Commentary

Bank Stress Tests are a Complete Farce!

Let’s hear it for the bankers! They only need another $75 billion in extra capital by November in order to stay alive. Nice work, boys! The NY Times reported today that ten of the nineteen bank holding companies subjected to regulators’ stress tests, the banks deemed “too big to fail,” will need to raise extra capital to withstand the weakening economy and the declining real estate market, which are causing loans to sour and profits to decline (and bankers to squeal).

The $75 billion price tag is far lower than many had feared. Because the overall amount is under $100 billion, the message sent today by the Obama administration is that the financial crisis can be handled with funds already allocated by Congress. In this piece I will explain why I believe this grand announcement is nothing more than political theater, and that the banking system is still on shaky ground. I will also discuss a recent article by Matthew Richardson and Nouriel Roubini, published in the Wall Street Journal, that implores the administration and Congress to face reality and deal responsibly with America’s largest troubled banks. The financial crisis brought on by the largest credit bubble in history is far from over, and it is the height of recklessness to encourage the public to believe that it is.

Just like rumors about earnings reports, the bank stress test results have been leaking out to trading floors and chat rooms all week. It seems that the Obama administration was concerned most with proving to the American public that the nation’s biggest banks will be able to recover without additional funds from the taxpayer. The administration does not want to send Treasury Secretary Geithner before a hostile Congress, hat in hand, to beg for more money for yet another rescue of the financial system. The Obama administration is desperate to show the American public that the financial bailout of the big banks is working – and that the light of recovery is what we all see at the end of the tunnel, and not the headlight of a train loaded with misery about to knock us all down.

Two of the largest naughty banks, Citigroup and Bank of America, will be forced to come up with a plan to raise more money by June 8. Regulators concluded that Citigroup must raise $5.5 billion in new capital, in addition to the conversion of $45 billion in bailout funds held as preferred shares into common stock. (This grants the taxpayer a 36 percent ownership stake in the troubled financial giant.) Bank of America will have to raise $34 billion in fresh capital, but it will probably do so through asset disposals as opposed to a conversion of the government’s preferred shares into common stock.

The problem, as I see it, is that the results of bank stress tests give the false impression that the banking sector is an attractive place to invest. Banks that are in need of capital receive it from the government, through the conversion of preferred shares to common stock, if they cannot raise funds in the private market. When money is being pumped into a bank in the form of common shares, the thinking goes, it must be safe to invest the bank, and to lend it money. But this is an illusion, because this investment in common shares is one that is forced, it is not based on the soundness of the banking institution in question. In my opinion, the bank stress tests are nothing more than smoke and mirrors. The Obama administration feels that it needs to show that all of the money spent so far on the financial bailout of the banking system is paying off. They are trying to establish confidence in America’s financial system simply by declaring that the worst is over. The administration is saying: It’s OK because we say it’s OK.

And, the way banks are being evaluated by regulators is shrouded in mystery. How are all of the bad loans being valued? What assumptions are being made with regard to how the economy will perform over the next two years? Matthew Richardson and Nouriel Roubini’s article in the Wall Street Journal earlier this week quoted a recent IMF study that estimated losses on American loans to be $2.7 trillion, which is twice as large as estimates derived six months ago. (The authors’ estimate losses of $3.6 trillion.) More than half of these losses sit on the balance sheets of major commercial and investment banks. They conclude that the U.S. financial system is near insolvent. Was this mentioned at all? They also note that regulators are using overly optimistic assumptions about unemployment – presumably understating it to improve the prospects of recovery for the banking sector.

The authors are in favor of Geithner’s plan (PPIP) to dispose of toxic assets festering on bank balance sheets, even though (as I have also pointed out) it offers ridiculously cheap financing to hedge funds and thus promotes overpayment for dodgy assets. But, it at least gets the process of clearing the financial system of its dross under way.

Richardson and Roubini also stress the importance of accountability. Banks receiving bailout cash should be put on a leash. They argue for the use of covenants to “generally restrict the use of assets, risk-taking behavior, and future indebtedness,” adding “It would be much better if the government focused on this rather than on its headline obsession with bonuses.” This is essential in order to ensure bankers do not make the same mistakes again.

Banks, they note, paid out $130 billion in dividends in 2007 and 2008 (according to a recent academic study by Viral Acharya, Irvind Gujral and Hyun Song Shin). And, the authors point out that Citigroup and Bank of America have been ignoring proper risk management procedures, buying up nonprime mortgage-backed securities – the very same securities that they bought over the past few years, and the government had to guarantee. (What a system!)

Matthew Richardson and Nouriel Roubini believe the government must develop a procedure for handling giant financial firms if they implode and enter receivership. They note that the Obama administration is pushing for fast-track approval to deal with failed financial giants – but Congress has not moved on this issue (berating bankers over extravagant pay is much more rewarding.) This, they argue, would push bankers to restructure outside of bankruptcy court, because Chapter 11 proceedings would force them to join the masses seeking employment on Craigslist.

There are a lot of problems with the bank stress tests and with the way the financial bailout of the banking system has proceeded to date. The Obama administration’s determination to alter reality to show that the bailout of the financial system is making progress does more harm than good. This exhibition of political theater is causing the real issues plaguing America’s financial system to be swept under the rug. The losses suffered by America’s largest banks are staggering, and will most likely grow as the economy continues to suffer from rising unemployment and a struggling real estate market. The administration is too eager to declare that all is well. Toxic assets need to be disposed of properly, banks receiving public money must be monitored closely so they do not repeat the same mistakes (Citigroup and Bank of America appeared to have learned nothing) and there must be a way to unravel these institutions quickly so that bankers know their monstrous creations are NOT too big to fail.

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