Summer Rerun: Quelle Surprise! Bank Stress Tests Producing Expected Results!

Yves here. It’s interesting to note that the point of the stress test exercise was to build confidence in the banks so they could raise equity at not massively dilutive prices and rebuild their balance sheets. But the Administration appeared to believe its own PR and relented on pushing the banks to raise capital levels (if you doubt me, look at how much walked out the door in record 2009 and 2010 bonuses).

This post first appeared on April 9, 2009

Should this even qualify as news? From the New York Times:

For the last eight weeks, nearly 200 federal examiners have labored inside some of the nation’s biggest banks to determine how those institutions would hold up if the recession deepened.

What they are discovering may come as a relief to both the financial industry and the public: the banking industry, broadly speaking, seems to be in better shape than many people think, officials involved in the examinations say.

That is the good news. The bad news is that many of the largest American lenders, despite all those bailouts, probably need to be bailed out again, either by private investors or, more likely, the federal government. After receiving many millions, and in some cases, many billions of taxpayer dollars, banks still need more capital, these officials say.

The whole point of this charade exercise was to show the big banks weren’t terminal but still needed dough, and I am sure it will prove to be lots of dough before we are done. But they now have the Good Housekeeping seal, so the chump taxpayer can breathe easy that the authorities are taking prudent measures to make sure his money is being shepherded wisely.

If you believe that, I have a bridge I’d like to sell you.

We said from the beginning the stress tests were a complete sham. Just look at the numbers. 200 examiners for 19 banks? When Citi nearly went under in the early 1990s, it took 160 examiners to go over its US commercial real estate portfolio (and even then then the bodies were deployed against dodgy deals in Texas and the Southwest). This is a garbage in, garbage out exercise. The banks used their own risk models to make the assessment, for instance, the very same risk models that caused this mess. And there was no examination of the underlying loan files.

The Times story does slip in some shreds of doubt, but a casual reader is likely to read past them. Consider these statements:

Regulators say all 19 banks undergoing the exams will pass them. Indeed, they say this is a test that a bank simply will not fail: if the examiners determine that a bank needs “exceptional assistance,” the government, that is, taxpayers, will provide it…

Regulators recognize that for the tests to be credible, not all of the banks can be winners. And it is becoming increasingly clear, industry insiders say, that the government will use its findings to press certain banks to sell troubled assets. The hope is that by cleansing their balance sheets, banks will be able to lure private capital, stabilizing the entire industry.

Yves here. So did you get that? They all will be declared to pass in some form, no matter how dreadful they really are (if the remedy is putting in more Federal dollars, rather than a receivership, then the fiction that the money is not being wasted must be preserved). But so as to look sufficiently tough, some banks will be treated harshly. If it winds up being, say, Fifth Third (which I am told by John Hempton is a very well run bank, publishes much more honest financials than its peers, but is in simply terrible geographies, Michigan, Ohio. Florida) and not Citi, then we know the process is not just hopelessly politicized, but shamelessly so. Back to the article:

The state of the industry will come into sharper focus next week, when big banks like Citigroup and JPMorgan Chase start reporting first-quarter results. Many analysts predict the reports will show banks are on the mend, with help from low interest rates, fat lending margins, dwindling competition and profits from trading in the financial markets in January and February. In the last six weeks, financial shares have soared on hopes that the worst for the industry is over.

But some analysts say investors’ hopes are misplaced. With the recession, banks are likely to record further large losses on credit cards, corporate loans and real estate.

“Nothing has changed with the fundamentals,” said Meredith A. Whitney, a prominent banking analyst who has been bearish on most financial institutions.

Yves here, Note the failure to point out that Whitney has been the most accurate in calling bank performance during this downturn. No, she is instead a mere bear. And the article also fails to mention that Leon Black, a distressed investor who has long been active in the real estate industry, is forecasting $2 trillion in real estate losses. I doubt the stress tests have that factored in. Consider the worst case scenario:

The tests, led by the Federal Reserve, rely on a series of computer-generated “what-if” projections in the event the economy deteriorates. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.

Based on the work of Carmen Reinhart and Kenneth Rogoff on financial crises, the expected trajectory for this crisis is for unemployment to peak in the 11-12% range, a fall in GDP of 5%, with it taking three years after the bottom for growth to return to normal levels, and housing takes over five years to bottom. And that is the typical trajectory for crisis countries, none of whom faced a backdrop of a global contraction. Whitney is calling for real estate prices to fall another 30%. So the worst case falls short of even likely outcomes, let alone a real disaster.

And the theater continues:

At a recent breakfast with a dozen or so corporate and banking executives in New York, Treasury Secretary Timothy F. Geithner warned he would take a tough stance. Many banks, he suggested, believe the investments and loans on their books are worth far more than they really are, according to a person who attended the meeting.

Mr. Geithner said that was unacceptable. The banks, he said, will have to sell these assets at prices investors are willing to pay, and so must be prepared to take further write-downs.

How does one parse tripe like this? First, the public private partnership program, aka cash for trash, is voluntary. Banks are not being compelled to sell. The idea that the banks “have to sell” is a canard. Second, the gaming of the program has already started (notice no lecture from Geithner about that?), so there is pretty much no risk that anyone will take a loss on the values they have in their books. The best summation of how bad this will get is from Rortybomb, who expects all the old Enron tricks to be employed (notice the terms of the PPIP prohibit the fund managers from gaming the process, not the banks trading among themselves. You can drive a truck through this oversight. And the Treasury has remained silent as the banks themselves have been loading up their balance sheets with toxic sludge, paying more than private investors are willing to bid).

I’m sure all the bankers understand full well the massive disconnect between talk and action, and are dutifully following Treasury’s lead in maintaining appearances.