Now It’s Official: Stress Test Results Pre-Determined

We have been skeptical that the pending Treasury stress tests on banks, designed to ascertain their state of health, were inadequately staffed and therefore could not do the job properly. Our big concerns were that they had too few bodies to test financial data versus underlying documentation adequately (usually done on a sampling basis) and they lacked the expertise (and perhaps the mandate) to vet risk models (which we all know have performed impeccably over the last two years.

Is it a test if the results are pre-determined? Apparently Team Obama thinks so.

From CNBC (hat tip reader Early Withdrawal):

Said one high-level official, “I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.”

Now consider this observation from a reader in comments:

I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I’m involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn’t securitize or otherwise sell participations in the loan). Even now, we expect the hotel needs at least another $100 million to finish construction and open (we are no longer under any delusions that more than a handful of buyers will close on the condo portion of the condo-hotel). So, in other words, Citi is $275M into this project, and it’s not certain that the completed hotel will even be worth the extra $100M required to complete and open. Hence, one might plausibly value this $275M loan at zero (i.e., a complete write off). I cannot imagine any stress test would uncover what a huge loss is on the way in the next 12 months. In fact, this loan has not even been pawned off to the nonperforming/distressed debt/workout section of Citi because the interest reserves make it “seem” like the loan is still performing, not to mention that completely out of date pro formas make it “seem” like (i) equity will come in to finish the project and (ii) condo sales will pay down a huge part of the principal once construction is complete. This scenario must be present in a large number of Citi loans, especially in their somewhat active foreign development divisions. Citi must be so far from solvent that it’s not even funny. Only hyperinflation in the dollar could ever make it possible for the borrowers to pay back some of these loans. I’d bet that the sooner we face reality on some of these loans and just halt future fundings, the less money the taxpayers are going to lose. As it is, it’s almost too late. Too bad for the US taxpayer.

This is merely one story, but there has been a fair bit of coverage in the business press as to how a lot of real estate development, particularly high end resort, is being mothballed or simply cancelled. So there are no doubt other deals like that at Citi and other US banks.

Commercial real estate is also only one of many many portfolios at Citi,. We noted earlier than when Citi was on the ropes in the early 1990s, 160 bank examiners went in to get a handle on Citi’s CRE book in Texas and the Southeast. Those alone were enough to put the bank at risk.

We now have 100 bank examiners reported to be at Citi to give a bill of health on a much bigger, more complex enterprise than the Citi of the early 1990s. Do you think this is a credible exercise?

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  1. doc holiday

    This is old, but, maybe a few clues?

    Bank Financial Strength Ratings: Update to Revised Global Methodology
    Tangible Common Equity is defined as Common equity less the sum of goodwill and other identifiable intangibles.

    Many respondents were concerned with our proposed use of a simple leverage ratio (Equity/Assets) for assessing Capital Adequacy, especially because it did not take into account risk-weighted assets (RWA) and could therefore penalize banks with a substantial volume of low-risk assets. Our initial rationale for including the simple leverage ratio was to incorporate one capital ratio that could easily accommodate those banks that do not disclose risk-weighted assets. However, after carefully taking into consideration these comments and the proposals made by some, we have changed the BFSR scorecard by replacing the simpleleverage ratio with the ratio Tangible Common Equity (TCE).

    The new ratio captures the risk profile of banks’ assets (on- and off-balance sheet) as per Basel criteria which the former leverage ratio failed to address. Tangible Common Equity – nearly identical to the “core Tier 1” ratio reported by many European banks– will be adjusted to reflect Moody’s Basket Treatment for hybrid securities. For those banks that do not disclose risk-weighted assets we will estimate risk-weighted assets using broad balance sheet and off-balance sheet categories and standard risk weightings. These estimates will be compared to those of similar peers with disclosed risk-weighted assets as a check on their reasonability.

    •We also received several comments questioning why the combined weighting for balance sheet-related sub-factors (capital, asset quality, and liquidity) was higher than the combined weighting on the profitability and efficiency sub-factors. The respondents felt this contradicted Moody’s normal approach of stressing the importance of stability and predictability of earnings. Other respondents mentioned that capital has historically been cited byMoody’s as a lagging indicator of credit worth, and wondered whether capital ratios should receive less weight inthe scorecard. The respondents are correct in that for banks with strong balance sheet ratios, much of Moody’s analysis is focused on the stability and predictability of earnings.However, the scorecard incorporates earnings stability and predictability into Franchise Value, and indeed indirectly into Risk-Positioning as well. Therefore, we believe thatoverall the scorecard continues to assign greater weight to earnings predictability and stability than to balance sheet ratios. And to the extent that the balance sheet ratios are weaker, they usually do play a larger role in Moody’s ratings decisions. For weaker institutions the role of capital has always been significant to Moody’s ratings. We therefore continue to believe that the relative weightings within the Financial Fundamentals section are appropriate. However, the changes to the relative weighting of Financial Fundamentals versus Qualitative Factors for banks in mature markets, as well as the changes to the maximum factor, both described above, will likely lower the overall impact of any particular financial ratio on the overall scorecard estimate.

