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.
The Administration is continuing a process of ignoring the laws and simply trying to direct the outcomes it wishes.
It will discover sooner or later that it is an impossible task; the law of unintended consequences is too powerful. For example, given the events of this week, why would any bank choose to sell assets, toxic or otherwise, when it knows full well that its very heft gives it permanent access to government funds on whatever terms it chooses? Prices would need to be ridiculously high…and why would hedge funds pay these prices, when they know from Chrysler that should push come to shove, the government will have no problem amending the rules to favor whoever has the ear of Rahm Emanuel? Which means the government will need to make the giveaway even greater, which…
The entire Administration ex-finance has been a breath of fresh air; from State to Interior, it’s a team that gets it. But Treasury combines the incompetence of the Bush Administration with the reporting standards of the Putin Administration.
It sounds like we need an alternative media publicization of the real stress test results where we can identify them (as in the case of this Citi figure), as opposed to the bogus “official” bank-approved figures the captured MSM are depicting as valid.
Really, what else did you expect?
From the citation: “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.” So on top of every form of deception and misrepresentation possible, the banks were allowed to exclude ~$70B in _known losses_ from consideration of this ‘test’ so that they could ‘pass?’
I’ll repeat myself from yesterday: these tests have absolutely no credibility WHATSOEVER as a measure of the current financial standing of these institutions. They are fabrications utterly of whole cloth. They put Bernie Madoff to shame; seriously, to shame. He at least dribbled out real money, from one set of pockets into others. This exercise is one of fiction, not of banking or regulation. My patience and blood pressure were the only things stressed.
Barack, Tim, and Larry: You’re living a lie. And you can expect the logical consequence of that. And no, the recovery which is _not_ just around the corner won’t ride into town in a white Cadillac to save you.
Do you honestly think that they pay any attention to those of us here who really know what’s going on? Does Yves get invited to the White House ala Klugman to discuss the current situation? I think not. Thay don’t want to here the truth….They can;t handle the truth.
sorry for the spelling, it’s late.
Goldman wanted to return its TARP money. Goldman passed. Ken Lewis “ratted out” the Bernanke-Paulson mob. BofA is nicked with $34 billion. Citi only $5 billion. You’re telling me Citi is in better shape than BofA? I don’t believe it. I saw Zimbabwe Ben on television the other day. He said the stress tests were not tests of “solvency”. This is just part of the continuing Wall Street-Washington kabuki dance.
YS: “. Second, the tone of all the leaks suggest that the banks acted as if they were at least equal partners in this exercise.”
I suspect the banks can behave this way, because they have plenty of dirt on Treasury, Congresscreatures and all the govt regulators, which they can throw onto the table at any time when they don’t get their way.
Everyone in this process is now corrupt, and no one wants the people to be shown this.
With respect to Cit, the 30B in pending transactions include:
1) the preferred to common exchange that builds up 15B of TCE (now raised to 20.5B to pick up the 5.5B shortfall). Given where the preferreds are trading in the market I think it safe to conclude that this transaction is 100% likely to occur.
2) The JV/sale of Smith Barney to Morgan Stanley that picks up 9.5B of TCE.
3) The sale of Nikko Cordial to Sumitomo for 5.5B of TCE.
So the pending transactions are already publicly announced, signed and sealed – just not delivered. The regulators could have said that Citi has a 35.5 shortfall and then Citi would have just noted we have these other transactions that will be done by November and the gap would have been filled. Fundamentally, the Citi common shareholders are getting massively diluted by the exchange and 2 arguably valuable assets are being sold. The stock price reflects that. But it is not some hypothetical pie-in-the-sky reduction in TCE need as your commentary seems to imply.
Much of the rest of your article is plausible although there are serious arguments in favor of BAC and Wells views that are not being addressed in your blog. I also think your assumptions about the I-banks derivatives books performance in these stressed enviornments are dead wrong. With the exception of the stupidty of the non-collateralized trades with AIG, MBIA, ABK etc…, the vast majority of derivatives trades are collateralized on a daily MTM basis. There just isn’t much credit risk there. I worked in equity derivatives for 9 years at a major investment bank. I have had plenty of clients go bankrupt, never had a credit loss as the daily MTM plus cushion really ameliorates the problem. Not unlike Reg T and margin requirements for retail investors.
