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Stress Tests Favor Big Trading Firms Over Regional Players

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Since the Associated Press has not yet had its position on fair use defeated in court, you’ll have to go visit them to read the text of their “exclusive” story. It is a doozy.

But by any standards, the broad outlines confirm yet again that crony capitalism trumps taking the best course of action for the financial system.

The AP report, based on Federal Reserve documents in the new service’s possession, finds that the stress tests are tougher on loans than other troubled assets. That in turn means regional banks, who do not have big trading ops but do have big loan books, will fare worse than those with lots of CDOs and funky derivative exposures.

We said some time ago that if the stress tests gave poor marks to Fifth Third (a well run bank with far cleaner accounting than the industry as a whole, but a terrible geographic footprint, namely Michigan, Florida, and Ohio) fares poorly but not Citi, you know the test was skewed. That appears to be where things are headed.

Why is being hard on loans but not on securities a distortion? Many structured products (and most of the troubled securities fall in that category) have what is known as embedded leverage. That means an increase in defaults, or other fall in cash flow can have a disproportionate impact on the value of the instrument. That’s why, for instance, some CDOs were downgraded from AAA to junk in an afternoon. That’s an impossible occurrence with a loan book, absent a catastrophe like the Yellowstone caldera blowing up. Even when loan books decay, they do so in a linear fashion. Complex securities often decay much faster (with structured securities, particularly when certain levels are breached).

Of course, the tacit assumption may be that enough of this dreck can be dumped on the Fed via the TALF that it doesn’t mater (yes, the TALF technically makes loans, but the TALF, like the public private investment partnership, can serve to validate phony valuations).

The other reason this is a bad approach is that it favors the big players when there are ample reasons to put the medium and smaller sized players forward instead. Bank analyst Meredith Whitney has recommended having policies promote regional banks, since they are closer to borrowers and have some (in many cases, a lot) of the apparatus in place to make old-fashioned lending decisions, rather than rely on FICO and simple score based methodologies that have proven to be hopelessly flawed.

A second reason comes from Richard Bookstaber, In his book Demon of Our Own Design, he pointed to the dangers of tightly-coupled systems, where information and actions move so quickly that the process cannot be interrupted. Tight coupling is a bad feature in system design, since it promotes feedback loops and thus greatly increases the odds of catastrophic failure. Efforts to restore a system primarily dependent on market based credit, as opposed to balance sheet based credit, restores the same breakdown prone system we had before unless other measures are introduced (and none appears in the offing). Worse, shifting more activity to the biggest players increases instability, since activity takes place in fewer nodes (having the Fed as a big node is a very bad idea from this vantage point).

Cynics have argued that one of the points of the stress tests was to permit the big players to take out some of the smaller of the big 19 on advantaged terms, as some (John Hempton in particular) claim occurred with WaMu. I didn’t think the system was that corrupt (and readers know I think it is plenty corrupt), but that scenario may be coming to pass. But that in some respects would be less bad than the one I believe is at work.

One argument made by AP is that the stress tests favor the big capital markets players because if one failed, it would pose a systemic risk. So the “no more Lehmans” doctrine is leading to airbrushed analysis being passed off as the real thing.

And the logic is beyond belief. If we pretend an insolvent player is solvent, that makes is solvent. At best this is Japan, but at worst, given that these firms trade actively, it does not forestall the run-on-the-bank problem. If enough people believe the financial reports and the government reassurances are a crock, they will view everyone with considerable nervousness and be prepared for a quick trigger exit at the first whiff of real trouble. And even with phony numbers, most savvy players, between even the fake numbers, analyst reports, and industry gossip, can make a good relative ranking, Without having the precise figures, a lot of people can reasonably infer who the weakest players are. So this approach solves nothing. Indeed, it makes matters vastly worse because it instills a sense of complacency in the officialdom (we solved that one, no reason to think about Plan B) and the at risk actors themselves (human nature being what it is). And that very complacency will increase the real underlying risk, by preventing both parties from taking the tough steps needed to REALLY reduce risk, as in loss recognition, management changes, recapitalization and restructurings.

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12 comments

  1. Aiden

    The stress tests were a mistake from the beginning. Regulators and banks often do their own “stress tests.” You can see the kind of tests that JPM Chase did on their Wamu acquisition (some would say robbery) as they filed it with the SEC.

