Bank Stress Test Dance of the Seven Veils Continues

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The latest leak, arriving curiously after the markets closed, is that the Treasury wants Citigroup to raise $10 billion as a result of the famed stress tests, which the bank is fighting tooth and nail. Another rumors circulating in the media Is that Bank of America is being asked to convert $45 billion of preferred to common. Wells Fargo has been fuming in public since the tests were announced, but so far I haven’t seen any detail on the indignities to which they think they are being subjected.

Let’s recap. On the one hand, the stress tests aren’t turning out to be the complete farce that I had thought they might be (my benchmark was whether Citi got off clean while some regional banks, such as Fifth Third, were dinged to validate the process). But that comes well short of being sufficient. Consider:

1. The adverse case in the scenarios is far from the worst reasonably conceivable, so the “stress” is too favorable to the industry

2. The banks submitted results using their own methodologies, and most important for the big capital markets players like Citi and Bank of America, their own risk models. In my view, the biggest single error of the Greenspan era wasn’t the famed “Greenspan put” but his complete hands off posture concerning derivatives. Not only did he adopt a “let a thousand flowers bloom” stance, but allowed banks to adopt their own risk models, and did not require Fed staffers to develop sufficient competence to evaluate them. Mr. Market knew best. The inability to look under the hood and assess risk models and practices, except at a very superficial level, is an enormous failing and hamstrings the effort underway now.

3. There was no verification of underlying accounting and loan books, not even a teeny bit of sampling.

With this as background, the “stress test” process was awfully industry friendly. Yet some were nevertheless singled out for action, and they are protesting bitterly. That in turn suggests:

1. Even with a liberal grading scale, some banks are still pretty punky. I am wondering if Treasury is surprised. I suspect the hope was that Treasury would draw the line in such a place that the banks would look more or less OK, with only minor remedial action required. Team Obama has made it clear that it is not up for nationalization, yet results like this are a reminder that this outcome may be foist upon them (we think it’s a given for Citi unless it dismembers itself instead).

2. The fact that Treasury is letting the banks negotiate the outcome means:

It isn’t hugely confident in the results, and/or

It is still a hostage of the anti-regulatory logic of the last twenty years. A regulator with any guts would not take backchat from its charges on a determination of safety and soundness.

One also had to wonder whether Citi, in conjunction with trying to persuade Treasury that it is in rude health, is hinting at the danger of precipitating a run on the bank. Citi’s roughly $500 billion in foreign deposits are a huge impediment to putting the bank into conservatorship. It seems inconceivable that Uncle Sam would guarantee those deposits, yet failure do so could have catastrophic consequences. A run with that much in the balance would be beyond the big bank’s ability to satisfy on any short-term timetable (even its now large Treasury holdings are below that level, and dumping any asset type on that scale to pay off depositors would roil markets).

So bizarrely, Citi holds a sword of Damocles over the Treasury, much as AIG does. And that means the problem of dealing with Citi if it is indeed not the best shape, is tantamount to disarming a nuclear warhead without an instruction manual.

The Wall Street Journal story on the continuing soap opera contained some interesting tidbits:

The Obama administration is expected soon to outline what type of investor it will be in companies where it has a stake, according to people familiar with the matter. The Treasury is discussing applying different levels of governance depending on the size of the U.S. government’s stake. The overall goal is to get out of the investments as quickly as is possible and minimize government intervention in banks’ operations.

The outcome of the stress tests could play a major role in shaping the next phase of the U.S. government’s intervention in the nation’s ravaged financial system. After the results, banks will have 30 days to give the government a plan and six months to put it into effect. The banks are expected to reveal their plans next week.

We’ve been grumbling for some time that the automakers have been raked over the coals, presented with strict deadlines for plans proving their viability, while the banks have gotten off close to scot free, save demands for restraints on pay (which given that they are wards of the state, seems not at all unreasonable, despite the howls of protest from supposed capitalist employees having trouble adjusting their lifestyles to the new reality. And don’t give me the talent argument. Yes, some are defecting to boutiques, but time will tell if they can be as successful as they think in the “eat what you kill” model). One presumes these plans are mere fundraising plans, not operational plans, and thus will be far less demanding that what GM and Chrysler faced.

This comment was a useful reminder:

The stress tests are a central part of the Obama administration’s effort to restore confidence in the U.S. banking system.

While this may be shorthand, it reveals a preference for optics over substance. The priority should be to assure depositors and investors that banks are sound, not to “restore confidence”, a more nebulous and subjective standard.

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12 comments

  1. Doc Holiday

    "If you put the federal government in charge of the Sahara Desert, in 5 years there'd be a shortage of sand. "

    Milton Friedman

    > Nice post there Yves!

  2. Tony

    If Mastersoftheuniverse in Citi need $10bn, – why don’t they do it the old fashion way and earn it, or acquire it in the socalled freemarket. Simply slithering into Giethners office buggering the American taxpayer is low, week, a sign of unprincipled incompetence, and conduct unbecoming, – if not illegal.

    Great post, but if had supported the Cramdown proposals in the recent Bankruptsy law that would have benefited the TAXPAYER and 1.7mn HOMEOWNERS, or recognized the hypocrisy of the resistance the Credit Card Bill of Rights benefiting the American TAXPAYER and CONSUMERS, – then maybe the government – in an act of goodwill – should support Citi’s begging, – I mean request; – but – since Citi has spit in the face of the American taxpayer, homeowners, and consumers and promoted and advanced abusive policies – – then Citi can go to hell. Get you $10bn on the street biaatches like real predators, and quit robbing and pillage poor and middle class Americans.

