Stress Test: Tangible Common Equity, 3/31/09

Ahead of official announcements regarding stress test results, OA thought we’d publish our latest update for banks’ tangible common equity, a metric that is likely to figure prominently.

A recent Reuters report said “U.S. regulators want the top 19 banks being stress-tested to have at least 3% [TCE].”  In other words, regulators want leverage ratios below 33x.*  Surreal, no?  That the banking system has grown so bloated that 32x leverage can be considered “healthy?”

(For a tutorial on TCE, go to this post and follow the links at the top.)

Anyway, using the 3% Test, the results for the nation’s nine largest banks are mixed…..four pass, five fail.  And by the way, this is before “stressing” the balance sheet per future “adverse” scenarios.  As you can see, most banks fail the test before they even sit for it…

(Click to enlarge)


To be clear, this is not a prediction of the government’s verdict.  As Jack Ciesielski of The Analyst’s Accounting Observer points out: “there is no iconic definition of TCE.  Treasury may come up with one of their own that takes into account questionable items” so that all the banks pass.  That would be totally consistent with early reports

The banks themselves have varied definitions of TCE.  The measure is supposed to be the true acid test of bank capital, which means it should be calculated conservatively.  ALL intangible assets have to be backed out.**  To calculate the TCE Ratio in the highlighted column, I’m using a very conservative calculation.***

Banks’ own methodology for calculating TCE varies.  My calculation is in the “Tangible Common Equity Column;” banks reported figures are in the “reported TCE” column.  The “% overstated” column is meant to show which ones have taken the most liberties with their internal calculation.  (Interested parties can contact OA via e-mail to purchase our data set containing more detailed info about each bank’s calculation methodology, as well as quarterly TCE data and Level 1/2/3 assets dating back to Q1 ‘08.)

A huge caveat with this data is that each of these companies has off-balance sheet commitments.  Some of them huge.  And many have big chunks of “other assets” on balance sheet, some of which may be intangible.  When there is disclosure for these, it varies.  So to keep the data consistent, both are excluded.  Hopefully the stress testers got a decent view of these risk buckets in order to factor them into results.

Incidentally, I added the right-most column in order to give readers a sense for the degree of vulnerability on the asset side of bank balance sheets.  Level 2 (”mark to model”) and Level 3 (”mark to myth”) asset values are the ones over which management has the most discretion.  These days management can’t be trusted so it’s  bet that those with the biggest discretionary buckets—JPM, BofA, C—are the ones sitting on the largest losses.


*(3¢ of TCE for each $1 of tangible assets = 33x leverage)

**All the banks fail to back out mortgage servicing rights from TCE, even though these are intangibles under GAAP.  Some banks (BofA, Wells, Chase) have substantial MSRs, others (GS, MS) don’t.  Some banks add back “def’d tax liabilities” related to intangibles (BNY Mellon, Wells, Chase, PNC).  This is not conservative.  Two banks (Wells, PNC) goosed TCE by reclassifying “noncontrolling minority interests” from liabilities to equity.

***TCE = shareholder’s equity (excluding noncontrolling minority interests) – goodwill – intangibles – preferred – MSRs.

Fair Disclosure: OA has short positions in companies mentioned in this post

Originally published at Option ARMageddon blog and reproduced here with the author’s permission