    I don’t think that the banks are insolvent, they may be below capital requirements, but that does not make them insolvent. The problem here is that the capital requirements right now are too high, it makes no sense to give money to the banks if they can eat into their earnings provided or investor provided capital. The time to infuse money into the TBTF banks is when they have totally gone through all of their capital. This is would be based on hold to maturity or impairment basis. Then you don’t waste money if you don’t need it, because if they don’t deplete all of their capital, they are not by definition insolvent.

    Citigroup, Merrill Lynch, and possibly Wachovia are the only TBTF firms that were probably insolvent, but because of the gauarantees and TARP capital at Citigroup and the TARP capital for Bank of America and Wells Fargo, which were very well capitalized before the acquisitions they can no longer be insolvent.

    The other thing I think will happen is that Morgan Stanley will buy Fifth Third on the cheap after they fail the stress test. Sheila Bair really loves giving institutions away (this is evidenced by Wamu, the original Wachovia-Citigroup deal, and the Indymac sale) and this is a perfect opportunity for John Mack, who apparently wants to own a retail bank.

  2. EDC

    The banks are insolvent.

    If it wasn’t for the shenanigans by the FED to prop up these institutions they would be gone via LEH.

    The question maybe is how do we define insolvent, if Gubermint meddling and accounting fraud that keeps a bank alive is solvent. Yes the banks are good to go, two thumbs up. On the other hand if you can only run a business by borrowing more and more with an unfair or non free market advantage because you have all politicians on your payroll then no you are not solvent. (both of these answers are the same thing…)

    If you can’t have either of the two above you are insolvent.

    Either way we look at it. If a bank needs some sort of lifeline it shouldn’t be in business. LET it fail, pre-privatize it and dump the assets for pennies to wolves who will fix them and have them going without sacrificing generations ahead. There is plenty of cash on the sidelines, that cash would take risk if we knew what the truth is… until then. “paradox of thrift” Good luck on deflation “*IN*-Solvent” banks.

  3. RPB

    Yves,

    This favoritism may go much further than toxic asset valuations or toxic asset purchases. The same may hold true for the cash treasuries market. Over the past several weeks the relatively new 7 yr cash has appreciated considerably. In fact, by our estimation it was overpriced by more than 20 ticks (based on several calculations).

    In the market, over these past several weeks a large player has been in the open cash markets buying up every on the run seven year in sight to the point where it drove its price beyond what it rationally should have been. In the latest QE purchases the FED has bot roughly 2 billion dollars of the 7 year cash, paying roughly an entire point what we estimated its worth to be! This large entity(ies) made roughly 20 million dollars on these 7 yr notes.

    Now I am no conspiracy theorist, but these seems far too coincidental to occur.

    As follows:

    1. Big player gobbles up 7 yr cash significantly mispricing it over several weeks. They continued to purchase as it was 10 ticks, 20 ticks, even ~25 ticks overpriced. Why would someone do that?

    2. FED buys 2 billion far overpriced 7 yr cash in latest QE repurchases

    While this does not necessarily mean this was orchestrated to benefit this large party; it is a very unusual event to say the least.

    Thoughts?

  4. tyaresun

    The best takedown of the stress tests. Thanks a bunch.

    This is really going to come back and bite the US. They are getting rid of the seed corn.

  5. Doc Holiday

    Are there any patriots or saints looking at SEC reports lately? I gave up that sport a long time ago, but I wonder if it’s time to look under the hood again?

    “Come what come may,
    Time and the hour runs through the roughest day.”

    - William Shakespeare, Macbeth

  6. Richard Kline

    If one were to conceive of The Worst Way Possible for the government to intervene in the financial crisis closing in on two years’ duration, it would be _exactly what we are doing NOW_. Phoney marks. Forcibly silenced regulation. Massive giveaways of public money to the worst, largest, and deadest players in the system. Suffocation of smaller, effective regional banks that are not survivably impaired on their own. Gaming of the markets day by day and week by week in a confidence game with the public. Supine and completely capture senior government officials up to an including the Current Occupant of the West Wing.

