We hate to keep harping, but more details of the stress test farce are coming to light.
It was bad enough that the Treasury came up with an adverse case that is hardly a worse case scenario. As we pointed out, it is considerably more optimistic, both in duration and intensity of the downturn, than is typical for serious financial crises. And the earlier comparables did not take place in the context of a global downturn, which meant the afflicted countries got a substantial boost from depreciating their currencies and rising an export boom. Pursuing that strategy aggressively risks competitive devaluations and worse, overt protectionism. a negative sum game.
The tests also did not sufficiently allow for the just-started commercial real estate downdraft, nor did they probe the exposures most subject to sudden decay, namely, complex securities and derivative exposures. Those are big risk factors at the firms with large credit trading operations namely the former investments banks (Merrill, now part of Bank of America, Morgan Stanley, Goldman) plus the banks that have made successful entree into the big leagues, Citi and JP Morgan. And there was no examination of the risk management models and practices, nor sampling of the underlying loan books….
This is the legacy of regulators who are so subject to what Willem Buiter’s “cognitive regulatory capture” that the believe the Wall Street party line, that they are the best and the brightest, and therefore are better judges of how to manage their affairs than any outsider. Despite ample evidence to the contrary, plus the danger of giving hungry organizations a taxpayer backstop, the Treasury has shown a predictable lack of resolve, completely in keeping with its industry-favoring posture.
The most disturbing revelation comes via the Financial Times:
US banks have been given government assurances they will be allowed to raise less than the $74.6bn in equity mandated by stress tests if earnings over the next six months outstrip regulators’ forecasts, bankers said.
The agreement, which was not mentioned when the government revealed the results on Thursday, means some banks may not have to raise as much equity through share issues and asset sales as the market is expecting. It could also increase the incentive for banks to book profits in the next two quarters.
So get this: the official releases on the stress test results and process weren’t honest and complete. We basically have the real deal, which is the unwritten understanding between the Treasury and the banks, versus the phony version presented to the public. And if we can’t even believe the headline number in the tests (the amount of money they are supposed to raise), is there any other aspect we can trust? How many other winks and nods were there between the Treasury and banks that weren’t leaked to the press?
Admittedly, there is normally some give and take with a regulator, but the public has been led to believe that this process would be transparent. It has wound up being somewhat so by virtue of leaks rather than by living up to its promise.
And in case you missed it, the phrase in the FT, “increase the incentive for banks to book profits in the next two quarters” is code for “fabricate earnings”. Per below, there were quite a few instances of permissive accounting this quarter. The powers that be are inviting more of the same. And this is all in the name of boosting confidence.
Additonal tidbits from the Wall Street Journal story on how far the banks beat the Treasury:
Citi’s shortfall was lowered from $35 billion to $5 based on “pending transactions”. Given the open skepticism among M&A professionals about the appetite for bank assets, this sounds pretty dubious. Update: some readers in comments point out that these deals include the preferred to common swap, the sale of the Nikko Cordial JV and the sale of a controlling interest in Smith Barney to a JV with Morgan Stanley. f I am not mistaken, the preferred to common swap was expected to be inevitable. However, remember the only addition to equity that would come from other transactions was if the entities were sold at a premium to book value, and then you’d have to know how large that premium was to ascertain how much of an equity increase resulted. Selling a business at book merely increases liquidity and does not raise net worth (however, as we noted in comments, the Morgan Stanley did produce a large tax gains, $6 billion, but that deal was announced in January, so I am a bit puzzled that it was not factored into the analysis, The total TCE gain for that deal was allegedly $6.5 billion, the Nikko Cordial JV sale, $2.5 billion, but again, I am leery of single metrics for safety and wonder what their impact was on other net worth measures). Citi happens to be pretty liquid right, now, so increasing liquidity alone is not much of a benefit. Back to the original postL
BofA’s tab was lowered from “over $50 billion” to $33.9 billion, Wells’ from $17 billion to $13.9 billion. The reductions at other banks were larger in percentage terms but vastly smaller on an absolute basis.
Another troubling element is that banks persuaded the regulators to base their earnings assumptions based on first quarter results. That’s awfully aggressive. Few banks analysts expect those earnings to be sustained. They included one-offs at many banks (under-reserving at Wells, non-cash items like flowing falls in the market value of outstanding debt through earnings, which is permitted but hardly a sign of strength, the unwinding of AIG positions which reportedly made meaningful contributions at the capital market players, and 1Q economic activity benefiting from higher than usual tax refunds).
The authorities tried to claim that these negotiations were typical of regulatory reviews. but I beg to differ. First, the banks came after the Treasury even before the exams had begun. Some, Wells in particular, made a frontal assault to put them on the defensive, and it appears to have succeeded. Second, the tone of all the leaks suggest that the banks acted as if they were at least equal partners in this exercise. That’s not the right footing for a regulatory exam, but it appears that the authorities fell into that dynamic.
Consider these snippets:
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed’s exaggerated capital holes. A senior executive at one bank fumed that the Fed’s initial estimate was “mind-numbingly” large. Bank of America was “shocked” when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.
Yves here. I’m willing to hear otherwise, but I cannot imagine, say a pharmaceutical company being told it had manufacturing violations getting “furious” with the inspector. Fury is a deal tactic, bullying by any other name, and works only if the other side lets itself be cowed. Returning to the story:
At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as “asinine,” were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed’s findings.
Yves again. The fact that the threat of a suit carried any weight shows, as we have argued, that the process was superficial. The Fed has a clear mandate (in its original charter) with respect to the safety and soundness of the banking system, and measures to require banks to meet standards of capital adequacy should be safe ground for action (and Bill Black is fond of reminding us that regulators have considerably more latitude re the determination of safety and soundness than most laypeople realize).
The flip side is this shows a complete lack of resolve, and decent advice, on the part of the Fed. I guarantee that a serious discovery process would unearth very damaging e-mails, and per William Black, who knows what digging into the accounts would unearth. But making Wells look bad, which push comes to shove, could be accomplished, would undermine the larger Administration aim of “restoring confidence”. The fact that the goal was framed that way, and that the powers that be will do just about anything to avoid putting the big banks into receivership means the banks know they have the upper hand. That explains the intransigence. Back to the story:
According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks’ cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.
Federal officials said their projections reflected the most comprehensive analysis ever conducted of the industry.
I don’t find that reassuring, but clearly I am in the minority.
Given the $30 billion reduction in Citi’s fundraising requirement based on the questionable premise that they will sell enough assets at decent prices (remember, if they get offers of less than book value, a sale would not improve their equity base), the odds are high that they will be back at the TARP trough. But Team Obama is sufficiently adept at the art of spin, expect some sort of “whocouldanode” angle.