  2. Anonymous

    “Said one high-level official, “I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.”

    That is a flat out lie. Roubini says they’d need $1.5 trillion. Treasury and the Fed aren’t authorized to spend that much.

  3. Timo

    USA is going to collapse big time. The taxation level should already be Swedenlike or more in order to stop going deeper into debt, mainly thanks to SS and Medicare future liabilities, growing every single year 2000-3000 billion dollars on top of that 60000.

    That would mean doubling income tax NOW and VAT of about 30 percent on everything you buy…for starters. Sweden would be then actually considered tax haven by Americans!

    Is that going to happen in the USA? Hell no, they will prefer keeping their precious “tax cuts” and go down with the ship.

  4. Anonymous

    Total window dressing, nothing more than we’d expect from the Bush adminstration (may it rest in everlasting hellfire).

  5. Anonymous


    Hmmmm …

    Actually the transition from the Bush Administration to the Obama administration of slowly and incrementally metering out the pain, both foreign and domestic, seems to be going quite well.

    What an amazing and well orchestrated bumbling idiot show. Its all so believable. So real! Ha, ha, ha!

    Still a little time to organize the street demonstrations to make them less chaotic and more focused on the perps instead of each other.

    Burn your voter registration cards! Boycott the electoral process! Nationalize the Rule of Law!

    Deception is the strongest political force on the planet.

    More skepticism please.

    i on the ball patriot

  6. doc holiday

    Pardon me again:

    This is newer stuff: Bank Financial Strength Ratings

    Adjusting problem loan number

    Room for defining problem loans It is important to have a better idea of what real capital would be. To reach the accurate level of capital, it is also important to know the true quality of the loan portfolio. In this connection, adjusting problem loans (PL) is justifiable in certain circumstances given the diversity of PL reporting across the world. In some systems, PL is not publicly disclosed, while in other systems disclosed PL includes so-called restructured loans that are not classified as problem loans in other systems. While it is practically impossible to reach uniform agreement on this point, adjusting problem loans to reach the true level of capital is justifiable. Adjusting for and estimating Economic Solvency Differences in reporting and regulatory standards affecting any balance sheet items will inevitably create distortions in reported capital, because it is nothing more than the net of assets and liabilities. Given the importance of capital adequacy, especially for emerging markets and for weaker banks everywhere, it is vital that the scorecard’s capital adequacy ratios be adjusted for these differences when the analyst and the rating committee agree that reported numbers do not provide a true measure of a bank’s capital. The Economic Insolvency Override used in the score cardis, in fact, an estimate of just this sort of capital adjustment. The most typical valuation adjustment is for over-valued loans, resulting from under-reported and/or under-reserved problem loans (PLs). Having adjusted the PL number as described above, the analyst then estimates thelikely loss among the problem loans and adjusts capital and risk-weighted assets accordingly. Assuming that the loss rate is estimated to be 50%, a normal loan loss reserve for the bank of 1% and that the loans carry 100% risk-weights,the formulae for the scorecard’s capital ratios would be.

    >> Anyone know why these retards are still in business? Amazing!

    >Many thanks, so sorry!

  7. Anonymous

    Noted from Wiki…..

    In 1997, together with then-Federal Reserve chairman Alan Greenspan, Rubin strongly opposed the regulation of derivatives, when such regulation was proposed by then-head of the Commodity Futures Trading Commission (CFTC), Brooksley Born. Overexposure to credit derivatives of mortgage-backed securities was a key reason for the failure of US financial institutions Bear Stearns, Lehman Brothers, Merrill Lynch, American International Group, and Washington Mutual in 2008.

    According to the New York Times, “In November 1999, senior regulators—including Mr. Greenspan and Mr. Rubin—recommended that Congress permanently strip the CFTC of regulatory authority over derivatives.”[9] This advice was accepted and derivatives were kept clear of regulation by the CFTC.

    January 9, 2009 Citigroup announced his resignation [Rubin], after having been criticized for his performance. He received more than $126 million in cash and stock during his eight years at Citigroup.

  8. Anonymous

    I’m guessing that within this quarter, Dow Jones will remove three issues from the DJIA — Bank of America, Citigroup and General Motors — and replace them with non-zombie companies.

    Thanks to arithmetic averaging, their influence on the average is now negligible anyway.