    No system gets this corrupt naturally, and even then not overnight. Institutionalized cronyism cascading into the panic of devastating losses makes people excrete crazy bricks, which are then stacked in a tower of irrationality mortared together with spit and denial. Such edifices do not stand over long. I’m not sure that I think that the _point_ of the stress test was to drive out smaller survivable banks—but the point of the tests was to animate a stonedead lie, that the Big Boys are healthy, when in fact they are dead. Once a lie like that starts, it can be twisted to ever grimmer ends.

    Ask yourself a question: Who is running the Bank bailout, the government or the banks? Look at the facts on the ground and on the ledger; it’s the banks, stupid. And there just is not enough money to go around for all of them, so, *cough* some of them have to go. It’s not personal, it’s business. The government may not have had it as a goal to kill the healthiest but least connected banks, but it is easy to look at zombie maws like JPM and GS and see such hearts of blackness in their treasured chests. And since _the banks_ are clearly, effectively in charge of where this is all going . . . .

  7. Doc Holiday

    Just taking a fast peek at Citi:

    CITIGROUP – QUARTERLY FINANCIAL DATA SUPPLEMENT 1Q09
    http://www.sec.gov/Archives/edgar/data/831001/000110465909024705/a09-10245_1ex99d2.htm

    Average Assets (in billions of dollars) in INSTITUTIONAL CLIENTS GROUP
    SECURITIES AND BANKING is down 27%

    Average Assets (in billions of dollars) in Global Cards, is down 66%

    Average Assets (in billions of dollars) in CONSUMER BANKING is down 16%

    Average Assets (in billions of dollars) in CONSUMER FINANCE JAPAN is down 11%

    Average Assets (in billions of dollars) in GLOBAL WEALTH MANAGEMENT is down 13%

    Average Assets (in billions of dollars) in NORTH AMERICA is down 21%

    Average Assets (in billions of dollars) in EMEA is down 34%

    Average Assets (in billions of dollars) in LATIN AMERICA down 15%

    Average Assets (in billions of dollars) in Asia down 17%

    Assets Under Custody (EOP in trillions) = $10.3
    Trillion which is down 20% YOY (what’s 20% of 10 trillion… anyone??? )

    Pandit said in a statement Friday that he was “pleased” with Citigroup’s performance

    Then I got really friggn bored of looking at this garbage and now will jump over to my instant Citi valuation calculator, which is patent pending, so piss off and don’t ask:

    Ok, so C is selling $3.24 with EPS of -(5.59) and they intend to pay a div yield of 1.40% and they suggest they will somehow make $21.30 Billion by next Qtr…. and they have about $200+ Billion to find ….

    So, Everything they touch is garbage — they are in a very deep dark hole and they are floating along on tax payer revenue. This toxic shit is something that wall street wants to push as an investment …….but to who? I imagine either tax payers, retards or pension funds…

    While Citigroup posted first-quarter net income of $1.6 billion last week, the New York-based bank suffered an “underlying” loss of 38 cents a share, Richard Ramsden, a Goldman Sachs analyst, wrote in a research note dated yesterday. He repeated a “sell” rating on the stock.

    Citigroup’s institutional clients group, which includes investment banking, swung to a $2.83 billion profit from a year-earlier loss, helped by strong results from fixed-income trading.

    Citigroup, which received $45 billion in government aid, ended a five-quarter losing streak on trading gains and an accounting benefit for companies in distress. The bank, which cut compensation costs and took fewer writedowns, still reported higher delinquencies on home and credit-card loans.

    In early March, Citigroup stock hit an all-time low of 97 cents per share. It has since quadrupled, but remains down 40 percent for 2009. And at $4.01 a share Thursday, Citigroup stock was down 93 percent from its late 2006 peak.

    Since late 2007, Citigroup has gotten a new CEO, a new chairman, and a new structure that splits its traditional retail and investment banking business from its consumer finance units, asset management, and risky mortgage-related assets. It’s also been downsizing by selling off businesses and laying off a fifth of its employees. And it’s gotten $45 billion in government funding and a federal backstop on roughly $300 billion in assets.

  8. Doc Holiday

    One last thing. I enjoyed this story the other day, which reminds me of all these banks and their pathetic stress tests, continued lies, distortion, manipulation, collusion, false and misleading information, fraud and theft of tax payer revenues!

