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.

Wells Fargo: Profitable Does Not Mean Solvent

One week you're announcing "record profits," the next analysts are saying you need $50 billion more in capital. As Matthew Yglesias notes:

This is why nothing you near from the financial sector about how all’s well should be taken too seriously. It’s true that given very bank-friendly monetary policy it’s easy for banks to run an operating profit. But most of these large banks are zombies—insolvent. They’re only able to run an operating profit because they’re not going out of business and being liquidated. And the reason they’re not being liquidated is government guarantees. It’s as if I had a profitable business selling cookies, except I didn’t actually have any cookies to sell and was just putting government-provided cookies in boxes, then bragging about how profitable my company is and how the government should stop hassling me about paying myself a bonus.

How long will it take for banks to earn their way out of insolvency? If the administration thinks the type of hands off approach Volcker took with probably insolvent banks in 1982 will work today, they're most likely wrong. As Krugman points out, any economic recovery probably won't be as steep today as it was then, creating a more difficult environment for lenders and borrowers. Please tell us this isn't really the plan.

Buffet Hints at Geithner's Plan

During a marathon interview on CNBC this morning, Warren Buffet had a surprisingly upbeat take on the banks.

Buffet claimed that banking has never been more lucrative than it is now do to historically low interest rates and wide bond spreads. While he admitted some of the worst capitalized banks will likely not make it through this crisis, Buffet did say he expected most banks to earn their way out of the holes they are in.

And this is essentially the Geithner plan: give banks enough capital to keep them alive, and hope that they can earn their way back to health. Of course as a major shareholder in Wells Fargo, Buffet favors letting the, according to its own fair-value accounting, insolvent bank try to rebound. But why is Geithner apparently so willing to just cross his fingers and hope for the best? The politics would certainly be easier if the banks did not require massive injections of capital, but instead just needed enough to tide them over till they returned to profitability. But what about banks' increasingly toxic balance sheets makes this likely? Even if banks return to robust earnings, a whole host of mortgages, commercial real estate loans, auto loans, student loans, and credit card loans made at the peak of the bubble that have yet to go bust threaten to overwhelm any new revenue streams, and send banks further into insolvency. This seems like a repeat of Japan.

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.