Two Problems with the Stress Tests

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.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[andygaus]

Little news item here on 5/11: Washington Mutual is moving all its loans to Chase. People with loans in process are being told that they can withdraw their application or expect things to pretty much start from scratch. Call 866-272-1823 x 4622799 for a sample of the recorded message and the information that no one is or will be available to speak to you about this move for some time.

[liecatcher]

Can a hedge fund manager commenting on banking & finance problems be objective?

I believe the answer is no.

After reading Mr. Schram's comment from a previous blog in which he states:

"I believe that at the root of the problem is the Federal Reserve's monopoly power to determine the money supply. Facing no competition in supplying dollars, the Fed sometimes behaves irresponsibly, usually without even being cognizant of it at the time. "

While the privately owned FEDERAL RESERVE was granted monopoly power by Woodrow Wilson on

that day of infamy, December 23,1913, the FED is not only always 100 % aware of what it is doing, but

plans on the intended consequences of its actions. For example, stealing $trillion with no

accountability or disclosure.

[JBS]

Transparency? There's no transparency.

And your "everything will be ok if the banks aren't forced to mark to market" argument is for LESS transparency.

[getsmart86]

People lie. Let's remember the 40's when people were told that the train was going to take them to another village only to be gassed. In the 60s we were told that Vietnam was a communist threat. And in the 70s tricky Dick said he was not a crook. Reagan forcefully said that he did not trade arms for hostages in the 80s. Bill did not have sex with that woman in the 90s. Mr. Greenspan said a bubble could not be seen until it burst. And now the Obama administration is telling us that thirty years of excessive credit and outsourcing will only inflict pain for twelve months and all of the big banks are solvent. I am ok, your ok, everything is ok. The can is being kicked for the last time. Its now in the corner. 1987 crisis was serious. 1997 crisis was more serious, 2008 was even more serious. The next crisis will be catastrophic. We are a hollow country.

[bwshook]

The Stress Tests were designed to allow the results to be interpeted in a generally positive manner; and to answer or address any questions about them in a generally positive manner. I like both fact and fiction based entertainment, but we need some real-life facts here!

[WritusMaximus]

Obama doubled down on the Bush approach to solving this mess, and Obama's doubling down is Bush's fault, of course, because Bush who is obviously out of office, somehow is forcing Obama to follow Bush's "solutions­." It will always be Bush's fault, no matter what Obama does. In essence, Obama is a pawn. Obama should step down for he is obviously a Bush puppet.

[Halsey]

writusmini­mus....you­'ve GOT to get a grip..aski­ng Obama to step down...um.­...and who would you have step in? Cheney, Specter, Powell... the banking system is incestuous­...always has been...and Prez. Obama is trying (I submit his HAS made mistakes with many appointments in this incestuous ring..)..b­ut at least he's not W..or Bill Clinton for that matter (such an enabler...­.)....


Alan, you've written a thoughtful piece..but frankly that YOU, mgr of a hedge fund even speak of "lack of transparency" sadly is a joke..sure­...you may be the ONE honest hedge fund guy who IS honest...b­ut let's face it...there is a shroud over hedge funds bigger than our pathetic banking system... I'll just bet your minimum account size is at least 10 million $$....you have no clue how most of us live...kud­os to your success; but it is hollow. Hedge funds...la­ck regulation, are private, ergo..no public disclosures (just strategies­)....for my smallish clients who need "hedging".­..I will put a small amount in a short ETF and a Gold ETF and yes..even managed futures... You seem like a nice guy....but you live in a glass house and shouldn't be throwing rocks at our corrupt banking system (hey..Well­s Fargo showed good numbers..b­ut oops....cl­osed their books in Nov....BEF­ORE having to include the debacle called "wachovia" aka.."walk over ya"..on their books...th­e mess of Golden West..has yet to be aired....

[idest]

Are you denying that our economy is in such dire straits due to 8 years of Bush? Admitting to reality only hurts your pride, I promise.

[David Sternfeld]

The stress tests are delaying tactics of those in power who hope growth will rescue insolvent debtors and banks.

These 'tests" will be derided widely as incomes and demand continue to deflate along with the global credit bubble.

Keep in mind option-arm and alt-a mortgage resets will peak in 2011. There's more stress to test the financial system going forward, much more than the sort-of passed, flabby stress tests - of the 19 largest banks - have assessed.

