Timing Losses & Financial Institutional Strength

Let me tell you a story to prove a point. Assume that you loaned me $1,000 2-years ago (thanks, by the way) and I had not paid you any interest or principal ever since. Assume further that we met today to negotiate a settlement and I offered to pay you $200 as a one-time payment to satisfy the entire amount of the loan. The question: how much money did you lose and when did you lose it?

Those of you who are financial inclined are likely already doing some discounted cash flow calculations, but let's keep things simple; let's ignore the time-value of money. Many of you, then, are likely shouting a loss of $800 today, and I'm sure that many more of you would be tempted to agree, but to see why this is the wrong answer, we need to differentiate between paper-losses (accounting) and actual losses (cash flows).

From an accounting perspective, you, the lender, had created an account to represent the account loan and the expected future repayment. What is important to acknowledge, however, is that the $1,000 that you lent to me flowed out from your bank account 2-years ago - not today. Put differently, you have had $1,000 less funds for 2-years; my offer to repay you only $200 of the full amount does not represent a loss, but rather a positive cash flow today. Actually, it's as simple as:

-$1,000 :: cash flow out to me in the form of a loan

$0 :: cash flows from my repayment of principal and interest

+$200 :: cash flow from my repayment and settlement of the loan today

Now, I'm sure you're asking yourself why this revelation is important. Well, let's consider the banks that are scrambling for credit and new sources of financing in light of the so-called credit crisis spurred by the billions of dollars in write-downs. Ask yourself when those related losses actually occurred. Also, ask yourself whether the settlement of these debts at $0.20 on the dollar leaves more or less cash on the balance sheets of these banks. Notice, that I asked about whether this left more or less cash - I didn't ask about net assets. This is the difference between accounting losses and actual (cash flow) losses.

The interesting conclusion that many of you are now likely making is that the settlement of these bad debts is actually leaving these banks in a stronger, rather than weaker, financial position. So why are they scrambling to borrow from the Federal Reserves auction facilities? Good question. They certainly don't need the cash - their cash positions haven't changed! Only their accounting positions have changed. It is true that this does affect their ability to lend as it leaves them with fewer assets and collateral, but fears over bank failures is certainly unfounded. Now, as an investor watching the markets and seeing the tumbling stock prices of many, if not all, financial institutions, ask yourself if the broader market has misinterpreted the events over the past few months. Lastly, ask yourself the market's overreaction leaves you with an opportunity to profit from the rebound that is unquestionably going to happen - given enough time for the banks to restart their lending engines.