Recent Items

Guest Post: Stress tests reveal Citi and BofA need more capital, but you knew that already

Posted on by

Submitted by Edward Harrison of the site Credit Writedowns

The leaks about who failed the stress tests are already starting. Who got a big fat ‘F’? Apparently, Citi and BofA for starters. But is that any surprise?

Regulators have told Bank of America Corp. and Citigroup Inc. that the banks may need to raise more capital based on early results of the government’s so-called stress tests of lenders, according to people familiar with the situation.

The capital shortfall amounts to billions of dollars at Bank of America, based in Charlotte, N.C., people familiar with the bank said.

Executives at both banks are objecting to the preliminary findings, which emerged from the government’s scrutiny of 19 large financial institutions. The two banks are planning to respond with detailed rebuttals, these people said, with Bank of America’s appeal expected by Tuesday.

The findings suggest that government officials are using the stress tests to send a tough message to struggling banks. Bank of America and Citigroup have been the highest-profile problem children in recent months, but it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.

Just three months ago these two mega-banks were on the verge of collapse and needed yet more cash to sustain them. So, the ‘stress tests’ haven’t provided any new information. But, ah, there’s that last sentence: “it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.” Who else might need more dosh?

Industry analysts and investors predict that some regional banks, especially those with big portfolios of commercial real-estate loans, likely fared poorly on the stress tests. Analysts consider Regions Financial Corp., Fifth Third Bancorp and Wells Fargo & Co. to be among the leading contenders for more capital. Wells Fargo declined to comment. Representatives of Regions and Fifth Third didn’t respond to requests for comment made late in the day.

Government officials say their meetings about the stress tests with bank executives over the past few days conveyed preliminary results and that discussions were expected to continue this week about specific findings. They also say that banks directed to raise more capital shouldn’t be viewed as insolvent.

Come again? Banks directed to raise more capital shouldn’t be viewed as insolvent? Then what is the purpose of the stress tests, pray tell?

Instead, the capital is intended to cushion the banks against potential future losses under dire economic conditions. Federal officials say they won’t allow any of the top 19 banks to fail.

Still, it is unclear how flexible the government will be about adjusting the results, especially as banks plead their cases individually. Banks have until the middle of this week to lodge their formal responses to the tests. Bankers expect that will set the stage for several days of intense negotiations between the banks and their examiners.

Ah, I see, it is all a sham.

It sounds a lot like a test where the student banks who just failed go to the teacher regulator with mommy and daddy bank lobbyists in tow to see if they can get their grades changed higher. See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem.

According to MIT Professor and former IMF Chief Economist Simon Johnson, this is very nearly what Larry Summers said in a Feb 24th speech at the Inter-American Development Bank. Summing up Summers’ statements, Johnson says:

Summers made five points that reveal a great deal about his personal thinking – and the structure of thought that lies behind most of what the Administration is doing vis-a-vis the crisis. Some of this we knew or guessed at before, but it was still the clearest articulation I have seen.
  1. All crises must end. The “self-equilibrating” nature of the economy will ultimately prevail, although that may take massive one-off government actions. Such a crisis happens only ”three or four times” per century, so taking on huge amounts of government debt is fine; implicitly, we will grow out of that debt burden.
  2. We will get out of the crisis by encouraging exactly the kind of behaviors that “previously we wanted to discourage” two years ago. It is “this insight, this view” particularly with regard to leverage (overborrowing, to you and me) that “undergirds the policy program in the United States.”
  3. There is a critical need to support financial intermediation and to ensure it is adequately capitalized, with a view to the risks inherent in the current situation. He then said, with a straight face, that the current bank stress tests are designed with this in mind.
  4. Growth in the 1990s and more recently was based too much on finance (this appears to be a relatively new thought for Summers). The high and rising share of finance in corporate profits “should have been a warning”. The next expansion should be based less on asset bubbles and more on investment in key public services.
  5. The financial regulatory system “in fundamental respects has been a failure”. There have been too many serious crises in the past 20 years (yes, this statement was somewhat at odds with the low frequency of major crises statement in point 1).

Just one look at the credit ratings and stock prices of the 19 banks and financial institutions in the stress tests will tell you which are the weak institutions. So, why the charade?

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

So, Geithner and Summers are hoping FDIC-subsidized funding, toxic asset removal, fiscal stimulus, quantitative easing and all the other measures now in place will kick in and provide a recovery – and solve the banking problem. However, if the problem is not solved, there is plan B – debt-for-equity swap, nationalization, or asset seizure.

In my view, we should be going to Plan B right from the start rather than going through this jerry-rigged sham of a stress test.

