocks to new lows.

To grasp the magnitude of the problem that has freaked out investors, please sit through a quick, glib explanation of world financial regulations and then consider some basic math, courtesy of Australian derivatives expert Satyajit Das.

First of all, capital requirements at major banks are governed by the Bank for International Settlements, or BIS. In a set of accords hammered out in Basel, Switzerland, in 2004, regulators determined that banks must hold equity capital equal to 8% to 10% of their total loans outstanding. In other words, they need about $1 million in capital to make $10 million in loans.

That doesn't sound so hard. But all of those loan-loss write-downs that you have heard about lately have eroded banks' capital base. And there are many more multibillion-dollar write-downs to come. Plus, you may recall from previous columns (see "Your 'safe' money isn't so safe") that most large banks created off-balance-sheet entities called structured investment vehicles, or SIVs, for the purpose of generating fees by speculating on a variety of highly leveraged loans. Now that many of those loans have gone kaput, accounting regulations have required that banks bring the SIVs onto their balance sheets. Since they are considered liabilities, they further weigh on those BIS capital requirements.

No magic bullet

Das figures there is $1 trillion to $2 trillion in SIVs, leveraged loans, warehoused loans and other assorted junk coming onto banks' books, all of which will tie up liquidity. Add to that the $150 billion to $250 billion in losses already recorded. Then add the roughly $100 billion that authorities believe will be required as reserves to shore up the troubled monoline insurers Ambac Financial Group (ABK, news, msgs) and MBIA (MBI, news, msgs). Call it $1.5 trillion in total (the midrange). So to reserve against that, Das figures banks need at least $250 billion to $400 billion in new capital, because the deficit is constantly growing.

At present the global banking system has about $2 trillion in capital in total. So banks need to raise something like 10% to 25% of that amount in short order at a time when the market is scared and earnings are plunging.

Where will that money come from? The answer is nowhere, at least not very quickly. And that is why the markets are in danger of asphyxiation. It's also why the economy is threatened: For despite the lower cost of money, it's hard for businesses to get loans for expansion because banks need to keep as many dollars as possible on their balance sheets to meet reserve requirements.

One semi-reasonable way out at this point is a cheat: Bankers may need to throw BIS regulations out the window and rewrite the world's financial rule book. Another alternative is for central banks to take all of the bad loans onto government books and print enough money to make them whole. That would lead to mind-blowing inflation and a loss of confidence, but at least it could hit the restart button on the global liquidity machine. Beaten-up commercial bank and brokerage stocks would then roar higher as they have after every other financial crisis, though from a much lower level.

I'll have more on potential fixes next week. In the meantime, I leave you with Das' bottom line: "The most fundamental thing is that people are pretending there is a magic bullet when there isn't one," he said.

Fine print

To learn more about the BIS capital-rules framework known as Basel II, click here. . . . To learn more about Das' views and the origins of the credit crisis, read my Sept. 20 column, "Are we headed for an epic bear market?" . . . To learn more about the problems with cities' and states' obligations, see my Feb. 7 column, "The big threat of muni debt." . . .

To learn more about Singaporean politicians' growing skepticism of investments by the country's sovereign wealth fund, check out this MSN Money blog item. To learn more about the problems with insurance on credit derivatives, check out my Jan. 24 column, "A bad market? You ain't seen nothin'."

At the time of publication, Jon Markman did not own or control shares of the companies mentioned in this column.

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