Reader M&M called my attention to a Bloomberg story I was really hoping to avoid, “U.S. Sets a Six-Month Deadline for New Bank Capital“. The opening:
The government set a six-month deadline for the biggest 19 U.S. banks to raise any new capital deemed necessary after a mandatory review of their balance sheets.The regulators will oversee the so-called stress tests by the end of April, which will identify how much extra cushion each bank will need, the Treasury said today in Washington. Lenders will have six months to raise private capital or accept government funds and the conditions that come with it.
“While the vast majority of U.S. banking organizations have capital in excess of the amounts required to be considered well capitalized, the uncertain economic environment has eroded confidence in the amount and quality of capital held by some,” the Treasury said, announcing guidelines for new bank reviews.
Let’s work through this starting with the last paragraph. The new Administration has been in office only a bit more than a month, and the double-speak has already started to wear thin. If anyone really believed these banks’ capital was adequate, would we have this never-ending parade of special facilities, rate cuts to near zero levels, and programs to rescue stressed borrowers? All the interventions say loud and clear that most if not all of the big banks are in parlous shape, but the Administration keeps repeating the canard that the banks have more capital than needed “to be considered well capitalized.” Well, either the standards for capital adequacy are rubbish or all the weekend specials and Congressional high stakes poker have been a complete waste of taxpayer money. You can’t have it both ways, and you reduce your credibility by peddling this sort of thing. And this isn’t just my reaction; readers who have seen this sort of formulation (it has shown up before) find it either comic or pathetic.
Let us return to the first part, which is even more remarkable. The government is giving banks six months to raise more equity if they are deemed to need it, and if not, they will have to take government funding on whatever terms are on offer.
Anyone with a passing familiarity with the banks suspected of being in most urgent need of new funding, Citigroup and Bank of America, knows that their stock prices have fallen to levels that suggest serious doubts about their survival. Meredith Whitney, the bank stock analyst whose forecasts have been most accurate, said her best idea was to short Ciitgroup, last week, even at super depressed levels.
So my assumption in reading this post was that this was the Team Obama approach to nationalization, or whatever term they use to try to rebrand the process. Show you’ve bent over backwards by given banks every chance to dig their way out of their mess (six month is long enough that they could try a restructuring or breakup, as well as conventional fundraising) and then do what needs to be done.
But my assumptions may be uncharacteristically optimistic. Tom Ferguson (via e-mail) has another take:
The stress test “worst” scenario is pretty silly and optimistic; 3.3 % decline this year, small rise next year. So not too much stress. That sets the parameters of necessary capital. If you believe Bernanke, most pass. They just won’t lend.
While I agree that the stress test scenarios are not dire enough (and others, see here and here share that view). Even the anodyne New York Times casts doubts:
But analysts say the administration’s worst projections, which it describes as unlikely, are not much more dire than what many private forecasters already expect.According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3 percent this year and remains almost flat in 2010. They would also have to assume that housing prices fall another 22 percent this year and that unemployment would shoot to 8.9 percent this year and hit 10.3 percent in 2010.
“I don’t think they are harsh enough,” said David Hendler, an analyst at CreditSights, who said the dire projection was itself too optimistic about the growth that would be generated from President Obama’s stimulus program. “That would be a pleasant outcome, but you have to plan for the worst.”
However, there has also been language in some of the pronouncements on the stress tests that it would call for capital above normal levels. That may simply be to finesse the difference with regulatory requirements, but the wording was sufficiently imprecise as to give the impression the new buffer might be temporary (forgive me for failing to find it, but I have to be on an early flight tomorrow, and was unable to locate it in the five minutes I could spare). Thus even with the less than dreadful worse case, banks could still be required to stump up more equity.
But the scary view comes from Ed Harrison:
Obviously, Geithner, Bernanke, et al. believe ‘irrational despondence’ is the source of what ails us and that propping up asset prices will be the cure.Witness remarks made by Ben Bernanke just recently before Congress:
Federal Reserve Chairman Ben Bernanke said Wednesday recent sharp declines in stock prices mostly reflected investor attitudes about risk and had become detached from real U.S. economic fundamentals.The risk appetite of investors changes over time and right now the standard measures of the risk premium that investors are charging to hold stocks are at very high levels relative to anything we have seen in recent decades,” Mr. Bernanke said in semi-annual testimony to Congress.
The stock values reflect not so much the fundamentals, the long-term profitability of the economy, but they also reflect investor attitudes about risk and uncertainty which right now are at very high levels,” he told lawmakers during questions.
U.S. stocks have fallen to 12-year lows this month, with the benchmark S&P 500 down about 15% and the Dow Jones industrial average off about 16% since the start of 2009.
This goes to the mindset here. What Ben Bernanke does not say but clearly suggests is that asset prices are being depressed artificially by ‘irrational despondence.’ Stepping in to offer a bid to these assets will lift them — at which point the despondence will go away and all will be fine with the world.
This view is misguided because many asset prices are still above their long-term trend. This is certainly the case with house prices, where renting is still significantly cheaper than purchasing in many locales.
Yves again. Looking at “recent” norms with stock prices is also misleading. Martin Wolf, who had no axe to grind, pointed out that equities were overvalued in March 2007. Indeed, a significant deviation from long-term trends started in late 1996 (remember Greenspan’s “irrational exuberance” remark?) and the excess of that decade was enough to shift long term averages. When I was a young person on Wall Street, market PEs of 16 were peak multiples. They came to be seen as normal.
What is amazing is the degree to which Bernanke has been unable to process what has happened over the last year and a half. It isn’t simply that he is trying to restore status quo ante; he seems to see the only possible operative paradigm as the status quo ante. Worse, he has a romanticized view of it too.
We had a massive stock market bubble, followed by an even bigger asset orgy, with housing at the epicenter, but plenty of other types got dragged along with it. Having asset appreciation fueled by debt is NOT how a healthy economy operates. It is going to take some time for the excesses to work themselves through. Carmine Reinhart and Kenneth Rogoff’s study of major postwar financial crises have found stock prices take 3 1/2 years to bottom.
But Ben believes the trend from here has to be up, and seems unable to consider that rather than the risk appetite being irrationally low now, it may have been irrationally complacent earlier.
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I thought the same about the unemployment rates until I saw the footnote that it said “annual average” and then did a calculation to see how quickly unemployment would have to rise in order to break 8.9% average. I think it’s realistic. I also think the housing price drops sound realistic and the GDP of -3.3% sounds pretty right with all the government injection into the economy (I have no opinion about next year’s GDP).
But my skepticism comes not from their scenarios but the dynamics of the stress test itself. I seriously doubt that a -3.3% GDP drop from Fed tightening has anywhere close to the same impact on asset prices and default rates as a -3.3% GDP drop in a deflationary environment and a large spike from government spending. Same thing with housing prices…another 17% drop is going to start cutting severely into the people that still think of themselves as responsible and have positive equity, what will happen then? I don’t think any of this stuff has enough precedent to model.