    The Case of the Missing Month
    http://norris.blogs.nytimes.com/2009/04/14/the-case-of-the-missing-month/

    So what was the A.I.G. effect in December? They did not say. Is it possible the loss then would have been larger without the A.I.G. bailout? We’ll see if any analyst asks.

    7:15 a.m.| December Write-Offs: They did discuss December up front (unlike in the news release). It sounds as if they took write-offs everywhere, including commercial real estate and private equity. They took more write-offs in both of those areas in the first quarter.

    So how did they make money? One answer is that this is a great time to be in the banking business — if you ignore what we politely call legacy assets. Customers are desperate for cash, and will pay for it. Fees are up. If underwriting volumes continue to rise, this could be a great, great year. Assuming, of course, that the write-offs are over.

    6:50 a.m.| Where’s December?: Goldman Sachs reported a profit of $1.8 billion in the first quarter, and plans to sell $5 billion in stock and get out of the government’s clutches, if it can.

    How did it do that? One way was to hide a lot of losses in not-so-plain sight.
    Goldman’s 2008 fiscal year ended Nov. 30. This year the company is switching to a calendar year. The leaves December as an orphan month, one that will be largely ignored. In Goldman’s earnings statement, and in most of the news reports, the quarter ended March 31 is compared to the quarter last year that ended in February.

    The orphan month featured — surprise — lots of write-offs. The pretax loss was $1.3 billion, and the after-tax loss was $780 million.

    Would the firm have had a profit if it had stuck to its old calendar, and had to include December and exclude March?

  9. The Ror

    Clearly the plan is for the regional banks to be weakened, then forced into being *saved* by the Wall Street banks, hence centralising their power even further (and now far too big to fail), but improving various capital adequacy ratios thanks to the large deposit bases of the regional banks.

    After PPIP, the taxpayer will have all the crud on their book, PIMCO et all will have a highly leveraged and hard to lose on bet, and the Wall Street banks will have a huge retail deposit base to support their gambling operations with the rubbish off their books.

    I think we should find out if GS/JPM et al. are currently employing Gary Kasparov.

  10. Ginger Yellow

    I absolutely agree that the stress tests are a bad joke, but I can see some justification for treating loans more harshly than securities. Securities are much more likely to be marked closer to their ultimate value – even if they’re held in the banking book – than loans. And while the actual risk profile of some securities features greater cliff risk, from an accounting perspective, loans are (or can be) fine and dandy until losses are incurred or immminently expected to be incurred, which is its own form of cliff risk. All those dodgy Florida CRE loans could be sitting on balance sheets at par, when we know that a huge proportion are going to go badly sour over the next few years.

  11. skippy

    Go Doc H,

    Simple maths tell us all, that with out help they would DIE, MORTE, FIN.

    How can you make a profit, with the life blood of the tax payers stuck in your arm, et al transfusion.

    Hell did someone force them to create this synthetic BS, then spread it through every molecule of the investing construct, NO.

    Now they need help from the little people to make them hole again, shezzz what buddy fkers, pipers me thinks, never ending gluttony, is that one of the deadly sins, humm.

    I wonder if, their even American in heart, do not what you can for your self , but what can you do for your country eh. Who will you be remembered when the tally is weighed.

    Skippy…who are we…slaves…or free men and women. I would be poor and free, before slavery.

  12. Neal

    It all comes down to a “realpolitik” assessment that the US economy only grew in the last decade through the “financial innvation” and real estate inflation. What other engines of growth are out there?

    So patch up the FIRE engine–cost, laws and sanity be damned.

    From 24/7wallst.com, Doglas A. McIntyre

    (quote)

    What Geithner has found out, most of all, is that he has his interrogators cornered. Each and every one of them knows that the banking system cannot be allowed to fail and that no one is certain how to fix it. Too much criticism could lead to public anxiety about the entire set of programs meant to repair the broken financial and credit markets and suddenly there may be much more to fear than fear itself.

    Geithner has finished answering questions. He has gained the leverage to keep secret.

    (end quote)

    No wonder why China is busy trading it’s dollars and Ttreasury notes for assets and comoodity sources that they know will go up.

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