http://www.safehaven.com/article-9880.htm
If the Rules are Inconvenient, Change the Rules
Several times in the past few months I have reminded readers of the
problem that developed in 1980 when every major American bank was
technically bankrupt. They had made massive loans all over Latin
America because the loans were so profitable. And everyone knows that
governments pay their loans. Where was the risk? This stuff was rated
AAA. Except that the borrowers decided they could not afford to make
the payments and defaulted on the loans. Argentina, Brazil and all the
rest put the US banking system in jeopardy of grinding to a halt. The
amount of the loans exceeded the required capitalization of the US
banks.
Not all that different from today, expect the problem is defaulting US
homeowners. So what did they do then? The Fed allowed the banks to
carry the Latin American loans at face value rather than at market
value. Over the course of the next six years, the banks increased
their capital ratios by a combination of earnings and selling stock.
Then when they were adequately capitalized, one by one they wrote off
their Latin American loans, beginning with Citibank in 1986.
The change in the rule allowed the banks to buy time in order to avoid
a crisis. It did not change the nature of the collateral. They still
had to eventually take their losses, but the rule change allowed both
the banks and the system to survive. I have made the point that the
Fed and the regulators would do whatever it has to do to manage the
crisis.
All the major new multi-hundred billion dollar auctions at the Fed
where the Fed is taking asset backed paper as collateral for US
government bonds does not make the collateral any better, of course.
It just buys time for the institutions to raise capital and make
enough profits to eventually be able to write off the losses.
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