Sources
Fed Pushes Citi, BofA to Increase Capital – WSJ
Larry Summers’ New Model – The Baseline Scenario

Print Friendly
Twitter0DiggReddit0StumbleUpon0Facebook3LinkedIn0Google+0bufferEmail
This entry was posted in Banking industry, Regulations and regulators on by .

About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward

13 comments

  1. gcja

    This whole exercise is a total sham. What more can you say. The Obama Admin are disgraceful; hell, even reputable MSM outlets like the WSJ are all over this like the pig flu.

  2. Mr.Candid

    I’m a regular reader of NC and its great to read posts of various bloggers who’re not only intelligent but also emphathetic towards US public.Why you guys don’t start a movement and atleast block few funds going to crap like citi, jpm, GS and others. Why can’t you think about it.

  3. "DoctoRx"

    While I substantially oppose PPIP, the whole concept of Big Finance uber alles, etc., and while I agree with the point Yves has made repeatedly that there was no way to do a thorough eval of the companies, nonetheless it strikes me as a bit harsh to call the evaluations a sham exercise.

    I fail to see how having the banks respond proves the exercise is a sham. Of course, if the Govt were to roll over at every disagreement the bank made, that would prove the “sham” charge.

    I would rather say that the entire importance of the stress tests has been overstated, because the Fed and the Bush administration should have been doing much more than this stuff all along.

    Just as Yves has limited the comments section of NC because of too many personal attacks and the like, so I would ask all bloggers that after they write what they really think, to review their post calmly and perhaps, having vented, temper the language a bit.

    You don’t have to be as bland as David Broder to write an engaging blog.

  4. Steve R. Barbour

    “The leaks about who failed the stress tests are already starting. Who got a big fat ‘F’? Apparently, Citi and BofA for starters. But is that any surprise?”

    Edward HarrisonTo a degree yes. It is very promising if the stress test is going to declare that multiple banks need to raise capital. There was a lot of speculation that the stress test would amount to nothing, and with the current ‘banks turning a profit!’ atmosphere there was even the possibility that no bank would fail.

    So given the presented attitudes about this so called sham test, there should be surprise being uttered.

    Of course, these are just leaks and the end results will be measured by whether this is 1) Actually true, and 2) The amount of capital required to be raised.

    Come again? Banks directed to raise more capital shouldn’t be viewed as insolvent? Then what is the purpose of the stress tests, pray tell?

    Edward HarrisonAnd suddenly I am left forced to speculate on your intelligence.

    Of course the government said they shouldn’t be considered insolvent. No bank that was insolvent would ever be able to raise capital. Telling the market: “Please view all these banks as insolvent and immediately start a run.” Not only would this defeat the purpose, but many would then blame the government of irresponsibly killing the bank.

    Of course if a bank is deep enough under then the government should just close the bank. This changes little about how much your above statement lacks thought.

    Overall this is promising news. I will, however, wait until we get the actual results and see how the by play falls out before deciding on my opinion.

  5. Edward Harrison

    Steve, you comment:

    “And suddenly I am left forced to speculate on your intelligence.”

    That strikes me as a fairly personal attack. However, I will overlook that and respond to your comments and the reasoned rebuttal from DoctoRx.

    I am in the process of writing a post from the Administration’s point of view which I may post here but will be available on my site. It is intended to present a cogent counter-argument as to why the Administration is acting as they are.

    In my view, the Administration’s strategy is not terrible. I disagree, but I understand the logic behind it. It hinges critically on their belief that time is our friend and that we can always take more drastic action down the line, if necessary.

    In the meantime, under no circumstances do they want to admit or hint that any bank is insolvent because it will start a run. This is one reason the stress tests are very much a political exercise and won’t actually solve anything.

    The real point of the exercise is to differentiate enough between institutions without suggesting any of them are actually insolvent so that remedial action can be taken at the worst capitalized institutions.

    Sheila Bair is already laying the ground work for more FDIC power to take over bank holding companies if necessary. So, obviously, they do have a Plan B here.

    The crux of my displeasure with the plans to date are twofold: they are a massive gift to bondholders and shareholders at the expense of taxpayers. And the plans do create more systemic risk because, in my view, time is NOT our friend. expect to see more on this theme later on my site.

    Thanks for the spirited pushback. These are the types of debates we should have. But do try to keep the personal attacks in check. (You should notice that while I think the stress tests are a sham, I in no way impugn the Summers and Geithner, two experienced and intelligent individuals with whom I strongly disagree).

  6. Alan

    One of the major lynchpins of the testing that I remember (but haven’t written about) was the US requiring the onloading of around $900 billion of off-balance sheet assets.

    The last time I checked this was a drop in the bucket. Just a few months ago, the last figure for off-balance sheet assets I remember seeing was around $5 trillion.

    This is the biggest farce of all in the testing. Ignoring these massive off-balance sheet exposures and pretending that their book values approximates market (i.e., their future cash flows and defaults) is fraud, plain and simple.