First of all, what happened to the Basel II capital requirements levels that the banks are supposed to be meeting any day now?
Oh, did that 20-year exercise go out the window?
All a charade and a facade for what was supposed to be the orderly move to One World Bankcorp?
And, do we really have Mr. Barack “change-you-REALLY-can’t-believe-in” putting the PRIVATE federal reserve Bankcorp in charge of uber-regulation of all financial services operations?
It is getting a little queasy in here.
Abolish the Fed.
Put the money-creation powers in treasury, along with ALL of the financial services regulators.
As Krugman says, this is the age of the anti-Cassandra. Do keep harping!
Just one comment about the preferred to common swap at Citi and other banks. Calling it “dilutive” is surely misleading in a case such as this. Certainly, when there is a chance that an enterprise will earn vast sums of money above the earnings already allocated to the preferreds, this might be correct. But when an enterprise is in the hole (and not likely to get out anytime soon), taking a part of the capital stack that has *higher priority* as to full payment and a return thereon and then dropping that part into the bottom stack of capital is almost never dilutive to those already in the almost worthless bottom stack. Even if the existing common is severely squeezed down, they do not have to “earn their way out” of the preferred stack anymore, and a smaller piece of something is almost assuredly worth more than a larger piece of nothing. Common shareholders at Citi hold nothing more than a call option at this point. Swapping preferred for common leaves them holding a piece of a real business but decreases the value of the call option, which may or may not be a losing proposition overall. In Citi’s case, I would be astonished if the preferred for common swap is actually harmful to the commons.
You say that “it appears that the authorities fell into that dynamic” re the banks being “at least equal partners” w the regulators. Do you mean to say that, or do you mean what I believe, which is that the banks ran this charade from the beginning through their tools of Geithner and Summers?
I stand corrected re the swap of preferred to common, although I had thought that was in the cards regardless and am thus not certain of its validity as a credit against equity requirements (ie, were the goalposts moved during the negotiaitons?)
A sale of an entity adds to equity ONLY to the extent a profit on book value results. The figure you gave for Nikko Cordial was gross proceeds, not any gain. While they may result (techinicaly) in an increase in TCE because it was an interest in a JV and therefore not consolidated, from an economic standpoint, the improvement in equity is only to the extent a gain was booked. I am never a fan of the use of single metrics to judge safety and soundness for that reason, they typically give an incomplete picture. The gain on that deal was $2.5 billion, not $5.5 billion.
The sale of the stake in Smith Barney took place in January, that can hardly be called “pending”. The articles I found said that the sale allowed Citi to show a tax gain of $6 billion and add $6.5 billion of TCE. That again is less than you claimed.
My take is less nefarious. I think this was cognitive capture, plus the long standing belief by Geithner in particular that the banks can’t be regulated effectively (he has said so in speeches re complex products, see his March 2007 speech on financial innovation).
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. Citi happens to be pretty liquid right, now, so increasing liquidity alone is not much of a benefit.
I’m not as sanguine as you are re complex derivatives (the plain vanilla stuff is a different matter). You have counterparty risk, as AIG demonstrated in spades. Posting collateral works fine until you suddenly have a problem with a counterparty who can’t post the collateral. If that happens on sufficient scale, as we saw in October, traders dump positions, sometimes in seemingly unrelated markets, creating dislocations elsewhere. Those are often non-linear changes. And hedges are almost never perfect, and slippage can be greater than expected in sudden downdrafts.
Thanks for your responses. I still, however, mostly disagree.
1) Citi preferred exchange – that is definitely happening, talk to any arb it is the biggest position for most of them. The point of the exchange was not Tier 1, by any analysis Citi is way above having any Tier 1 issues, thanks to both the 50B of prefs they sold in early 2008 privately and the 45B they sold to government in late 2008. The problem, for Citi, was that the Fed has added a 4% Tangible Common Equity requirement as well. That is why Citi had to do the exchange. The 35B shortfall for Citi that the SCAP regulators came back with was TCE and had not included the preferred exchange since it had not happened yet. Since it is going to happen, whether or not it was included in the published “shortfall” is all optics.
