> Um, loans are assets.  And there is a liability for every asset - that
> is an accounting identity.

> Selling loans that are in higher risk categories doesn't change
> assets, it lowers the amount needed as reserves against the same
> number of assets.  If the whole portfolio has higher average credit
> quality, then fewer reserves are needed against the risk of default,
> according to standard Basel capital requirement formulas.  Those
> requirements have risk adjusted assets in the numerator, and reserves
> in the denominator.

> If a bank sells assets generically, all types evenly, and uses the
> proceeds to repay debts, then it shrinks the balance sheet on both
> sides - both assets and liabilities.  That will also raise the ratio
> of available reserves to overall assets - same denominator, smaller
> numerator.  But not nearly as fast as moving "up market" in credit
> risk terms.

> Right now, Citi has nearly a quarter of its assets in the lowest risk
> treasury and governments sector, which require no reserves for credit
> risk (still can for interest rate risk etc).

> Thing is, moving up market in credit risk terms does come with a cost
> - lower available spreads.  Short term treasuries yield less than bank
> borrowing costs right now (bank borrowing costs are a mix of fed
> funds, LIBOR, CD rates, commercial paper rates, and portion of higher
> cost, long term debt and preferred).  So a bank that puts a ton in
> treasuries is sacrificing income for safety.

> What is going on with all of them is their losses in mortgages have
> reduced their risk capital from around 12% to a bit over 10% of risk
> adjusted assets.  10% is the regulatory line for "well capitalized".
> 8% in the Basel legal limit.  In practice, banks that drop to 9% get
> visits from regulators and orders to reduce risk or raise capital or
> shrink the balance sheet, to avoid dropping below 8.  Citi's is like
> 10.5% before the recent loan sale.  They try to run more like 12% in
> good times.

> Right now the spreads on the riskier bits are so wide, it is hard to
> not make money if you have free reserves.  By that I mean, banks can
> borrow at 3% in multiple ways, and can invest at 5-6% in low risk
> securities (GNMAs, higher grade intermediate corporates, etc).  Do
> that 9 times over plus 1 of owning the asset with your own equity, and
> you are grossing 23-35% on that equity.  Even if you pay half that in
> running costs and salaries etc, it is pretty hard to lose money that
> way.

> A few years ago, they chased spreads by using dodgier assets and
> higher leverage, and that is the source of present losses.  But there
> is no need to in this environment - prices have already moved, giant
> spreads are back, and a bank that just doesn't make obvious mistakes
> can make money hand over fist, standing still.  On the other hand, put
> everything in treasuries and you can fail to earn anything.

> For investors, the key thing to understand is that spreads have
> already widened.  It will take time for that to appear in new earnings
> and therefore equity, and in the meantime they can have losses on
> older stuff etc.  YMMV, and stocks will fluctuate.  But the Fed has
> basically already engineered the conditions needed for renewed bank
> profits (wide spreads).