Stress? Don’t Worry, Be Happy!

By Jeff Harding       

I wasn’t going to report on the bank stress tests because I saw it as political theater rather than as anything significant. I knew it wasn’t going to be a rigorous test. It’s like the physical education requirements in public schools where they have lowered the standards to pass the weakest kids. (Look, Little Timmy can do a push-up!) The Saturday Night Live skit on Tim Geithner, (see below in this blog), echoed my thoughts.

Then I read the article in the Wall Street Journal on how the banks jawed the Fed until they got concessions on the tests:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests’ rigor.

[Emphasis added]

If the banks can talk the regulators into changing the test standards, as opposed to challenging mathematical errors or incorrect assumptions, then there are no standards except those which meet political requirements.

Senior government officials said the stress tests were as much about bringing confidence back into the banking system as they were about the banks themselves. They also felt that by preparing banks for a “worst-case scenario” with an abundance of capital, they could actually avoid such a scenario.

The whole purpose of this exercise was not to properly examine bank solvency, but to deem them solvent and boost the public’s confidence in the banking system. They didn’t use a stricter test because if the banking system failed, they were worried about the collapse of the banking system:

Concerned about investor and depositor panic, government officials have said banks needing more capital should not be viewed as being at risk of collapse. In fact, the government has said it would not allow any of the 19 banks undergoing the test to fail.

Just to give you a “for instance,” Yves Smith at Naked Capitalism notes that Citi has about $500 billion in foreign deposits. If the depositors sniffed a systemic collapse and caused a run on Citi, the government would be forced to back up their deposits. Add that guarantee to all the other guarantees …

Therefore, it makes political sense to construct a stress test that isn’t too stressful so that banks will pass the test and not start a run on banks. In this case the 19 banks chosen for the test did pretty well. Ten of the 19 banks were required to obtain $75 billion of new capital. Of that total, Bank of America needs $34 billion, GMAC needs $11.5 billion, Citi needs $5.5 billion, and Wells Fargo needs $13.7 billion.

Why do they need more capital? According to the government:

“Banks are being told to boost their capital not because they are in trouble, but because regulators think they don’t have a big enough buffer to continue lending if the economy worsens in coming months.”

What? Is this not Orwellian Doublethink where we are expected to believe two inconsistent statements at the same time?

These tests are now seen as a turning point in the economy. Why? Because the government says it is. Here’s how the Wall Street Journal put it:

In retrospect, the tests were akin to hitting the pause button. The period allowed Mr. Geithner to buy time for the government’s evolving approach to the banking crisis, which had previously been ad hoc and heavily criticized.

“Obama stopped bashing Wall Street. They are learning that it’s better to have the market at 8000 than at 6000,” said Paul Miller, a banking analyst at FBR Capital Markets, in reference to the level of the Dow Industrials.

In early April, only a few weeks after Citigroup Inc.’s stock closed at $1.02 a share, President Barack Obama said he was starting to see “glimmers of hope” in the economy. Fed Chairman Ben Bernanke’s assessment of the outlook also has improved over the past several weeks.

Be assured that the banking system is not as healthy as the government insists it is.

There are six important test flaws you need to know about. Much of this analysis comes from Yves Smith at Naked Capitalism, from Calculated Risk, and other sources.

The first flaw is in the measure of the financial strength of a bank. There are several tests but the ones commonly used determine what would be left over for the common shareholders if the bank were to be liquidated. The test they used to measure this is Tier 1 Common Capital. Although they said they were going to use the more rigorous standard of Tangible Common Equity (TCE), they didn’t. The difference between the two is that Tier 1 counts as assets common stock, preferred stock, and deferred tax benefits. TCE is based on common stock only. Obviously the Tier 1 capital base is larger and you will look better than with TCE. I believe that TCE is more significant if you are going to measure the real problem, which is the amount of debt they have relative to their capital base. Here is a good chart done by the Journal to show the difference:

Just look at this list. It’s shocking. What it says is that Citi’s TCE is less than 2%. You may recall that Citi took $45 billion in TARP money to keep them afloat.

According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks’ cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.