    Dow 7286 was the Oct. 2002 closing low. This is a test … this is only a test.

  9. Early Withdrawal

    not Early Writedowns, Early Withdrawal.

    There’s no sexual innuendo in Writedown (I don’t think?)


  10. alex black

    That high level official comment is hysterical – the banks have enough capital for the worst scenario, and we’re ready to give them that capital. That’s either a non sequitor, or an admission that the “banks'” only capital is actually not the banks’, but the government’s.

    Was this official out on a bar crawl with Japan’s Finance Minister when the reporter interviewed him? If so, the reporter should have dutifully included the hiccups in between the words.

  11. Anonymous

    What else would one expect from this banana republic.
    Gold, guns, groceries and short the hell out of this thing.

  12. doc face value holiday

    Sorry, left something out that seems on-topic from previous mindless post:

    Adjusted Tier 1 CAR = (Reported Tier 1 Capital – (EL-LLR-(.01*(Gross Loans – EL))) / (Reported RWA – EL)
    Adjusted TCE/RWA = (TCE – (EL-LLR-(.01*(Gross Loans – EL))) / (Reported RWA – EL)
    Where EL is assumed rate of Expected Loss: EL = .05*

    Adjusted Problem Loans

    Moody’s generally proceeds from the assumption that liabilities will have to be settled at face value. Thus, the
    analyst’s task is to adjust any asset valuations deemed problematic. As loans often make up the majority of a bank’s
    assets, other adjustments may not be necessary as they will not result in any material change in capital. However,
    Moody’s analysts will look at both over-and under-valued investments should they be material.

    Goodnight and sleep well!

  13. Miguel_Swanstein

    There’s already been too many mooted trial balloons, contradictory statements, rescheduled announcements, and 11th hour changes-of-plan for me to take this quote at full face value.

    Statements like these may be a result of having a lot of open microphones in front of an administration that’s facing many difficult questions and has yet to establish exactly who speaks for what issue.

    Events sure are moving fast….I just wish Summers and Geithner would hurry up and fix the auto industry so they can get back to stabilizing our banking system….

  14. doc holiday

    Ok, your gonna kill me, I know, but I had to follow one last thing, which was this (*) that little bullet-thing, which has a name, but, nonetheless, that last sentence there was:

    Where EL is assumed rate of Expected Loss: EL = .05*

    The "*" goes to this, which seems important to me, because IMHO, Citi is insolvent and it's obvious Citi does not have net income, thus it would fail a stress test! The last 4 qtrs at Citi have all been negative losses, so essentially, besides some goodwill magic and some Level lll trash and Billions in handouts from The Fed — Citi is a blackhole and the sooner they kill it the better!

    * The relevant market(s) for Market Share and Sustainability should be determined based upon where the bank makes the majority of its net income. The geographic size and scope of a market for any given business line depends upon the nature of the customer, the products, and the existence (or lack) of legal or de facto barriers to entry. The relevant market for many retail banking products may be local or regional, while for other products it may be national or international in scope. The relevant market may also include nonbank competitors depending upon the product.

    > Goodnight for real!

  15. Anonymous

    I hope that, for whatever good it will do, folks posting here are also writing to their Congressfolk. I’m sure the banks are staying in constant contact with them; it’d be good if the people funding all this garbage are at least making it known that they’re pissed.

  16. bg

    “New administration, nothing has changed.”

    No, its getting worse.

    The old administration seemed to know the banks were in trouble, but wanted to help their friends in banking.

    The new administration seems to hope the system will be stable long enough to subsidize their policies.

  17. Anonymous

    Change! Looking at things so far (it may be too early, but) looks like nothing we should expect. First, cabinet members’ tax issues are okay, then look at the IL’s senate seat fiasco, it was finally sold! And now predetermined stress tests! What next …

  18. Anonymous

    >> Said one high-level official, “I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.”

    I'm sorry, do these people know anything at all? Did they ever even take a class in in basic accounting? Either a bank has capital or it doesn't. If you have it, you do not need some kind of "program" to give you access to it. Good Lord.

  19. Anonymous

    Citi and BAC rumor, gossip rumor…still total crap and going to zero. Only day traders who will all get shot.

  20. fresno dan

    When Geithner ran the NY Fed, did he know how Goldman Sachs…er, (sorry, hung up of GS)Citipoop operated? Does he know how? How would you know?

  21. MarcoPolo

    This is so far off the wall. I don’t know if it’s worthy of your comments.

    Consider however, that Obama, through his minions Geithner & Summers, knows that nationalization is the only possible answer, but that there are either political obstacles and/or physical limitations which make that impossible now.

