Yet More Stress Test Doubts

The unduly charitable coverage of the stress tests continues. Even though the New York Times does raise a few questions, it still features industry preening and misses some of the important lapses:

Industry executives reacted with jubilation, as if they had proved their critics wrong and passed the tests with flying colors.

“The results off the stress tests should put to rest the harmful speculation we have seen over the past few months,” declared Edward L. Yingling, president of the American Bankers Association, hours before the results were even made public.

Investors had already bid up share prices of the big banks in reaction to leaks about the results earlier this week.

Regulators and bank executives alike predicted that most of the institutions would be able to build up the necessary capital from private sources — either by selling off assets or by converting shares of preferred stock into ordinary stock.

Now on the one hand, the Times does get credit for distancing itself from the bankers’ crowing about the outcome. However, there is nary a word in the story about:

1. The fact quite a few of the banks negotiated their fundraising requirements down, calling the integrity of the process into question

2. No mention that the purpose of this exercise from the outset was to prove the banking system to be solvent. What kind of a test is that?

3. No mention that asset sales (the reason Citi was able to negotiate its fundraising down from $10 billion, and presumably others as well) are almost certain to be a non-starter.

In fairness, the Times did signal a couple of reservations:

But regulators gave the banks a break by letting them bolster their capital with unusually strong first-quarter profits and also by letting them predict modest profits even if the economy again turns sour.

By contrast, the Financial Times gives a dire report on the prospect for asset sales:

Some banks that require more capital after the stress tests will turn to asset sales to raise money, but their ability to find willing buyers is likely to be limited…

Branches and deposits, which are typically in great demand, will be harder to sell because of accounting implications, bankers say. Such assets usually are sold at a premium. But that would force bank buyers to take charges against earnings for the premium, which is difficult for banks already facing shortages of capital.

Some experts were concerned that a broad attempt at government-supported asset sales could result in another AIG-type situation, in which a sweeping effort to sell assets largely fizzled out.

Many banks have put their asset management divisions up for sale, for example, and attracted little interest. “The government made that mistake already lending money into M&A that didn’t happen,” said one adviser.

“There’s no M&A,” said one adviser. “People have got enough trouble working out their own stuff.”

Asset management operations are normally prized. If these aren’t selling, it’s doubtful anything will get unloaded at a profit (remember, a loss on book value would reduce capital).

The Wall Street Journal , in “How the Stress Tests Stopped the Market Bleeding,” depicts Geithner, the Fed, and Obama as saviors of the market:

Mr. Geithner successfully beat back criticism that the examinations were a political ploy, leaving much of the number-crunching to the Federal Reserve. The stock market regained its footing as consumer confidence crept back. And several major banks reported unexpectedly strong earnings for the first quarter, boosting confidence about their long-term health.

Yves here. Um, the only critic Geithner “beat back” were some of the bankers themselves. The stock market regained its footing because it was oversold and Citi and Bank of America said they’d had a good January and February. The consumer confidence numbers are stronger in no small measure because stock market movements are included in the computation! In fact, in the Conference Board’s release, the stock market rally was the single biggest contributor to the improvement in sentiment. Back to the story:

Investors fretted for weeks that the Treasury wanted to nationalize parts of the banking system, despite repeated efforts by Mr. Geithner and others to dispel that idea….

“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…

A number of analysts pointed out that shares in the 19 stress-tested banks now carry more upside potential than downside risk, if only because the government said in March it would allow none of the 19 firms to fail.

With that assurance in hand, said Brad Hintz, an analyst at Sanford C. Bernstein, the only risk facing bank-stock investors “is dilution risk” — the worry that a firm will need to raise new common equity, which hurts existing shareholders.

Investors “love to have a one-sided bet, and that’s the bet on the financial institutions,” Mr. Hintz said.

Yves again. The illogic is breathtaking. It has now become conventional wisdom that a bankruptcy is the only way to straighten out GM, yet there is no realistic plan for getting the banking industry into a configuration that reduces systemic risk or end incentives for banks to gamble with their now explicit government backstop or a realistic plan to clean up the bad assets (we do not believe the PPIP will succeed). Receivership for the weakest banks is a far better approach for taxpayers and the economy, yet the Journal is touting the line that what is best for incumbent bank management is surely best for America.

And Hintz is kidding himself if he thinks existing shareholders are not exposed to serious dilution, particularly from either nationalization or from debt for equity swaps. It’s way too early to be declaring victory.

Another Journal story did give a useful recitation of some of the stress test shortfalls:

It is hard to quibble with most of the government’s worst-case loss rates, which are calculated for this year and next. For example, an 8.8% loss rate for first-lien mortgages seems suitably tough, even when taking into account the aggressive underwriting during the housing bubble. The government’s 13.8% worst-case loss-rate for second-lien mortgages seems fair. But it is a stretch to think Wells Fargo, with its large home-equity book focused on stressed housing markets, will have a lower-than-sector loss rate of 13.2%.

The government may have been too optimistic in positing an 8.5% commercial-real-estate loss rate. This sector is just starting to fall apart, and defaults may move sharply higher as borrowers struggle to refinance loans…

The government’s earnings projections also need to be taken with a pinch of salt. It is optimistic to assume banks can repeat their first-quarter revenue generation, for instance. Given the Fed has unleashed a tidal wave of liquidity into the system, interest rates are going to be extremely volatile for several quarters, making bank revenue very hard to predict.

Another reason to be skeptical is few banks have to substantially increase overall levels of Tier 1 capital, which includes common and preferred shares, by raising new money. The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year.

Instead of immediately raising overall capital levels, some banks are just shifting the mix toward common equity — the highest-quality capital. Lenders that need to raise fresh money include GMAC, General Motors’ lending arm. Also, Wells Fargo’s offering of common stock, announced Thursday, suggests its overall capital will increase.

Finally, the government has effectively said it wants banks to have Tier 1 common stock equivalent to 4% of risk-weighted assets. First, investors have to decide whether they have confidence in the risk weightings.

Second, Tier-1 measures of capital leave out certain unrealized losses on securities that could become real later — something captured by tangible-common-equity ratios.

Then they must decide whether 4% — which still translates into 25-to-1 leverage — is safe for the unpredictable environment we are in.

And the other big shortcoming is that the securities and derivatives exposures at the big capital markets players (Citi, BofA, JP Morgan) were given the short shrift.

Originally published at Naked Capitalism and reproduced here with the author’s permission.

3 Responses to "Yet More Stress Test Doubts"

  1. teju   May 9, 2009 at 6:25 am

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