  7. Brick

    Summers claim that the nature of the economy is self-equilibrating is not always true. Certainly it has tended to be in the last 50 years, but if you take a longer view point then the statement is highly questionable.

    I am not happy with the insight that we get out of this by encouraging activities that ought to have been frowned upon two years earlier. This sounds rather like pushing levers and a see saw action. The question must be why he thinks stimulus must be funded from new money either by printing money or from tax payers rather than redirecting money currently used elsewhere.

    The whole point about bubble is that money gets misdirected and I think government money gets misdirected as well. The politically easy answer is to borrow money rather than redirect. It also concerns me that banks are expected to earn their way out of this mess. Certainly on new loans they ought to make money, but since there are less loans it is not clear to me that earnings and the capital buffer will be big enough for the coming defaults on some commercial loans particularly loans to build retail space.

    The assumption seems to be that we are in a V or at worst case a U shaped recession when all signals seem to point to an L shaped recession. If this is true then a bank which has passed the test will eventually fail causing more widespread damage to the markets than if there had been no stress test at all.

    But hey lets tippy toe around while more jobs are lost and the real economy gets worse.

  8. profnickd

    Federal officials say they won’t allow any of the top 19 banks to fail.“Federal officials” can’t save anything. Federal officials can rob me of my wealth and give it to the banks but, then again, that would mean I would be saving the banks.

    But I can see no particular reason why I should. I have, to the best of my ability, competently saved and invested my wealth.

    The 19 largest banks haven’t done so with their wealth.So I’m trying to figure out how this fact justifies robbing me.

  9. Neal

    I think the charade is the front for the assessment that the US economy is really in trouble without the inputs from the FIRE sector.

    Where will growth come from? Subtract the profits and salaries and wages generated by the sector and where does that leave the US?

    It leaves it a poorer place confronting the reality that the living standard assumed as a right by Americans is not really sustainable without substantial gimmickry. And even with “financial innovation” the fall will stil come.

  10. Doc Holiday

    The following from Ms Warren is important, because people should be asking why Treasury has the authority to play games with bogus “Stress Tests”. These banks and entities that are failures should be reporting fully disclosed data to SEC, which should be fully audited and reviewed by regulators — other than Treasury! Once again, Treasury is usurping power from congress and abusing its magical Bush/Paulson authority to spin bullshit — versus using law enforcement to take these crooked pirate Enron-like corporations to justice for fraud!

    Keeping tabs on the bailoutQ: Do you have a clear sense of what the overall TARP plan at this point is supposed to do? Are you capable of summarizing what it’s supposed to be doing?

    A: No. And neither is Treasury. Treasury has given us multiple contradictory explanations for what it’s trying to accomplish.

    There’s a major problem and a minor problem. The minor problem is documentation. I’ve spent four weeks now looking for someone who can give me the details of the stress test so that we can do an independent evaluation of whether the stress test is any good.

    We get: “someone will call [you] right back.” Only the call doesn’t come.

    The major problem is that Treasury has not articulated its goals. And without that, we can’t have a robust debate about whether they’re headed in the right direction; instead, we’re stuck with this more technical argument about the implementation of the [Term Asset-Backed Securities Loan Facility] or the details of the Capital Acquisition Program. And that misses the central question of, should we be subsidizing failing banks or liquidating them? When we acquire capital, should we exercise more control over the institutions that take the money or less control? Those are the central policy issues that the American public has a right to participate in.

    Q: What [is] the underlying problem? Is it that there aren’t the right people at Treasury? Or is the lack of transparency and the lack of resolution on the conceptual front, is that an unspoken part of the policy?

    Also see: Outrageous: Tarp Oversight Bd. Denied Bank Stress Test FormulaQ: You’ve been quite critical of the Treasury. What troubles you most about what you’re getting and what you’re not getting?

    A: There’s no discussion of the overall policy. Instead, there are specific programs that are announced, and from that, it’s necessary to reason backwards to figure out what the goal must have been. It’s like a “Jeopardy!” game. If this is the answer, what was the question? It’s frustrating because without a clearly articulated goal and identified metrics to determine whether the goal is being accomplished, it’s almost impossible to tell if a program is successful.

    And does the TARP oversight board have ANY idea what is going on in the TARP program? You can probably guess the answer.

    Q: Do you have a clear sense of what the overall TARP plan at this point is supposed to do? Are you capable of summarizing what it’s supposed to be doing?

    A: No. And neither is Treasury. Treasury has given us multiple contradictory explanations for what it’s trying to accomplish.

