Banks Won Concessions on Tests

And presto! This is how a failing and insolvent bank is made to look healthy and viable. “Why?” you ask. I’ll be damned but it sure looks like they just need to make some bond holders whole before they let the whole thing imploed in one last spectacular ball of fire that will consume whatever wealth and assets may be left to consume.

For a more sober assessment, here is Hussman. If you don’t want to read the whole thing, here is the essential excerpt. This is from someone that knows that of which he speaks, as opposed to some Italian freak sitting in some obscure country with too much time on his hands typing away at an $800 computer…

” […] Last week, financial stocks enjoyed a powerful advance and short squeeze on the announcement of the results of the “stress test” of major banks. It is important to begin by noting that this was not a regulatory procedure with teeth. It was initially a response to Congressional demands to introduce greater objectivity into the use of public capital for these bailouts, and gradually morphed into nothing more than a “confidence building” exercise. And keeping with the emphasis on keeping the numbers happy, as opposed to providing full and fair disclosure, the Wall Street Journal reported on Saturday, “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.”

To some extent, it is not possible to get full and fair disclosure using the method that regulators used in the first place, since it relied on banks’ self-estimates of their potential losses in a further economic downturn. These of course being the same banks that made the bad loans, and have already proved themselves vastly incapable of loss estimation and risk management. Moreover, the Fed only asked for loss estimates for 2009 and 2010, not beyond – “Each participating firm was instructed to project potential losses on its loan, investment, and trading securities portfolios, including off-balance sheet commitments and contingent liabilities and exposures over the two-year horizon beginning with year-end 2008 financial statement data.” This period specifically excludes the window where we can expect the majority of “second wave” mortgage losses to be taken, as it does not capture any losses that will emerge as a result of mortgage resets from mid-2010, through 2011, and into 2012.

The “stress test” procedure also conveniently excludes any potential mark-to-market losses during 2009 and 2010, as banks “were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (‘cash flow losses’) rather than discounts related to mark-to-market values.”

Now, just think of this for a minute. Even if you assume that the “risk-weighted assets” of the banks are about two-thirds of their total assets (as the stress-test does), we’re still looking at $7.8 trillion in total assets at risk in these banks, and despite being on the edge of insolvency only weeks ago, we are asked to believe that they will need less than 1% of this amount – $74.6 billion – of additional capital even in a worst case scenario. How do the stress tests arrive at this conclusion? 1) They underestimate potential losses by minimizing the horizon over which the losses would have to occur, excluding potential mark-to-market losses and restricting the loan losses to “cash flow” losses only; 2) They define capital well beyond tangible sources, to include about double what is available as Tier-1 common; 3) They include $362.9 billion in “resources other than capital” – essentially pre-provision net revenue expected to be earned by the banks over the coming two years to absorb potential losses; 4) They report the capital buffer that would be required after massive dilution in the common stock of these banks has already occurred.

As an example, Citigroup comes in with $119 billion in capital ($22 billion as Tier-1 common). Total assets are over $2.1 trillion, but the stress test assumes “risk weighted” assets of less than half that. Citi projects losses in 2009 and 2010 of $104.7 billion in a scenario where the unemployment rate reaches 10.3%. Citi assumes that it will earn $49 billion during that period which would partially absorb those losses, and that it will obtain $87 billion in Tier-1 from other capital sources, presumably including $33 billion of preferred that it would be willing to convert to common. Of course, Citi’s entire market cap is only $22 billion, so the “$5.5 billion” that Citi is reported to need under the stress test is what it would require after a 5-to-1 dilution in its common stock (87+22/22). Essentially, we’ve got a company with a common equity buffer of just over 1% of total assets, that just 8 weeks ago was on the verge of receivership, and investors are urged to believe that there are enough voodoo dolls in the vault to make the company solvent even in a further weakened economy.

Great. Then no more government money should be needed. Outstanding. Not a dime more of public funds beyond what remains in the TARP. No need to use public money to buy toxic assets either. Believe me, I would be overjoyed if the madness of public bailouts of private bondholders was to stop. Unfortunately, I don’t believe it for a second, because our regulators have clearly demonstrated that they do not want accurate public disclosure of losses (witness Ken Lewis’ testimony a few weeks ago, the watered-down mark-to-market rules, and the “negotiated” results of the stress test). Our regulators want confidence. And they’re willing to fudge the numbers to get it. If there wasn’t a freight train of additional mortgage defaults coming, perhaps confidence building would be a good thing. As matters stand, encouraging confidence is equivalent to encouraging investors to throw good money after bad.

As for bank equities, it is problematic to treat the stocks simply as a discounted stream of future cash flows, because when capital cushions become thin, the only way to properly value these stocks is to treat them like options with an absorbing barrier at zero. Indeed, that is how bank stocks have been trading lately – not as equities, but as option-like securities. I doubt that investors in these companies fully recognize the potential for the spectacular advance in these stocks to vanish if the current confidence about bank balance sheets is not sustained. Meanwhile, we can expect an immediate rush by banks to capitalize on the recent advance by heavily issuing new stock, which would be fine, except that the quality of disclosure is in question. Investors should be sure to read the offering documents carefully. […] “

Read the whole article here:

If you have time, you’d be well advised to read a number of Hussman’s previous weekly notes. Hussman is one of the clearest thinking money managers around; he is articulate and well versed in the arcana of finance.


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One Response to “Banks Won Concessions on Tests”

  1. Forex Market Buzz - March 19 | Forex Detailed Articles Says:

    […] Banks Won Concessions upon Tests […]

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