2) With respect to the Nikko transaction, I may be wrong. That entity was entirely bought for stock and the goodwill had been written to zero, so I was assuming the cash taken in had to be all TCE. By the way, it has not been a JV for at least a year, although it was before early 2008. In early 2008, Citi bought out Nikko enitrely.
3) Smith Barney transaction was announce in January, but in the announcement it was expected to close in Q3. I think they are now trying to get it done in Q2. I.e. it is still pending and certianly not in any TCE calculations.
4) Fundamentally, my point is to assume that the government just took Citi’s, or Fifth Third’s (whose 1.5B sale of the payments business has not closed) or BofA’s (who has a 20B odd stake in China Constuction marked at zero) word when they made the adjustments, also assumes that Summers, Geithner et.al. are frauds, idiots and crooks. I object to that stance (as does your esteemed poster Mr. Harrison).
5) With respect to derivative collateral, you would correct if there were super large books of hard to value complex derivatives on the books of the I-banks. But when you actually dig into them what you find is that the lion’s share of derivative exposure is vanilla interest rate swaps (like 70-80%). Then 10-15% is vanilla CDS and FX. These are not hard to value. I agree wholeheartedly with respect to AIG, MBIA etc… But those uncollateralized exposures are being marked against the counterpart credit. You can see it in the banks SEC filings. If AIG had gone down it definitely would brought a number of people down. But other than AIG, I cannot think of any other source of uncollatalized exposure.
I think we are talking past each other on the preferred exchange. My contention was that this appeared to be in the cards before the stress tests were on. Thus I still question to what degree the $30 billion total had already made allowance for that.
As for the adequacy of Citi’s equity, the bank has nearly a trillion of off balance sheet exposures that ost certainly are not off balance sheet in any real economic sense, as SIVs have shown. All SIVs liquidated in early 2008, when the values of most asset backed securities were higher than now, did so with very large losses. I don’t see any reason to assume Citi’s SIVs and other off balance sheet exposures are higher than average. These were all very thinly capitalized to begin with, certainly in negative equity as of late 2007 (you can check my old posts here, this was a big pet project of Paulson’s) and they have to be more underwater now. What might the losses be? $40 billion seeme like a bare minimum.
The other risk facto with Citi is its $500 billion in foreign deposits. There is absolutely no way Uncle Sam will bail out foreign depositors, but not bailing them out (if a run were to occur) would lead to withdrawals at other banks. That in totality is a certain systemic event. Thus there is good reason to set the bar higher for Cit than other banks, which per William Black, regulators can do. But given Citi’s risks, that does not appear to have occurred.
It is also very difficult to judge what an appropriate level of reserves is against Citi’s trading operations.
And William Black also reminded me that the three big Icelandic banks also passed their early 2008 stress tests.
As for your point 4, I am far from alone in criticizing the stress tests. Banking industry experts such as Christopher Whalen at Institutional Risk Analytics and Bill Black deem them to be woefully inadequate. I have worked as a consultant to banks, and let me tell you, it is s non-trivial exercise to understand the economics of a business in normal times, much the less when market conditions have changed. Whalen’s own risk models, which take data directly from FDIC call reports, shows a massive increase in risk in 1Q 2009 v. 4Q 2008. Paul Krugman, Simon Johnson, and Nouriel Roubini are also critical of them.
The exercises were mainly political theater. The goal was announced BEFORE the tests were done, to prove the banks were solvent, and “restore confidence” This was NOT an honest exercise.
I suggest you check Summers’ record in Russia, particularly regarding Andrei Shlieffer, and his fees that he took from DE Shaw while serving as Harvard President. This is simply unheard of. And he ran out Cornel West, a tenured professor, for having a comparatively trivial side gig. His ethics do not stand close scrutiny.
As for Geithner, aside from his taxes, he has shaved the truth on more than one occasion since he has taken office. And I expect another revelation when the Fed submits its next financial report.
Extremely instructive conversation above, thanks!