2 Responses to "Stress Test: Tangible Common Equity, 3/31/09"

  1. rfreud   April 30, 2009 at 2:14 am

    Distressed About the Stress Tests!Our government needs to start acting like it is the senior creditor of the banks, which it is by virtue of deposit insurance and more recently bond insurance via the FDIC.The amounts at risk far exceed the bailout programs.What we want to know from our bank Supervisors is how they assess that risk, rather than the results of a self-administred “stress test” using insanely optimistic assumptions.Do the good, readily marketable, unimpaired securities and loans on the banks’ books exceed the amount of insured deposits and loans? This is a key question.What is the ratio of money-good securities and loans to the liabilities to depositors and bond holders that the FDIC has insured? Unequivocally good assets to senior liabilities is more important right now than tangible assets to total liabilities or the ratio of tangible common equity to total assets, which is the same thing.If the bank were to be closed today, how much money would the FDIC have to pay out to make good on the insured deposits and bonds?How big would be the pile of assets that goes into the PPIP or some other Federal junk yard awaiting scavengers?Keep in mind that if the Federal Deposit Insurance Corp. runs out of reserves to pay claims (which are accumulated from insurance premiums paid by banks), Congress is obliged to appropriate funds to make up the shortfall.If, to be safe, a safety cushion of 20% of the amount insured by the FDIC is required, that is the amount of additional capital a bank needs to raise before it can be deemed healthy.The regulatory power of the FDIC is different from that of other Federal Agencies. Its power to seize a bank stems from its rights of subrogation as an insurer when it steps into the shoes of a creditor whose claim it has paid. From this point of view, an FDIC bank seizure is similar to a foreclosure–triggered not by a payment default but by a capital shortfall, meaning an excess of liabilities over assets (instead of the other way around).Until the FDIC’s exposure is safely above water, payments to any creditor or stakeholder with a claim on assets junior to that of the FDIC will have to be suspended. This action is within the purview of the FDIC’s regulatory power.Suspension of distributions will cause the profits earned by the bank to be retained within the bank as an addition to capital until the FDIC’s exposure is normalized.How each bank will manage this suspension of payments to creditors is best left up to its management and various classes of stakeholders. Conversion of debt to equity or raising new capital in the form of equity or debt subordinated to the FDIC’s position, merger, sale of operating units or assets–there are various possibilities. A bankruptcy court may provide a useful forum to sort out competing claims. The senior creditor, especially a senior creditor willing to advance new money, has only to demand that in fairness, the new money and the senior money gets taken care of before anything else.The temporary suspension of distributions to junior creditors doesn’t have to signal insolvency to the bank’s counterparties, especially if the US Government continues to insure deposits, guaranty bonds, provide ample liquidity and subsidies to profit-making like those recently visible in Q1 reports of profits from mortgage refinancing and trading.Inside the banking system, there is a daily exchange of deposits bought and sold, or loaned and repaid, as banks manage their surpluses and shortfalls of money relative to demands for disbursements. Among banks, there is a daily settlement of payment claims, as checks clear for one instance. Magnifying these functions of banks, they can be seen to be counter-parties engaged in a daily “re-risking” or repricing of credit default swaps with one another. “I lend you my deposit for one day,” says one bank to another, “and my fee or interest rate reflects my assessment of the risk that you might not pay me back.” If I can’t get comfortable with a quick assessment of your capacity to repay me, I won’t lend you my deposit at any price.Since last year, Geithner, Paulson, Bernanke and others officials have been concerned that the world interbank system of transactions will fail, with cataclysmic consequences. A lot of what has been done, in response to the crisis, has been intended to send a message that the US is standing behind its banks, which are among the largest participants in this system.The good thing about the stress test exercise is that it brings some rationality and transparency to this effort to support the banking system, where, on an emergency response basis, no such criteria existed before.The ratio of tangible common equity to assets is now being used as a scorecard to measure the results of the stress test in terms of capital inadequacy. It is in effect being proposed as the litmus test of creditworthiness in interbank markets. Heretofore, tangible common equity to assets was understood to provide no more than a good “down and dirty” estimate of capital adequacy using figures readily available from published financials. It can only work that way when asset valuations are not volatile and when wishful thinking re: impaired assets has immaterial consequences.Neither TCE/Assets nor the stress tests results should be confused with a thorough-going assessment of a bank’s financial condition. They leaves too much to dispute as to valuation and what should be included or excluded on both sides of the balance sheet. The TCE/Assets ratio can be gamed by converting debt to equity and by overestimating the value of impaired or questionable assets.The focus on the ratio as a hurdle, where 3% is a passing grade, obscures the fact that a bank of $100 billion in assets and a 3% ratio of tangible common equity to assets will, by definition, have $97 billion in liabilities. That is not much of a cushion in a period when the weather around asset valuations is uncertain to stormy.Government support for banks going forward should be centered on FDIC insurance for bonds in order to give the banks plenty of low cost money for lending and plenty of opportunities to make profits. When the guaranteed loans are repaid, payments to junior stakeholders can resume. A program crafted to stimulate lending would likely meet with success in Congress. Our chances of a decent economic recovery and the effectiveness of fiscal stimulus continue to be at risk of being blunted by a poorly functioning banking system.Outrage over compensation of bankers, outrageous as it has been, is a distraction from the monumental challenges we face. The problem can be solved by paying reasonable cash stipends and outsized bonuses in the form of future participation in recoveries on impaired assets.All the talk about nationalization of banks and conversion of debt increases rather than decreases anxiety about banks. The government has effective tools it is not using.

