The Diamond Blog

The Texas Ratio is used to determine the health of banking institutions.

When the examiners add all of a bank’s tangible capital plus the bank’s loan loss reserves, then divide that total by the sum of the bank’s non-performing loans, banks typically fail if that ratio climbs over 100.

There are two basic things that a bank can do control their Texas Ratio to stay alive. Increase deposits, or dump non-performing loans.

When a bank accepts a short sale (takes less than the amount of the mortgage balance in order to get the loan off their books) two things happen:

1. The non-performing loan is gone and deducts from one side of the Texas Ratio.

2. The bank gets cash which adds to the other side of the Texas Ratio. The short sale increase tangible assets (cash) and gets rid of a non-performing loan at the same time.

It is the same if you needed to raise cash at home and start selling off your assets, such as selling your $20,000 car for $10,000. You raise cash and stay alive for awhile, but pretty soon you run out of assets.

Same with the banks. As they keep selling off things for a loss, a different factor kicks in. When liabilities exceed assets that is called bankruptcy. So they can’t sell off too many assets at a loss. It is a fine balance. Some juggle successfully and stay alive, and some don’t.

Another juggle maneuver to stay alive is for a bank to increase the amount they pay for savings accounts and CDs (increase tangible assets = cash). Sometimes a sign that a bank that is about to fail is when they are paying depositors noticeably higher rates than the marketplace average. A desperate move to increase cash to help their Texas Ratio.

But, then their cost of goods (money) starts to erode the banks profit margin. That is the difference between what they pay for money and what they sell their money for (loans). Then another factor kicks in, since a business can only operate unprofitably for a limited amount of time, the reduced profit margin helps them go broke.

This is why so many banks have failed recently. Their nonperforming mortgages drove their Texas Ratio too high, and they couldn’t increase tangible assets or decrease non-performing loans fast enough.