The second flaw is the fact that the estimates of asset values were based on the banks’ own risk models. According to the NY Times:

They also use banks’ own estimates, meaning unscrupulous managers could tweak them to get a better grade. And bankers say they’ll produce very little information that regulators don’t already have. … That regulators are wrangling with banks over the results of these tests shows that they are not confident in their ability to understand the institutions. That gives banks too much power because regulators are forced to rely on many of their assertions about, say, complex products’ values. It would be better for watchdogs to demand that they reduce their complexity to comprehensible levels. Otherwise the banks will retain the upper hand and no amount of testing will be sufficient to diagnose their problems.

The third flaw is that banks were allowed to use earnings and pending transactions to mitigate the need for additional capital.

 US banks have been given government assurances they will be allowed to raise less than the $74.6bn in equity mandated by stress tests if earnings over the next six months outstrip regulators’ forecasts, bankers said. … During the tests, policymakers made adjustments after first-quarter operating revenues were stronger than forecast, reducing demands for equity by nearly $20bn compared with original estimates based on data for the end of 2008.

In other words, sales of assets that are “pending” (not completed) and promises of future earnings will count in the Tier 1 calculation. As a result of banks jawing the Feds, Bank of America’s requirement was lowered from “over $50 billion” to $33.9 billion, Wells’ from $17 billion to $13.9 billion, and Citi’s from $35 billion to $5 billion!

The fourth flaw is that the government’s “worst case” assumptions about the future of the economy may not be adverse enough. Here are their standards:

As you can see, their “worst case” scenario for unemployment has already been exceeded (8.9%), and in my opinion, is still on the way up. They assume GDP will be down only 2.2% in 2009, and then turn positive 2.0% in 2010. GDP was down 6.1% in Q1 2009, They are counting on “green shoots.” As to housing prices, their “worst case” scenario may be close to the mark on this.

As I’ve mentioned in the past, this kind of stuff is just guessing about the future. But, based on the underlying problems, I believe these assumptions to be rosy.

The fifth flaw you need to know is that their assumptions about defaults on commercial real estate are too low. They use a “worst case” scenario that 8.5% of their commercial loan portfolio will default. As noted in the Financial Times:

Experts anticipate that commercial real estate prices will drop another 20 per cent – on top of the 30 per cent drop so far. “There are two revaluations going on,” said Michael Pralle, a veteran real estate investor. “The risk premium is going up, the cost of debt is going up and the amount of leverage available.

This is a drop in the bucket since most of the commercial real estate loans are on the books of regional banks, not the Big 19. The combination of declining rents, loans coming due or being reset, and rising cap rates will require a huge amount of new capital to be raised by mortgagors. My guess is that the loss ratio will be higher than 8.5%.

The sixth flaw is that the exposure to derivative losses is greater than bank loan exposure. Here’s what Yves Smith from Naked Capitalism says:

There is another way the stress tests fall short. As was revealed earlier, the tests are focusing on bank loan exposures. Ahem. The real risk to the system is not in not-too-difficult to value (and sell) loans, but in the complex dreck and derivatives exposures at the big capital markets players, namely Citi and Bank of America. …

It’s the capital markets firms that pose the real systemic risk. The powers that be still have yet to develop procedures for an orderly resolution. The reason being that their large trading books depend on ongoing credit from counterparties; if a firm is put into receivership or bankruptcy, a counterparty can’t continue to trade with it (otherwise, it gets downgraded. So when a big trading firm gets into trouble, counterparties are fast to shut off credit, putting the firm, a la Bear, into a death spiral.

This is what the PPIP program was all about: get these toxic assets off the books of the banks. Haven’t heard too much about PPIP lately. As I’ve pointed out before, these assets can be valued, but the banks don’t want to do this because the values, if marked-to-market would render their asset bases much lower than they already are.

What does this leave us with?

Many of the big capital markets banks are insolvent by any decent measure of financial responsibility. Only because of TARP money do they remain solvent. Thus what we have here by these stress tests is largely eyewash. The Obama Administration is afraid that without the happy results they falsely achieved, we would lose faith in the banking system and the whole thing would collapse.

Maybe they are right to be afraid. Years of risky banking practices are one of the factors that have led us to where we are today. Many of these banks should fail. It’s the best way to reallocate capital away from these poorly run businesses into banks that know how to make money, safely. 

In a brilliant opinion piece in the Financial Times, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, says that many of these banks should fail. He notes the moral hazard issue of supporting failed institutions, and the fact that these companies have been given a competitive advantage. He notes:

 Failing effectively to resolve these non-viable firms has long-term consequences. We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Thank you Mr. Hoenig.

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