[Bonobo]

Delaying release of the criteria for the stress tests destroyed any credibility they might have had. Of course, they had lost relevance by that time because the administration had decided they weren't going to put any megafinancials into receivership, no matter how insolvent they were.

[jackwaddington]

Let's get beyond the hype. The Stress test was designed to make this financial failure look as if it was not that bad. Were we, the public/taxpayers, to know just haw disastrous this whole fiasco IS we'd be in total panic. Problem is that it is only 'in panic' that we might begin to see what the REAL PROBLEM is, then, and only then, solve it. The solution, to me, is not within economics.

[BurtonOerney]

"...it is only 'in panic' that we might begin to see what the REAL PROBLEM is..."

Hmmm. Something about that doesn't sound right.

[jackwaddington]

Try permitting yourself to panic; instead of running away from it and you'll get the greatest insight of your life. You don't believe me--just try it.

[gemcando06]

Its my opinion that when you ask someone to take a "test" it means that you want the evidence on paper.

[joebaggadonuts]

I think that's right. Now we have "something" on paper. What it actually says, we don't know, but it's in the record. The behavior of the banks going forward can be measured. Since we may be owning big chunks of this, it seems like a good start at a managing tool to control them. Given the lack of trust the public has for the banks, for government, and for each other, it's no wonder that everyone is upset about this. Trust must be earned over time. Time is short. Obama's mantra of don't make any sudden moves seems to be the only way to handle this mess. There may be better ideas out there, but I don't see any way to do anything but go along with the Obama plan. It's that or revolution or chaos or tyranny.

[weslenforever]

The "stress tests" weren't designed to do anything except distract from what is really going on. When they were brought up in the first place we were told "All the banks will PASS". At that point is was just another money pot for whoever they paid to write the results.
Stress test was supposed to tell us whether each one was viable or not. If not they should be closed. BUT, this "stress test" was simply to jury rig a set of numbers to show viability that IS NOT THERE.
They are simply counting on the public not paying attention AND they think we are ALL mindless clones who can't COMPREHEND what they DO.

[sposton]

There is really just one problem. It is the aim of these stress tests. The aim has an a priori determined agenda which is built into the very design of these tests so that they deliver what is desired. The true agenda is reflected in the willingness to do anything with taxpayers money while doing everything possible not to step on any toes of the oligarchic order. All of this is to be expected from the people Obama appointed to deal with this issue. After all, they are the agents of those same oligarchic interests. The ultimate responsibility lies squarely with president Obama.

[Bush-Rolled]

Sad but probably true.

[tompoe]

Now that the government has all the information they need to determine what the banks have, what they don't, and what they need, we can all look forward to learning about what they did with all the billions, yes, trillions, they were awarded under the Bush $1 trillion dollar going away present the Party of Corporate Welfare demanded on September 19, 2008. That information is available, I assume, because otherwise, there could not have been a legitimate stress test applied, right? So, just what happened to the money?

[harveyr2]

Its a confidence game, pure and simple.

Doom and gloom is gone. Now that Obama has driven through the stimulus bill and the trillions of dollars in deficit budgets, he, and the rest of the administration see only green shoots.

[peterg76]

No, you got it all wrong. The tests were designed to evaluate how much humiliation and blatant fraud the voters could endure before they started demanding government end the embezzlement.

Apparently, quite a lot.

[joebaggadonuts]

No, we learnt that lesson when we let W take the WH back in '00 in an unfairly contested election where the Supremes put their thumb on the scale of justice to decide Florida state law contrary to what the state supreme court of Florida had decided, and where the R's sent goons to disrupt recounts because their caging efforts had apparently not brought the results they wanted. The voters are willing to take quite a lot of humiliation and fraud before they bring out their pitchforks and torches - too damned much actually.

The stress tests were designed to buy time to let the market work its magic.

How it will do that without allowing for bankruptcy cramdowns is a mystery to me. There is no way to let the bad gas out of these inflated assets, unless we are waiting for a coming devaluation of the dollar to do it. If the dollar were worth half of it's current price, homes could cost twice as much, so the mortgages would no longer be upside down. At the current and increasing level of unemployment that's a lot of people who will be forced into the streets unable to buy inflated homes and unable to pay old high mortgages because they are out of work.

It would have been better to allow cramdowns.