Our headline at odds with the media reports on the newest confidence-bolstering ploy by the Federal Reserve, that of new, improved stress tests for the six banks at the apex of the US financial services industry looting operation: Bank of America, Citi, Goldman, J.P. Morgan, Morgan Stanley and Wells.
There’s a noteworthy gap between the scenarios employed in the 1.0 version, which took place in early 2009, when the banks were told to get more capital or else, and the ones about to be implemented. The current stress scenario is a Eurozone crisis, with unemployment to reach 13% in the US (versus a 2009 stress test peak in the “adverse scenario” of just over 10%), a European GDP contraction of 6.9%, and (supposedly) “market price movements seen during the second half of 2008.”
Per the Financial Times, the benchmark will be whether core “tier one common” equity stays higher than 5 per cent in the face of these projected conditions. Banks that fall short (and everyone sees Bank of America as the likely problem child) may be forced to raise equity. Firms that plan to issue dividends in excess of 30% of net income can expect further scrutiny by the central bank. The Wall Street Journal reports that the subjects are grousing about how badly they are being treated, including that staffers will have to work over the holidays (banks are to submit information by January 9, with the results due in March). Not surprisingly, per the Journal, this is yet another confidence ploy:
The switch to public disclosure [a change from a 2010 version of the exams] is the Fed’s way of demonstrating that the U.S. banking system can withstand any turmoil, said analyst Gerard Cassidy of RBC Capital Markets. The hope is “investors will say, ‘Wow the U.S. banking systems can handle these shocks very well,'” Mr. Cassidy said.
This all sounds well and good, right? We’ll get to the adequacy of these tests in due course, but the reporting conveniently ignores the fact that the Fed has gotten religion appallingly late in the game.
Pretty much anyone who was not part of the problem (admittedly a small group relative to the financial services industry propaganda machine) expected a major financial crisis in a maximum of five years after the last one. And there was also a widely shared expectation that the next eruption would be worse, given the failure to address core problems: excessive interconnectedness, overly high leverage, both at the institutional and the product level, opacity, and complexity. These conditions are made worse by the fact that major financial institutions operate internationally when times are good but are supervised and backstopped by their home country.
Somehow, the Fed has managed to wear blinkers since May 2010. As soon as Greece started going wobbly, a horde of analysts pointed out that the bond losses were likely to be in the 50% to 75% range, and contagion was a realistic possibility. Contagion not only arrived but metastasised while the Eurocrats engaged in policy shamanism in lieu of painful cures. Did US regulators not notice that Italy faces a major hurdle in February 2012, with €300 billion of debt to be refinanced? What good are “tests” to be scored in March against that timetable? And things are not getting any better in the meantime. Consider these extracts from the Tuesday market wrap at the Financial Times:
Bond markets ramped up the pressure on Spain and Italy on Tuesday as Madrid was forced to pay more for three-month debt than Greece did last week while Italy saw its yield curve invert, a sign of severe stress.
Spain paid an average yield of 5.11 per cent for the three-month bills, more than double the rate it paid last month and higher than the 4.63 per cent Athens paid last Tuesday.
Italy saw yields of all its bonds from two- to eight-years rise above its benchmark 10-year note, normally a sign of impending recession. The inversion of its yield curve last happened two weeks ago but, unlike then, purchases of Rome’s bond by the European Central Bank on Tuesday failed to undo the damage…
“With nothing to oppose higher yields these moves are effectively self-perpetuating and the spiral is vicious,” said Robert Crossley, head of European interest rate strategy at Citi.
In another bad day for eurozone bond markets, Belgium saw the premium it pays over Germany to borrow reach a new euro-era record of 323 basis points…
Bond markets have given no respite to the new governments in Spain of Mariano Rajoy and in Italy of Mario Monti, pushing borrowing costs to levels close to those that forced Greece, Ireland and Portugal into international bail-outs.
And if that isn’t troubling enough, on top of the generally recognized slow motion bank run in Greece, deposits are draining out of Spanish and Italian banks.
With that as backdrop, let’s revisit the adequacy of the stress test metrics. 5% tier one capital is simply not the right measure. Is the Fed really going to test for a repeat of the 2008 seize up in the repo market? A former Goldman employee involved in Occupy Wall Street reminds me that you couldn’t even repo 28 day Treasuries, which in trader land was tantamount to the opening of the sixth seal of the Apocalypse. No one wanted to deal with counterparties, period, even with the most pristine collateral. Yes, banks are widely reported to have much better liquidity buffers than last time around. But the Titanic was also believed to be unsinkable.
There is every reason to expect the upcoming European crisis to be not as bad as the last one, as the Fed assumes, but worse. The banking systems in the US and Europe are more concentrated than before. Advanced economies are in much weaker shape. There is far more active, organized, and vocal opposition to bank bailouts in Europe that the first go round in the US, when widespread public objections to the TARP were steamrolled in Congress.
Now the Bundesbank and the ECB, despite their loud insistence to the contrary, may come around at the last minute and stave off a Euroimplosion. But the stress test is not supposed to measure what happens in a happy ending, but in a realistic downside scenario. And perhaps the biggest difference between 2008 and now is the lack of a common vision among the central actors in the epicenter of the pending crisis. In the US, the three key players, Paulson, Geithner, and Bernanke, had shared goals: do whatever it takes to keep the system from collapsing and to the extent possible and preserve the status quo. The first goal was arguably necessary, while the second one was the polar opposite of what needed to happen once some measure of stability was restored.
By contrast, in Europe, you have banks in Greece, Spain, Italy, Portugal, Belgium, much of Eastern Europe, France and Germany at risk. Any serious problems, ex an ECB deus ex machina, must be dealt with at a national level. How is that going to happen when the Eurozone banking system is 325% of GDP, far bigger relative to the size of the economy than in the US?
The risk here is not a Lehman like disaster. It’s a modern version of Credit Anstalt: a major bank failure precipitating cascading collapses. And this is entirely plausible. There are a ton more moving parts than in the US in 2008: more institutions at risk, multiple domestic banking regulators and national legislatures, Maastrict treaty rules. Anyone who has worked with networks knows that more nodes and more communication lines between those nodes means more points of failure. The odds of things ending up badly if the markets go critical are far greater than the last time around, and that’s before we factor in the caliber of Eurozone emergency responses thus far.
I cannot fathom how people in senior regulatory positions who lived through the crisis cannot see the trajectory. It’s obvious to anyone who reads the financial press. This willful blindness, born out of a reluctance to firmly enough with a reckless, predatory industry will cost the citizens of the world dearly. I can only hope history deals with these corrupt officials as harshly as they deserve.