SNL Nails "Stress" Tests

When it comes to the stress tests, I think SNL's Tim Geithner might have been a tougher negotiator than the real Tim Geithner.

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.

More Stress: Wells Fargo Needs $15 Billion

Bloomberg reports that Wells Fargo will need to raise $15 billion in additional capital as a result of its stress test. If Wells is allowed to play the same accounting games as Citi and BoA, they can simply convert some of the $25 billion of preferred shares the government owns from the TARP to common shares and be done with meddlesome capital requirements. Of course, Wells Fargo may not want the government to be one of its biggest voting shareholders, if not the biggest, so actually issuing new common stock is not out of the question. And, of course, Wells Fargo plans on getting out from under its government shackles by earning its way back to solvency - soon! From Bloomberg:

Chief Executive Officer John Stumpf said last week that Wells Fargo will pay back $25 billion to the Treasury’s Troubled Asset Relief Program and restore its dividend as soon as possible.

“We earn our way out,” Stumpf, said at the company’s annual shareholders’ meeting in San Francisco April 28. “This company has a great capacity to produce wonderful results. That will be the driving force.”

The stress tests were designed to incorporate potential earnings in their assessments of banks’ capital needs.

Translation: with all the direct and indirect government subsidies to banks, even the idiots who ran their firms aground cannot lose money. If new revenues equal losses on "legacy" assets - and there are still huge time bombs on banks' balance sheets like CRE loans- then the banks should not require too much more help. Whether banks can survive and thrive without government training wheels is entirely another question, though.

But forget those concerns. Happy days are back again - right? At the very least, maybe Warren Buffet's favorite banks should unveil a new slogan: Wells Fargo - Not As Crappy As Citi or BoA.

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.

Relaxation Tests

About those "stress" tests...turns out they're not so stressful. From the New York Times:

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.

This is beyond farcical. If banks cannot fail the stress test by definition, then it is not a stress test. The notion that banks can both require "exceptional assistance" and "pass" their stress test is so absurd that it boggles the mind that anyone will fall for this. But, of course, some investors and talking heads (read: CNBC) will go bonkers when they see the headlines that the banks all passed, and they will pour into financials. Eventually, once writedowns continue to exceed puffed up earnings, even the slowest investors will realize that the banks are a bad bet. At that point, it will become apparent what an enormous waste of time this entire stress test exercise has been.

The saddest part is that the stress tests could have been the first step in a viable banking rescue. If Geithner had honestly assessed the banks' books and put hopelessly insolvent banks into receivership, there would be justified public confidence in the remaining banks. This is what FDR's banking holiday accomplished during the Great Depression. Unfortunately, Geithner seems to think that the minimal appearance of transparency and accountability is a good substitute for actual transparency and accountability. He is badly mistaken.

Pretending insolvent banks are healthy, pouring endless subsidies into them to prop zombie institutions up - it's all so Japanese. Weren't we supposed to have learned from their lost decade? And with each dollar siphoned off to Wall Street, Obama is throwing his presidency away...Maybe Obama and his political advisers will wake up and realize that flirting with economic stagnation is not a path to electoral success. We can only hope that they finally admit what an unmitigated disaster Geithner has been, and undo this mistake.