Stress Test "Negotiations"

When is a stress test not a stress test? If you said when the most "adverse" scenario in the stress test is not as bad as current economic conditions, you would be correct. If you said that the regulators relied on the bankers to report on their firms' financial health using the same models that failed to alert the banks to the impending financial apocalypse, you would also be correct. And if you said when the bankers negotiate with the regulators over how much capital they need to raise due to the stress tests, you would be triply correct. From the Wall Street Journal:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
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.

At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.

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.

The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.
Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.

A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.

"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.

This is exactly backwards. Throughout this sham of a process, regulators have bent over backwards, making sure not to offend bankers' sensibilities. Whether bankers are happy with the results of the stress tests is irrelevant - what matter is whether the numbers are accurate. Why would anyone have confidence in these numbers if banks lobbied for them? (Saying that what they were doing was not lobbying is a dead giveaway that they were).

This final nugget from the WSJ piece reveals the underlying problem with the stress tests - the regulators confused the ends and means. From the WSJ:

With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.

The purpose of stress tests should be to reduce opacity. Increased confidence should be a byproduct of this increased transparency. Lying about banks' balance sheets to create a short-term confidence boom in the banks simply puts off the problem, as the administration hopes the banks can earn themselves back to health. And if the banks are still insolvent six months from now? Will we finally get some sort of pre-packaged bankruptcy for systemically important financial firms? Or will we get Tim Geithner to come back and tell us everything is still fine...the banks just need another $500 billion or so.

Stressed: BoA Needs $34 Billion

The New York Times reports that Bank of America needs to raise $33.9 billion in additional capital according to the regulators who conducted the stress tests. BoA can either issue new common stock, or convert some of the non-voting preferred shares the government received for the TARP into common shares. And, of course, it's vital to keep in mind that economic conditions today are worse than the most "adverse" scenario regulators used for 2009 in the so-called stress tests. So if Geithner & Co. say BoA needs $34 billion, the actual hole in their balance sheet is likely much, much larger. From the New York Times:

The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank.

If the bank is unable to raise the capital cushion by selling assets or stock, it would have to rely on the government, which has provided $45 billion in capital through the Troubled Asset Relief Program.

It could satisfy regulators’ demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock.

But that would make the government one of the bank’s largest shareholders.

Executives at the bank, one of the largest being examined, sparred with the government over the amount, which is higher than executives believed the bank needed.

But J. Steele Alphin, the bank’s chief administrative officer, said Bank of America would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock.

“We’re not happy about it because it’s still a big number,” Mr. Alphin said. “We think it should be a bit less at the end of the day.”

The government’s determination that Bank of America doesn’t need as much capital as it has already received from taxpayers is an indication that even some of the most troubled banks may not need more government money than has been allocated to them.

None of the banks may need more capital from the taxpayers - if their bondholders convert debt-to-equity, or otherwise take a haircut on what they are owed. That does not mean the banks are healthy, merely that policymakers finally realize that it is not sustainable for the public to subsidize Bill Gross's portfolio any longer. Also: how reliable is this $34 billion figure if officials from BoA allegedly "sparred" with Treasury officials over this number? Back to the article:

Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own.

“There are several ways to deal with this,” Mr. Alphin said. “The company is very healthy.”

Bank executives estimate that the company will generate $30 billion a year in income, once a normal environment returns.

Here's the crux of Geithner's plan: hope something approximating a "normal" environment returns quickly so that banks can earn their way back to health without requiring any further restructuring or government bailouts. This is more or less how the Reagan administration dealt with de facto insolvent banks in 1982. While this approach could work, we won't know for several months. And if banks cannot earn their way back to health, the costs of bailing them out will only rise.

AIG Money Laundering Made Banks Profitable in Q1?

AIG is the scandal that never dies. There was the first bailout for $85 billion. The second bailout for $65 billion. The third bailout for $30 billion. The $165 million in bonuses to the employees in the Financial Products division responsible for bankrupting the company. And, of course, the revelation that AIG has been the conduit for a backdoor bailout of its creditors, particularly Goldman Sachs. However, the latest report concerning AIG is even more outrageous. AIG has not been simply paying its creditors back in full - it has essentially overpaid them on purpose. This is looting.

Remember when Citigroup CEO Vikram Pandit proclaimed his bank had been profitable through the first two months of 2009 in an "internal" memo released to the press? Bank of America CEO Ken Lewis and JP Morgan CEO Jamie Dimon followed suit the next day, claiming that they too had been profitable through February. While some dismissed these pronouncements as misleading at best, the beleaguered markets took off, rebounding from twelve year lows at any hint of good news. This rally has continued for nearly three weeks now, despite Jamie Dimon and other bank CEOs admitting that March has been "a little tough" - read: they are losing money hand over fist again.

What changed between February and March? According to an email financial blogger Zero Hedge received from a trader at a major bank, the explanation is that in the first two months of the year, AIG unwound trades on extremely favorable terms for the banks. In other words, AIG deliberately overpaid on what it owed. According to the trader

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent - these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades - ever"....