    Yes, the duplicity of the Treasury department vis-a-vis Wall Street has been apparent to all of us. But do you realize what this means? We have an oversight board that doesn’t understand what it was established to oversee, can’t get its questions answered to gain such understanding, and is nearly in the same position (the board members’ knowledge and expertise aside) as the rest of the public to oversee the bailouts. Why even have a board at all, then, outside of political optics? Of course, we can’t have a board that would be able to do actual oversight, that’s capable of actually overseeing or even minimally interfering with Treasury’s plans for the banks, Wall Street, and for the country.

    Finally see: Treasury Department Announces Specifics of Capital
    assistance program
    The CAP has two components. The first is a forward-looking capital assessment, or “stress-test,” that will evaluate the capital adequacy of a QFI under two alternative economic scenarios: a baseline, or expected, economic scenario, and a more adverse economic scenario. The second is access to additional high-quality capital through the sale of mandatorily convertible preferred stock to Treasury as a “bridge” to private capital in the future. The federal banking regulators have also released an FAQ document for the stress-test.

    On October 3, 2008, then-President Bush signed into law the Emergency Economic Stabilization Act of 2008 (EESA), which granted Treasury the authorityto allocate up to $700 billion to the Troubled Assets Relief Program (TARP). Approximately $200 billion of TARP funds were used in the Capital Purchase Program (CPP), which provided capital to QFIs by purchasing senior preferred shares and warrants for common stock. The application deadline for the CPP for publicly traded institutions passed on November 14, 2008, with many QFIs choosing to participate, but financial institutions have continued to see capital levels erode through markdowns of illiquid assets and downward pressure on prices of common equity.

    Full Disclosure: The Author has just had some cereal and is highly pissed off that Treasury is not being investigated by DOJ, which was dismantled by Bush, Alberto Gonzales, Paulson and all the other guys from The previous Coup, who obviously still are in control! Furthermore, if there are typos, I don’t friggn care!

  11. Waldo

    “Full Disclosure: The Author has just had some cereal and is highly pissed off that Treasury is not being investigated by DOJ, which was dismantled by Bush, Alberto Gonzales, Paulson and all the other guys from The previous Coup, who obviously still are in control! Furthermore, if there are typos, I don’t friggn care!”

    Bravo!!

    This problem is much deeper than what is espoused above as perpetrated by the Bush Administration. I think Paulson came in and was flanked by Bush’s vicious vice and colossal lying behavior. His attempt to save Wall Street is his demise. He too must be brought to justice.

    If we do not find the courage to bring justice to these past eight years this shit will not clean itself up. We will not really be back to the “creating” part of our economy until justice is applied.

    Ralph Waldo Emerson, from his essay “Literature”:

    “Whoever discredits analogy and requires heaps of facts before (criminal) theories can be attempted, has no poetic power, and nothing original or beautiful will be produced by him.”

    Our beautiful sailing ship is dead in the water. No strong breeze (truth) to get us creating again.

    Sonnet #48

    How careful was I, when I took my way,
    Each trifle under truest bars to thrust,
    That to my use it might unused stay From hands of falsehood, in sure wards of trust!
    But thou, to whom my jewels trifles are,
    Most worthy comfort, now my greatest grief,
    Thou best of dearest, and mine only care,
    Art left the prey of every vulgar thief.
    Thee have I not locked up in any chest,
    Save where thou art not, though I feel thou art,
    Within the gentle closure of my breast,
    From whence at pleasure thou mayst come and part;
    And even thence thou wilt be stol’n, I fear, For truth proves thievish for a prize so dear.

    William Shakespeare

  12. hbl

    Yes, Summers appears to be purposefully leading an effort to follow the Japan strategy. gaius marius has been suggesting the same thing in recent months — after reading Richard Koo’s book he changed his viewpoint on the optimal solution. He no longer believes it possible to do any kind of quick cleanup (e.g., Swedish style) without cascading failures throughout our massive web of debt, causing a very deep self-reinforcing depression. Hence the Japan approach of forbearance and a slow road of earnings helping to restore solvency. I don’t know which view is correct but I do think people underestimate how large the cascading effects of creditor losses could be in an economy with 300% private debt-to-GDP, no matter what is actually fair. Perhaps the administration doesn’t know either but isn’t brave enough to take the riskier but more just option.

  13. attempter

    The Summers speech is nothing short of sickening. It’s interesting that he admits that the welfare of the FIRE sector is what “undergirds” all other economic (and I would add social) policy.

    Indeed it seems that so long as the current “leadership” exists, all of American policy must more and more center around this corporatist class warfare goal, since only through ever more grotesque policy interventions can these bailouts (loot conveyances) and the delusion-based bubbles which have now long since replaced actual reality-based “growth” continue.

    (Summers says it’s implicit America must return to “growth”? How? America’s economy has had no real basis for many years now. And now that resource depletion is setting in, the reality pie can only get smaller. These guys really are as crazy as they are criminal.)

Comments are closed.