Bank Stress Test Insanity

“I’m not lost, but I don’t know where I am.”
– Talking Heads, “The Lady Don’t Mind”

More or less where it started two weeks ago, the market seems to be chasing its tail a bit of late. You can just imagine stocks chatting nervously to each other backstage every morning before the bell rings and the curtain rises. “So, do we rally? Do we retreat? What was the consensus? Does anyone know what we’re supposed to be doing out here?”

From where we sit, way out here in the peanut gallery, the performers look a little rusty. In fact, the whole production seems kind of ad hoc and off cue. One gets the feeling the tomatoes might start flying any moment.

Over the past couple of weeks, audiences have watched with growing horror as the government divulged the results of its much-ballyhooed “stress tests.” The whole thing, it seems to us, was little more than an untruth wrapped in a lie, inside a deception. Nevertheless, investors and traders waited with baited breath to see what the blind had seen and what the deaf had heard.

Initially, authorities held high hopes that the results would, as Ben Bernanke himself put it, “allow for greater confidence in the banks.” Alas, as the results unfold, that looks less and less likely. For starters, we know that 10 of the 19 banks tested need somewhere in the vicinity of $75 billion to reach “adequate capitalization,” or common equity equal to 4%.

But, as your senior editor, Eric Fry, pointed out earlier in the week, the tests themselves contain “at least three fatal flaws:

1) Re-building bank common equity up to 4% is woefully inadequate. At 4%, banks would be operating with 25-to-1 leverage – a balance sheet structure that any prudent investor would consider reckless and/or “insane.”

2) The assets on most bank balance sheets remain susceptible to severe impairment. In other words, these assets could still suffer extreme mark-downs. If, in aggregate, these assets were to lose 4% of their value, the nation’s banks would possess tangible common equity of approximately zero.

3) The “stress” to which the bank examiners subjected the balance sheets under their review was not very stressful. Examiners used an “adverse scenario” that featured a 3.3% drop in GDP this year and an 8.9% unemployment rate. Well, guess what, the unemployment rate is already 8.9% and GDP during the first quarter collapsed at an annualized rate of minus 6.3%, compared to the fourth quarter of 2008. So maybe the “adverse scenario” is not nearly adverse enough.”

In other words, banks need $75 billion simply to attain a “reckless” balance sheet structure under a “worst case scenario” that is already here…and worsening by the day.

So, how does a bank “de-stress?”

When Treasury Secretary Timothy Geithner first announced the tests, the idea was to assess exactly how much money banks needed to remain solvent and for the government to then supply the shortfall. But now, similar to its response to the moribund automakers, the government is giving undercapitalized banks time to “earn their way out” of absolute calamity before supplying them additional taxpayer monies.

But the longer the bank’s report cards are left out in the sun, the more they begin to stink. And the more money the cleanup looks likely to cost.

Citigroup, for example, was originally told to raise $5.5 billion. That might seem like a lot of cash but, relative to Well’s Fargo’s $15 billion shortfall and the $34 billion BofA was commanded to raise, Citi’s imprudence at first look appeared somewhat saintly.

But halos have a tendency to slip down and choke undeserving recipients. According to an article published in Time Magazine this week, Citi “got credit for a capital conversion it has yet to complete. Strip that out, and the amount of capital Citi needs balloons to nearly $63 billion, more than any of the other banks tested.”

It is the sworn duty of governments to underestimate costs by tens or even hundreds of billions of dollars, of course, but one does begin to wonder how these errors in calculation might ever be paid for.

The Daily Reckoning