    And that also nationalizing a Citi and not BA, which might be possible, would likely produce a run someplace else. Never mind the probable catastrophe in derivatives and the problems at the trading desks. So, the thinking may be that they need a holiday. And the stress testing is nothing more than a feasibility study. A sample population.

  22. David

    Why don’t they just do something like this. Covert the preferred shares to common but with a rachet provision. If the non-government common equity falls below certain limits then their stake in the company falls. So if Ken Lewis is right about their ability to absorb losses then they will keep the company. Otherwise they will lose all their stake if equity falls below a certain level. This way, BAC shareholders live or die on their loan book rather than the arbitrary decisions of officials. It will also allow for seamless nationalization if that happens instead of these dramatic Sunday nights. That should reassure markets.

  23. albrt

    Several smart people, including Krugman, have suggested that this plan is a Trojan horse, and that the weakest banks will be nationalized once the “stress tests” demonstrate fundamental insolvency.

    I am beginning to think that if the Paulson/Geithner/Potemkin plan were intended to be a Trojan horse, it would have been crafted more carefully. As it stands this plan is simply not plausible enough to pass as a Trojan horse. It is nothing more than a really bad plan.

  24. eh

    Let’s wait and see what comes out of it. Anecdotal evidence can be just that — anecdotal. Although I admit that, in retrospect, it would have been difficult to be too pessimistic in the recent past.

  25. Anonymous

    I propose the following stress test: tomorrow at 1 PM, Eastern Time, every other depositor shows up at his or her neighborhood friendly Citibank and withdraws the very last penny out his account. Let’s se how they’ll fare that stress test…

    Vinny GOLDberg

  26. Nicholas Mycroft

    From the NYT:

    The stress tests will use computer-run “what if” situations to estimate what would happen to each bank under Depression-like conditions, with unemployment surging to 10 or 12 percent, for example, or home prices dropping 20 percent further, Treasury and Federal Reserve officials said.

    Fed officials emphasized that these hypothetical events were “highly unlikely” to occur.

    Well, 10-12% unemployment and -20% more on housing is my baseline forecast, with risk skewed heavily to the downside. Nice robust stress-test, that.

  27. Anonymous

    I wonder if you can be so stupid as to post/believe this “anecdote” from the Caribbean hotel guy!!

    How is this guy “involved” in this deal??
    He has an interest for the hotel venture to be profitable or he has an interest for the venture to loose money? If he wants the deal to be profitable , then he would be the first person in the world to “talk down his book”. If he has an interest that the venture looses money then he is of course completely unreliable.

    In any case it is a shame for a blog that pretends to be serious to put up such tosh…

  28. Anonymous

    It sounds to me like the stress test is just a precursor to “give them more money”. From Bloomberg today:

    “Obama Bank Nationalization Is Focus of Speculation”

    Treasury Secretary Timothy Geithner and his fellow bank regulators said today that the government’s proposed “stress test” for the nation’s largest banks would start this week. The test will determine which firms should hold an extra buffer of capital to withstand a more severe economic climate. Those that fail will be given additional taxpayer money if they can’t raise it from the private sector.

  29. DanyBoy

    I’ve said it before:

    Japan IS the BEST case scenario for America’s financial sector.

    If we nationalize:
    -Your taxes will draw down your earnings by tens of thousands and for years to come.
    -Foreign countries will have the Federal budget on a leash for decades. Everything from healthcare to social security will be considered “largess” and be nixed. Forget about our national parks.

    -Nationalization IS A BANKSTER”S WET DREAM:in a marketplace where the entire sector should shrink by half, they’ll try to sell the governement (ie you) moribund companies for actual money!! And then also be off the hook for all those declining assets! Placing you and me on the hook forever.

  30. luther b.

    DanyBoy is right.

    when (sh)citibank & prominent good ol' boys on both sides of the aisle lobby for nationalization, we should know that nationalization is NOT the answer.

    it's a game of memes.

    got always stay one step ahead of the pack and trust that sooner or later they'll come crawling closer into the corner.

  31. Anonymous

    Yves, a pilot once told me a maxim: the result of any maneuver must never be seriously in doubt. By analogy, I’m a little concerned by the financial button pushing and lever pulling that I see going on, let alone the trillions of dollars being thrown at the problem.

    Furthermore, I don’t think stress testing those on life support is such a good idea. Since the results are predetermined, is this charade supposed to instill us with confidence?

    Seriously, I wish the Government would put as much effort into solving the problem as they are in trying to manipulate public opinion. Such tactics always backfire.

  32. luther b.


    the current Ad from Google:

    “Economic Stimulus Package. The US Guv is giving away over %10B a month in grants. The Economic Stimulus Package means FREE MONEY FOR YOU. Read how you can get your govt. grant that never has to be repaid.


    …and some wonder why…

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