    TonyForesta

  3. attempter

    I agree that, while the administration’s underlying corporatist ideology and strategy remain the same, we’re seeing some tactical/execution improvement on a few front: the stress tests are turning out, as Yves says, not quite as farcical as they were looking to be in principle, and the Chrysler bankruptcy is also being handled somewhat better than we might have expected (i.e., the admin did not completely cave in to bondholders and sell out the workers).

    While I don’t think this signifies (yet?) any real change of heart, perhaps it’s a grudging acknowledgement of political realities, which in turn may lead to an ideological shift (if the admin belatedly remembers that it was elected to effect “Change”, and that in principle it’s supposed to be the servant of the people, not of entrenched feudal rent-collectors).

  4. Steve

    If the Fed turned off the spigot, Citi, BoA and several others would be dead as a doornail. I predict this will still be true at the end of Obama’s term.

  5. don

    For the BO admin. to “restore confidence in the US banking system”, it must also restore confidence in C., etc. are healthy. This then would require that they paper over, go easy on, conceal the identities/substance of the S.Test, while providing them whatever support is needed.

    But in proceeding this way the BO admin. risks losing credibility with the public who so far at least are confidence that BO is looking out for the rest of us, thus the pressure to provide transparency.

    Providing transparency would require that government intervention, in protecting the taxpayer’s interest, requires government say over C. internal management. Doing this then makes other banks nervous, thus shaking banking confidence: Catch 22.

    So the bottom line, as it always has been, is whether BO will place greater emphasis on restoring the confidence of the banks, or in demonstrating that he’s out for the populace. My hunch is that he will continue as he has: in substance looking out after the banks, while doing an excellent job giving the appearance that he is looking out for the rest of us.

    No doubt that can be met with another nationally televised news conference.

  6. mr_a11is

    A while back someone proposed the “boiling frogs” theory of bank recapitalization (my apologies to the original theorist for not remembering their name, I’m an over-blogger). The gist of it was that first the shareholders get hit, then the preferreds, then unsecured creditors, etc, etc. That seems to be the path we’re taking. Nice and slow, don’t let the frogs get too excited, and just keep turning up the heat gradually.

    My only problem with this theory is that is assumes someone (Hank, Timmy, Volcker?) actually came up with a plan and is successfully executing it. I just can’t come to terms with that.

    And a special thanks to the WSJ for holding this story until after market close on a Friday. A 3 pm release would have been more entertaining.

  7. Richard Kline

    I’m of the view that one particle of reality has begun to sink in at the Treasury and the White Palace of Pennsylvania Avenue, that it is nearing a political impossibility to get Congress to authorize another $1T-$700B increment so shovel into the maw of raving _and ingrate_ zombie bankers. And with the loss positions at many of these insolvent financials reaching the stage of gangrenous eruption with commercial re exploding in the basement levels of its securities this presents a real problem. The Fed and the FDIC are already being frogmarched into legally grayscale, massive interventions to support asset prices, without which such efforts the complete dissolution of these money center corporates is impossible to obscure no matter how large the TARP. Where to get the money to make the dead balance sheets even fakeably vivid? There just isn’t enough dough.

    By that logic, some of them have to go, or at least have to radically change their configuration of woes.

    Reality eventually backs one into doing something like the right thing, like it or not. Soooo, when do we see Bo Prez throw a trashcan through the plate glass window of Citi? Of course, it should be JippyMo, or Goldbricks, but hey, these insurrection things are a whole lot harder to stop then to start. That’s something _I’m_ banking on, anyway.

  8. MrM

    The banks submitted results using their own methodologies, and most important for the big capital markets players like Citi and Bank of America, their own risk models. You should not underestimate the cross-sectional nature of these stress tests. While the banks were asked to you use their own models, those that produced loss rates lower than the peers had some explaining to do. As a result, the loss rates are expected to fall neatly within the provided expected loss ranges. It is inconceivable that Citi or BofA would be able to defend their assumptions that loss rates in their mortgage and credit card portfolios would be better than those of their peers. Yet, apparently, this is what is happening.

  9. Harlem Dad

    Yves,

    Great post, as usual from you. Thanks for not letting go of this story.

    > So bizarrely, Citi holds a sword of Damocles
    > over the Treasury, much as AIG does.

    I'm beginning to wonder, is the U.S. Government as we know it really "too big to fail?" I'm not kidding. This isn't the first time I've worried about this.

    Personal Antidote: I'm going shopping with my 10-year old daughter today to buy ingredients and supplies with which to make Jelly Doughnut Muffins.

    Tim in Sugar Hill

  10. Sacrifice

    Recent actions by the administration gives a whole new meaning to the term 'President & CEO'.

    IMHO

  11. Anonymous Jones

    I don’t know why most just don’t come out and say it…”the banks cannot survive under the current compensation models.” What about this is so confusing? To the extent that the top executives and traders get compensated for immediate results and never share the pain for long term losses, how can these banks be long term earners for their investors? It’s impossible, of course. Any palliative attempts by any administration are doomed to failure. The compensation models are purely for bubble conditions and must be completely overhauled if there is to be any equilibrium in our economy.

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