Debt for Equity - not liabilities to governments

There is a concern that banks have stopped lending. Is this because there are no solid borrowers or is it because lenders have lost faith as a result of arbitary changes to property rights and bankruptcy laws?
Banks will not advance money if they no longer see the equity of the borrower taking the first hit. If there is no first hit to be taken, then the banks must assume that they are pari passu with equity holders.
The main problem facing markets is that banks are facing immediate heavy losses arising from derivative financial contracts. Banks balance sheets are not designed for catastrophic losses of equity, but they can absorb up to 10% to 15% total losses on their loan book over say 5 years. This is equivalent to a 50% to 66% recovery on a bad loan book equivalent to 30% of the total loan book. Banks with non-performing assets = 10% of total assets will struggle. If the ratio reaches 20%, the bank will most likely fail.
For example, assume a typical bank with common equity of 6% of assets and a pre-tax, pre-provision ROA of 3.5%. If in any one year 15% of the loan book is non-performing then ppROA will fall to say 3%. Provisions and losses at 33% of these NPA reduce overall ROA to 0% and eat into equity to the value of 2% of assets, reducing equity to 4% of assets. The bank has an equity issue of say 1 new share for every one held but as the Price to Book Value will be <<1.0x, say 0.5x, the equity base only recovers to where it was before, at 6% assets.
If the same happens the following year, then shareholders will once again need to chuck money at the bank equivalent to 2% of the asset base until the problem eases.
But if I don't recover 67cents on the dollar and/or if the NPA ratio is higher, then the equity will be depleted by much more than 2% of the asset base. In addition, the ppROA will be adversely impacted by funding costs and the price to book ratio, ahead of the new share issue, will be even more bleak.
The forthcoming settlement of AIG, Fannie & Freddie, and Lehman CDS contracts means that we will get some market clearing prices on the bad assets. Then buyers and suppliers of capital will magically reappear because the calculations outlined above can be done with more certainty.
However, bank recapitalisation also requires time. As alluded to above, banks take the hits year by year and that is because the work out of loans or recovery of collateral are also time consuming processes. Furthermore, as these bad loans were "held to maturity" assets, and thus valued with some discretion, the banks had a chance to blend internally generated capital and external equity injections to restore the bank to rude health.

By contrast, the upcoming CDS auctions could be traumatic as we are trying to estimate in a few days the recovery value of the assets and the liabilities of four intertwined businesses. This is before the people now controlling the failed entities have barely started work on assessing the real assets of the businesses.

Unfortunately there is massively more value in the CDS being settled by auction than there is in the real assets of the business. Maybe 10x more derivatives traded than underlying assets, maybe much more. Mispricing the CDS values by 5cents on the dollar is equivalent to being 50% wrong on the value of the real assets.

But unfortunately the market price established will need to be used by the banks and this will almost certainly throw up some permanent impairments to their "held to maturity" loans. The chance for banks to smooth their way back to profits will have disappeared.

There seem to be three routes forward assuming banks remain in the private sector;
i) BIS and/or Fed relax the banks' capital criteria,
ii) another major overhaul of mark to market accounting is required or
iii) creditors take equity.

The purest route forward to offset the instant value destruction derived from the CDS auction would seem to be the creation of instant equity. In other words, there must be a mechanism for the instant swap of debt for equity.

But such changes cannot happen if governments have guaranteed all non-consumer deposits and liabilities, or if indeed the government has already split the balance sheet up.

As noted earlier, banks, in effect, already believe that they are no better off than equity holders which is why they are not lending. However, it is not the uncertainty of the credit market that makes holding equity unattractive but the unpredictability of government actions with respect to any holder of a bank liability.

At least with another bank's equity in their pockets, a bank then owns (albeit a very large amount) a homogeneous, transparently-priced security for which there is a liquid market - as long as the government doesn't interfere.

And finally, the conflict between going concern principles and fair value accounting can, in my view, best be resolved if liabilities are valued at the higher of par or market value. (Pension liabilities should be discounted at long-term government bond yields). There would need to be a balancing quasi-financial asset, but at least the ridiculous state of affairs where a struggling bank can show an enhanced equity valuation because the market discount to par of its own capital instruments are credited to equity, would disappear.

Invexit