Thursday, May 7, 2009

Ten Reasons the Stress Test doesn't SUCK

Before anyone gets too critical, they should actually read it. And review the spreadsheet.   A good list of the flaws can be found at naked capitalism: Yet More Stress Test Doubts.
This is an alternative point of view.

1.  After the extra extraordinary measures taken in the fall, especially the passage of the $700 billion TARP bill, the public needed some documentation. Something beyond Paulson's single sheet of paper.  Even if this is just an elaborate back of the envelope estimate, it is a single set of figures in a single document.

2.  Define "To Big To Fail"?  It has now been done.  Any "bank holding company" meaning financial institution with a banking license that has over $100 billion in assets.  It's 19 and it includes an auto finance sub (GMAC), a Life Insurer (Met), and a credit card company (American Express).  Two investment banks, two hybrids with investment and commercial banking (C, BAC).   

3.  What do the big 19 have in common?  Nothing other than size.  Most of the public outcry has been over excesses in New York Investment Banking.  Anyone think that USB's Minneapolis based bankers routinely get million dollar bonuses?  People should chill with the generalizations.  Or maybe just quit calling New York financial activity banking and the people that do it bankers.  There is an important distinction that has been deliberately blurred, and community bankers aren't happy about it.   

4.  It is a very big chunk of the traditional banking system. The two biggest, BAC and WFC have well over 20% market share of insured deposits.  I don't mind size as long as it is just vanilla banking scaled nationally.  Like the old Bank of America, when  they avoided investment banking.  A firm like Wells should think about splitting out it mortgage servicing business.   

5.  Maybe the traditional banking system really isn't the problem.  They are only involved with 20% of total lending. Per Jamie Diamon:
Traditional banks now provide only 20% of total lending in the economy(approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%.
 We have reps for all the players in the 'shadow' banking system.  Investment banks that did securitizations.  A credit card firm.  Brokerages that underwrite bonds.  

6.  A sense of how things could really play out.  People will either agree or disagree, but at least they have some numbers to talk about that are ground up rather then the economic aggregates tossed around by the economists.  

7.  $8 trillion in assets.  An estimate of $600 million in losses.  Two numbers that tie into published financials of specific firms.  Remember that a lot of assets were sold to non banks.  If this is 20% to 25% of the total assets exposed to losses, that corresponds to $2.4 to $3 Trillion that the economists talk about.  A lot of the worst stuff was sold off, so the $600 billion figure is big enough to be more than plausible. 

8.  What about the zillions in level 3, toxic CDO's?  Less than 2% of the total.  
At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non‐agency mortgage‐backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages.
How much hand wringing has there been over this topic when discussing banks? Way too much, it seems. It isn't like there aren't problems, but most of the problem assets aren't owned by banks, and those that are were pretty much written down over the last year and a half.  It is a big problem, but one that was sold around the globe.  The banks thought they held the best CDO's and they definitely sold stuff that was materially worse then they kept.

9.  Just like Japan?  There are $60 billion or about 10% of the estimated total losses that have already been booked via purchase accounting adjustments associated with the larger mergers.  This includes WB, MER, WM, CW and a few others.  

You work through $600 billion in big chunks over a couple of years.  As noted above, 10% is done.  There is capital in excess of regulatory requirements right now, if needed.  This was done using 12/31 data, and over $100 billion has been done during that period.  We have 7 more quarters of earnings to use for loss provisions.  Finally, there is the $75 billion of additional common equity that is required to be raised.  

10.  Everyone can apply their own judgment against these figures.  However, I think that it isn't the banks.  It's the real economy.  People might be able to chill about banks and start thinking more about jobs, etc.  

Maybe it is just too optimistic.  If so, a next step could be to relax capital requirements IF there is strong evidence the economy has turned.  The economy is cyclical and there are lags.  Do we need to have banks that are capitalized above the regulatory level at the trough of a monster recession?  Capital is there for a reason and there are times that you relax the requirements and let the levels drop.  If you can NEVER use it, why have it in the first place.  


babar ganesh said...

nice piece.

another thing to note is that by the end of 2010 the losses will be known with much more precision than now. at that point, if the losses aren't a great deal higher than the losses in the stress test, banks will be able to raise a lot of equity privately.

a bank like BAC which would have a profit of around $25B in a normal year might be worth $250B with a clean balance sheet and today the market cap is around $80B. if raising $50B would clean the balance sheet they would have no problem doing so.

at this point there are still a lot of worries about huge losses and blowups and the state of the macro economy and so $50B wouldn't do the trick. but in a year or so if things are not markedly worse than the stress tests say it will.

cap vandal said...

In 1Q, BAC had $18 billion in pre tax, pre provision income. They have the earnings capacity to eat a lot of bad assets over the next two years.

I wouldn't be surprised if the required capital amounts are too small. However, it is a long way from the tacit assumption that ALL banks were insolvent -- which held sway in Feb-Early Mar.