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

That AIG's counterparties have been made whole at taxpayers' expense was scandalous enough. After all, companies took a risk when they entered into CDS contracts with AIG that AIG would not be able to make good on the payments. Why should taxpayers foot the entire bill for Wall Street's mistakes? (That's a rhetorical question - the obvious answer is that the financial sector controls the levers of power inside the Beltway). But words fail when AIG more or less launders money directly onto bank balance sheets. As Zero Hedge summarizes

AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam....

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

Our democratic system is in jeopardy. Sadly, this is not hyperbole. The pernicious influence of Wall Street - which has spent some $5 billion over the last decade lobbying both parties for increased deregulation - has made the government responsive to the moneyed interests rather than to the people. As MIT professor and former IMF chief economist Simon Johnson argues, we risk turning into Argentina or Russia, in the sense that crony capitalists have captured the government, and are blocking reform after crashing the economy. Demanding transparency in the bailouts, and an honest accounting of where our money is going is the first step towards reclaiming our government. Absent such clarity - and replacing bank CEOs and boards - Congress should not authorize any further bailouts, because, clearly, Wall Streeters paying off their pals with public money cannot be acceptable. Hopefully, President Obama will realize that a little populist rage is warranted, and is actually not such a bad thing. His presidency may depend on it.

Markets Forcing Nationalization?

Will the bond markets force the administration's hand when it comes to nationalizing banks? Bloomberg reports that:

Citigroup Inc. and Bank of America Corp.’s bond prices are sliding on concern that owners of debt issued by U.S. financial firms will be forced to swallow losses if the industry needs another bailout.

While there has been speculation for some time now that unsecured bondholders might take a loss in any future bailout, analysts are now openly questioning just how safe supposedly ultrasafe senior debt is as well. Again from Bloomberg:

“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” Mehernosh Engineer, a London-based strategist at BNP Paribas SA, said this week. “There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”

James Kwak over at Baseline Scenario observes that

this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.

There is the potential for this fear to become self-justifying. Since Citi and BoA are more or less insolvent, loans to them are only worth as much as investors think the government will guarantee. If investors become convinced that some sort of government receivership is inevitable, despite the government's protestations to the contrary, then not only will bank bonds trade at distressed levels, but the banks themselves will have a harder time raising private capital than they already do. Cut off from private capital, the government will then be forced to nationalize the banks.

The risk, of course, is that a panic develops beyond merely Citi and BoA, and that solvent banks find themselves unable to finance themselves, as investors flee from all bank debt. To avoid this, the government must decide who needs to be nationalized rather than the markets. To this point the Treasury has tried to encourage private capital to flow back into the banks to no avail. It has not worked. The markets are not buying it. Treasury needs to finish its stress tests, determine which banks cannot be saved, and then nationalize them all at once. It will be messy and enormously challenging. But it's better to proactively address the problem, rather than have policy reacting to panic.

Ken Lewis: We're Not Insolvent! We Promise!

Ken Lewis takes to the Wall Street Journal to tell us to pay no attention to that man behind the curtain.

Lewis assures us that "the vast majority of banks will weather this storm" and that nationalization is misguided, because its "announcement would undermine confidence in the financial system and send shudders through the investment community."

Undermine confidence in the financial system? Really? As Paul Krugman would ask, what's the weather like on his planet? Trillions of dollars of credit losses worldwide has destroyed confidence in the financial system. Paying billions of dollars for the right to absorb Countrywide and Merrill Lynch's billions of dollars of losses has crippled confidence in Lewis's BoA. Nationalization only raises the specter that creditors won't be made whole. That could create a renewed panic among holders of unsecured bank debt, but if there's an orderly process it should be a tractable problem. At this point, nationalization might be the only way to convince the public that banks are actually healthy.

So nice try Ken. But you're not distracting anyone from the real question at hand: why do you still have a job?

Who Needs Stress Tests?

Can we just put our major banks into receivership and be done with it? According to banks' own estimates of the fair market value of their financial instruments, Bank of America and Wells Fargo are insolvent. Citi is clearly there too (no wonder they never sleep). And it's hard to imagine JPMorgan won't join them, as more commercial real estate, auto loans, and credit card debt go bust as the real economy deteriorates over the coming months.

Yes, a temporary nationalization will be ugly. Wiping out management and shareholders is easy. But dealing with bondholders will be harder. Some will have their holdings converted to equity; others will have to take significant haircuts. Furthermore, to prevent a run on unsecured debt at other banks, all nationalizations should take place at the same time so that there is no uncertainty about whether a bank might be taken over. Simultaneity and transparency should prevent panic from engulfing the markets. Again, this is not a free lunch. In most cases, the bondholders who will take a hit are pension funds, money market accounts, and insurance companies. This will be painful for ordinary people. But the alternative - pouring potentially trillions of dollars into zombie banks - is far, far worse. If the IndyMac experience is any guide, where a group including John Paulson and George Soros bought the troubled lender six months after the government seized it, the four major banks could be back in private hands within a year. That's about the best we can hope for at this point.