Sunday, May 24, 2009

Two Problems with the Stress Tests

Original Link:

By Alan Schram

Treasury Secretary Timothy Geithner defended the decision to examine 19 of the nation's lenders by saying the goal of testing the banks was to "replace uncertainty with transparency."

I have two problems with the stress tests:

One, I don't trust them. These stress tests were probably designed to come up with a dollar figure below the $110 billion left in the TARP and already approved by Congress. Secretary Geithner does not want to repeat the PR disaster of last October. He wants to be able to declare that big bailouts for the banks are over.

And indeed, it looks like ten of the country's largest banks will need to raise about $75 billion in new capital, which happens to be less than S&P's capital shortfall estimates of $120 billion.

Second, a one-size-fits-all, checklist type test is destined to be very lacking. Banks are different in their capital positions and loan exposures. In that context it is interesting to note that the market does not seem to pay nearly as much attention to capital ratios as the Treasury department does. For example, as of yesterday, seven banks were trading at discounts to their equity values (Citigroup, Regions Financial, Capital One, Fifth Third, SunTrust, Bank of America and KeyCorp), indicating that shareholders are concerned about their financial positions. Meanwhile, eleven banks were trading around or above the value of their equity, implying shareholders feel they are safe.

But those latter banks have worse tangible common equity than the banks in the first group (with the exception of BofA and Citigroup). It logically follows that the stock market cares more about their ability to earn money going forward, which I believe is the correct judgment to make.

Most banks can probably survive without further capital as long as they are not forced to mark their loan portfolios to market. If forced to mark loans to their current distressed prices, almost all banks would prove to have no equity left. With their loss reserves insufficient to absorb the losses, they will be essentially insolvent. However, those losses happen over time, and so if they allowed not to mark-to-market, they will be able to build back their equity capital. After all, with low interest rates business is booming, and most banks are now perhaps more profitable than they have ever been.

Fortunately, the markets seem to believe the stress tests. If the economic data continues to be positive, this may prove to be a brilliant move by the Treasury. But if the data gets worse, and if you examine the housing market doldrums you might be tempted to believe it will get worse, then we will have to go back to square one on the banks bailout.

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