But Yves, what about 5440af’s last point #5 re the derivatives? Does the fact you didn’t address that, mean you agree with 5440af that the uncollateralized ones make up only some 10-15% of total and therefore -apparently- pose only limited risk of losses? And if so, does ‘limited’ indeed imply ‘immaterial to the outcome of those stress tests’?
Again, thanks for the engagement. This is my first participation in one of these discussions and I think it is important that more sanguine views get represented in the “econ” blogosphere every once in a while.
1) I guess we disagree on the ethics of Geithner and Summers. Based on personal interactions with people who know them (pretty far away, I admit), I believe them to be ethical and you do not. Fair enough.
2) I definitely challenge your description of the off-balance sheet items for the major banks.
a) the SIVs are a special case, in that the banks did something they legally did not have to do by supporting them in an environment that was a lot better than now. Citi ultimately took a few billion dollar loss on an 81B dollar structure. Not enjoyable but not the end of the world.
b) I’m wondering what other exact off-balance sheet issues you worry about for the banks. The only plausible danger spot to my mind is the credit cards, in that those securitizations are well enough structured that I could imagine a bad issuer (like Capital One) losing more than their equity tranche. But it would have to be an extended mega-recession. Not saying it couldn’t happen, just that it would need to. To the extent the stress test addressed credit cards, it used beyond record expected losses and still found Amex and Capital One with no need for capital.
c) The biggest piece of off-baance sheet items for the banks are their mortgage securitizations/servicing books. No way those are coming back on. No moral obligation, nor expectation by the senior bondholders.
d) I’d love to know what I’m missing, but I cannot figure out what the banks have put off-balance sheet that is coming back, i.e. that they have risk to. This a favorite bloody shirt for the blogosphere and I cannot for the life figure out what problem structures are left. Please tell me.
3) With respect to Citi’s pref/exchange, please read the newspaper reports and the actual SCAP report, plus the public statements by the officials and executives involved. The 30B did not include the pref exchange, the Smith Barney JV or the Nikko Cordial sale.
4) Your point on the foreign deposits is an ok one. I’m not sure I agree that Citi has not been given a tougher bar, but we will have to differ. In any case, it does seem appropriate that in a context where every country is guranteeing its home deposits, a bank with global deposits is at a disadvantage. I’d note that in the very recent past (before nation-based unlimited deposit guarantees), Citi’s model of diversified deposit base was actually viewed as a plus. I’d also note that a good chunk of Citi’s deposits in say Australia are in Citi’s Australian bank, so they are guaranteed by Australia and not a US taxpayer problem. Finally, I’d also point out that there has not been a run on Citi’s deposits. Given the media on Cito, the stock price and the blogosphere, the fact that that has not happened is quite stunning and I think says something.
5) The Icelandic bank point is not a good point, unless you think the Icelandic bank regulators (for a nation of 300,000 people with a banking system at 8 times it GDP) are as competent are our banking regulators.
There is really no point in talking to a true believer.
The Iceland factoid came from Bill Black, a former US bank regulator in the S&L crisis who feels it is quite germane. You believe you are more competent to make a judgment about the adequacy of regulatory practices in general, and the stress in particular, than a senior level regulator who led investigations and prosecutions during the last US bank crisis?
The New York Times tonight disagrees with your "mega recession" characterization what would be required for issuers to show losses on credit card ABS.
You also ignore the fact that the stress test assume in the adverse case scenario that prime delinquencies reach 3-4%. The serious delinquency rate on Fannie's credit book for single family homes is currently 3.15%.
Similarly, you dismiss my pointers to Summers' and Geither's track record. I know people who have had extensive dealings with them who do not hold them in high regard.
I know senior Japanese who are very close to the regulators. There were in fact significant withdrawals from Citibank in Japan last year. I have heard similar reports, but evidently not the same level of withdrawals, from Europe. Given what happened last year, a run is not implausible.
Simple question to anyone who may have a plausible explanation:
What is the endgame for the Administration? Is it possible they believe for real, that by “restoring confidence” the problems shall take care of themselves in a not too distant future? Are they THAT deluded?
I forgot another question:
Why is President Obama so eager to risk his presidency for the sake of the financiers?