By: Larry MacDonald

U.S. banks are now struggling to raise capital, according to reports from the Wall Street Journal, investment managers such as Sprott Asset Management, and financial blogs such as Naked Capitalism (see links below). This shows up in the concessions being made to get deals done and regulators’ efforts to increase inflows. Of note: i) stock and rights offerings at substantial discounts to market prices, ii) offerings with ratchet clauses entitling new investors to be compensated with more shares if a subsequent share issue is done below their purchase price, and iii) Federal Reserve pushing to remove limits on stakes taken by private-equity investors.

That brings the financial crisis to a new and scarier phase. If regulatory capital requirements can’t be met through capital infusions, then it may be necessary to cut more deeply into loan portfolios – and that would have serious consequences for the real economy, i.e. lower business profits, more business bankruptcies, less investment, greater job losses, etc. The recession watch is by no means over.

One might suppose enough capital has been raised given the billions of dollars of paper already floated. But just as leveraging magnifies the upside, deleveraging magnifies the downside. For example, if capital requirements are 5 per cent, then a bank can leverage $50 million of capital into $1 billion of loans; just having $25 million of those loans (2.5 per cent) go bad cuts a bank’s capital in half. If that capital can’t be replenished (or assets sold), then, in theory, loans could be cut by as much as one-half to $500 million.