  2. Guest   May 1, 2009 at 8:15 pm

    Stated by commenter “Neither TCE/Assets nor the stress tests results should be confused with a thorough-going assessment of a bank’s financial condition. They leaves too much to dispute as to valuation and what should be included or excluded on both sides of the balance sheet. The TCE/Assets ratio can be gamed by converting debt to equity and by overestimating the value of impaired or questionable assets.” —Essentially gaming.”“U.S. regulators want the top 19 banks being stress-tested to have at least 3% [TCE].” In other words, regulators want leverage ratios below 33x.* Surreal, no? That the banking system has grown so bloated that 32x leverage can be considered “healthy?”” — this could be a temporary measure, they can improve this in 2010.I dont agree that FDIC is a solution, it is a safeguard, and an insurance protection, it shouldnt be considered a solution, no one should push the “foreclosure” of any of the top 19. I dont think it has been seen in history when institutions that carry so much responsibility, and are at the core of economics system fail on this scale. Has anyone really assessed the consequences of the top banks failure? $1-5 trillion liquidation? what a mess. If the Feds are in support of keeping them viable, and running, maybe that should be a signal. FDIC should signal to depositors that to not be overwhelmed, by bad news in the economy. That they are a last resort, if nationalization is not an option, And investors should be eased that the feds, treasury are working tirelessly to prevent failures from occurring. The 3% TCE ratio as a measure shouldn’t be confused with actual operations, the banks are still viable, and none that are below the 3%TCE mark want to be there. Thus, setting a time scale of when the re-capitalization period should take place. That figure was taken in 12/31/08, today’s figures are probably different since the treasury changed its holding.The reality is that we are not out of this storm, the banks need to be structured to take on the rest of the storm. There are other fall outs that the banks will have to face, from corporate defaults side of banking, if exports and imports continue to be restricted by the credit squeeze, smaller companies failing (recession), more mortgages falling it to foreclosure due to layoffs. It can easily unwind.Brisk decisions, and panic are a way to increase the problems. I am sure that the Fed has a worst case scenario plan in their laptops, its probably the first plan that they put together. “The government has effective tools it is not using.” I do agree with this, I wish this comment elaborated on the tools not being used.———”To be successful over the long run, systemic bank restructuring should employ measures which are “cost effective and simple to implement, distribute losses equitably, aim at minimizing the burden on the public sector, avoid generating future moral hazard problems, [and] promote good governance.”15The legal framework for systemic bank restructuring can be separated into four linked elements: A) Restoring Confidence in the Banking System, B) Establishing a Legal Process for Government Intervention, C) Establishing a Mechanism for Intervening Failed Banks, and D) Establishing a Mechanism for Maximizing Recovery on Non-Performing Loans.”And: am not in support of nationalization, but I am warming up to the notion if the recession begins to become unmanageable.But that is an “if this, then” scenario.