| Wed Oct. 8, 2008 6:23 PM EDT

CAPITALIZATION....A couple of days ago I complained about pundits and economists who (seemingly) couldn't make up their minds about whether the real problem preventing banks from making loans in the current market was (a) fear or (b) lack of capitalization. I got a few emails asking me what I was talking about, and it occurs to me that a lot of people are just assuming that all us non-economists understand why capitalization is important. But that's certainly not the case, so here's the kindergarten version of what it means.

Suppose that Acme Bank has $2 billion in capital and is leveraged at 20:1. This means they have $40 billion in assets, primarily consisting of loans of one kind or another.

Now, suppose that due to trading losses their capital is reduced to $1 billion. Unless they want to increase their leverage even further, that means they need to reduce their loan portfolio to $20 billion.

But it's worse than that. 20:1 is an insane amount of leverage. It ought to be closer to 10:1, and lots of banks are now in the process of deleveraging to get there. But with $1 billion in capital and leverage of 10:1, Acme can only have $10 billion in outstanding loans.

In other words, over the course of a few months, they need to reduce their loan portfolio from $40 billion to $10 billion (for example, by declining to roll over commercial paper when it comes due), and until they get there they can't loan out any more money. It doesn't matter if the borrower has a AAA rating. It doesn't matter if Acme's CEO is calm or frightened. Until they get their asset base down to $10 billion, they can't make any more loans.

(The grown-up version of this is way beyond my pay grade and includes a working knowledge of things like Basel risk-weighted asset requirements and our own local version of them. Obviously you're not going to get that from me. But hopefully the kindergarten story at least provides the basic picture.)

This is the theory behind recapitalizing banks rather than buying up their bad assets, as the Paulson plan does. If the government buys a bunch of preferred shares in Acme in return for $1 billion, then its capital is, once again $2 billion. They still need to deleverage, but that's going to happen regardless. The happy news is that even at 10:1, the extra capital expands their lending capacity by $10 billion.

Now, fear is obviously still a part of the picture. That capital injection doesn't do any good if Acme has so many toxic assets that it barely knows what its capital base is in the first place. Maybe it's so close to insolvency that it's going to go bust next week regardless. And even if that's not the case, they still won't want to lend money to other banks if they don't know how strong those banks are.

Still, one is primary and one is secondary. If capitalization is the fundamental problem, then calming down the markets won't do any good. There still won't be any money to loan out. If it's not, then confidence building measures are obviously of some value. Most likely, the story is somewhere in between. But it's kind of scary that nobody really seems to know for sure, isn't it?

UPDATE: Why do banks like high leverage? Because it allows them to make lots of loans, and therefore lots of money, with only a little bit of capital at stake. In good times, high leverage is a great way to make fantastic investment returns.

In bad times, though, it's not so great. The problem is that even small losses on a highly leveraged portfolio can wipe out your capital completely and make you insolvent. This is what's happening now, and it's why more stringent regulations on allowable leverage ratios are a good idea. Good times never last forever, after all.

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