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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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.