Stressed

America's 19 largest banks have spent the last couple of months strapped with wires, monitored by shiny steel machines and prodded with pointed instruments, huffing it out on treadmills owned and operated by the U.S Treasury Department. But as of yesterday afternoon, the so-called stress test of the U.S. banking system is over. And the results are in.

So, how'd we do? Before I get going, I should point out to the entirety of my loyal and trusting fan base ('Sup, Dave? Hey, where'd Lion go?) that when it comes to disentangling the labyrinthine language of financial regulation--to deciphering the various definitions of capital adequacy, the regulatory definitions and categories of equity-types, all those scary looking numerical charts--I, for the lack of a better word, can't. Not always anyway. So, for everyone's sake, without getting into too much of either the nitty or the gritty, how'd we do? The answer: I don't think it's really that kind of test.

First, tired treadmill metaphors aside, how did the Treasury Department and the Fed "stress" the banks? Unfortunately, it's not nearly as exciting as you might have expected. And I doubt you were expecting much. Maybe too simply put, the government looks at the balance sheets of these various banks and runs them through hypothetical scenario models. For example, let's say Dave Bank has only one kind of asset: loans to people named Sol. At the moment, what with the economy and everything, a lot of Sols are having trouble paying back their loans, so the default rate on Sol loan's is about 6%. The government looks at Dave Bank's balance sheet and says, "but what if things really went to hell?" The government wonders what would happen if the GDP growth fell by x-amount next year and unemployment rose by y-percent. It then estimates as best it can how those particular contingencies would affect the default rate on Sol loans, how that would affect Dave Bank's balance sheet, and where that would put Dave Bank on the solvent/not quite so solvent spectrum.

And here are the numbers presented in neat graphical form courtesy of the Wall Street Journal.

According to the government's "more adverse" scenario (more on that later), the overall short-fall in capital, the amount that these 19 banks must cumulatively raise in order to weather those "more adverse" conditions, is $75 billion. Of the 19 banks, only 10 are considered under-capitalized, and of those 10, Bank of America sits at the top (or at the bottom, depending how you look at it). Disproportionately so. B of A needs $33.9 billion, more than half the total estimated short-fall. Next in line is Wells Fargo, needing $13.7 billion, followed by GMAC for the bronze, which needs $11.5 billion.

So how nay the nay-sayers? The New York Times invited six people considered to be in-the-know to weigh in on the entire effort in blog forum format. On one side, you have the skeptical: Yves Smith of Naked Capitalism, Simon Johnson of every-god-damn-thing-lately but also Baseline Scenario blog, William K. Black, former bank regulator, and Bert Ely. In the middle, bravely offering no discernible opinion about anything, Douglas Elliott. And finally, offering a tentative thumbs-up, Alex J. Pollock and a dropping pin.

According to frowning majority, the entire approach was flawed from the start. Yves Smith, for example:

[T]he stress tests fell far short of the needed level of review. First, they were administered by the industry based on scenarios provided by the industry. Most observers found the “adverse” case to be too optimistic. Even worse, banks got to use their own risk models, the same ones that got them into trouble.

So it turns out the "more adverse" scenario really wasn't quite so adverse. Following up on that thought on a different site, Bonddad has put together a number of revealing graphs. I'd suggest any interested parties take a look, but for the lazy, a summary:

GDP is already performing more poorly than the Fed's stress test.
The worse case scenario for unemployment is the most realistic possibility.
Home prices are already closer to the Fed's worst case scenario than the median baseline forecast.
Bottom line: the worst case scenario is the most realistic scenario.

So kuddos to the Treasury for getting the patient with congestive heart failure to get off the couch. But a little jogging would have been helpful too. And according to Smith and then, scrolling down the Times' blog, William Black too,

Banks continue to overstate asset quality. The bankers pressured Congress, which extorted the Financial Accounting Standards Board, which gutted the accounting rules on loss recognition. Because there were no real examinations, there were no real stress tests.

Which is to say that regulators were accepting as truth the values of assets supplied by the banks themselves. If I ask Dave of Dave Bank how much all of his Sol loans are worth and he tells me that, well as a matter of fact, they're still pretty valuable all things considered, is this truly actionable information? Furthermore, as I mentioned briefly in a previous post, the stress test began with the initial assumption that derivatives and other assets of a bank's trading desk were less risky than individual home loans. Since larger banks and financial institutions tend to have disproportionately large trading desks, this constitutes a built-in bias towards the too-big-to-fail and against perhaps significantly more viable regional banks.

The capital requirement posited by the Treasury now that the stress test is over is that each one of these banks must raise Tier 1 common stock equivalent to 4% of all the risk-weighted assets of the bank. What does this mean? Tier 1 common stock is just the standard kind of stock one might purchase of any company. Why is the government focusing on this category of equity specifically? It's seen as the most safe form of capital for the bank. If the bank comes upon some unexpected losses, it is the common stock cash that gets wiped out first. The more common stock a bank has, the bigger its proverbial cushion.

At the moment, most of the big banks are currently planning on issuing more stock to raise the money. The market is, go figure, welcoming this announcement with open arms and higher share prices. I suspect the enthusiasm is coming very much from the fact that the Obama administration, with the publication of the stress-test, has implicitly (maybe explicitly at this point, I haven't been keeping track) pledged that no bank will fail. In fact, a fair amount of this capital is expected to come from a simple accounting maneuver conducted by Uncle Sam. Much of the TARP money came to these banks in the form of "preferred shares"--less risky and easier to get out of for the investor than common stock. But all those preferred shares can be converted into common equity and--POOF!--, in a cloud of financial wizardry, the banks are capitalized. Not being a financial wizard myself, I fail to see how this actually helps the banks. One kind of equity moves from one part of the balance sheet to the other and a regulatory standard has been met through a loophole. All snarkiness aside though, I could legitimately be missing something in this.

In any event, I suspect the sweaty-palms of the market will dry as soon as investors wake up to the fact that these new shares are diluted in value and that the banks themselves aren't out of the woods as the economy scrapes the bottom of the barrel. After all, even if all the banks do manage to get together the 4% equity, even if we assume the TARP switch-a-roo is somehow helpful, even if we do trust the in-house risk-weighting of these assets, 4% is still only 4%. That translates into a 25-to-1 asset-to-capital ratio (leverage).

What about the positive news in all of this? There is the faintest of clues that Obama is beginning to consider other options.

It’s not that Barack Obama isn’t aware of what’s at stake. That’s very likely why on April 27, the president gathered in some of his chief outside economic critics —including two of the most vociferous, Nobelists Joseph Stiglitz and Paul Krugman—for a secretive dinner in the old family dining room of the White House. Also in attendance: Paul Volcker, who has one foot in and one foot out of the administration as the head of Obama’s largely cosmetic economic recovery board; Princeton economist and former Fed vice chairman Alan Blinder; Columbia’s Jeff Sachs; and Harvard’s Ken Rogoff. Representing the home team, as it were: Obama’s chief economic adviser Larry Summers, Treasury Secretary Tim Geithner and Chief of Staff Rahm Emanuel. Why did Obama hold the meeting? “I think he wanted to hear the [opposing] arguments right in front of him,” says Blinder. “All I can say is if the president of the United States devotes that much personal time, and it was about two-hour dinner, he must want to hear what people outside the administration are saying and hear what his own people say in rebuttal to that. Why would you do that if you aren’t at least turning over your mind what to do next?” (source: Newsweek)

Well, we can all dream anyway.