The Truth Behind the Bank Stress Tests

Forecasting loan losses at banks is inherently speculative. Forecasting future cash flow from existing loans is also speculative. Both estimates lie at the core of this week’s leaked (and eventually announced) stress test.

Isn’t it ironic how creatively regulators were interpreting Reg FD laws with all of this week’s leaks to the press? The leaks may not be very relevant, but they are yet another sign that this stress test was designed for public consumption. It was intended to bolster public confidence in the banking system, and I’m shocked at the lack of skepticism among the professional investment community.

Once it was announced that bank executives were pushing back on regulators about their forecasted losses, the stress tests instantly lost a great deal of their credibility. What kind of test in school allowed you to argue with your teacher about the correct answer?

Just like a student either knows their subject or does not, a bank’s capital will be sufficient to weather this crisis without obscene levels of government subsidies, or it will not. If it is not, the FDIC should resolve it at a measured pace to minimize taxpayer losses. With Bear Stearns more than a year in the rearview mirror, there’s no excuse for top regulators to not have a mechanism for unwinding complex bank/brokerage institutions – in which losses would be borne by shareholders and bond holders – rather than taxpayers. Instead, the authorities are trashing the value of the U.S. dollar and blowing up the deficit to potentially unmanageable levels.

Independent regulators – not bank executives – should be the sole judges of capital adequacy under a stress scenario. We all know what kind of biases bank executives tend to hold about their own loan books.

We have probably not seen the end of the stress test process. If the future data flow on loan delinquencies comes in higher than the current “stress” scenario, then we may see a scenario where a major bank (or three) gets massively diluted. For a model of what night happen to shareholders at the most toxic of the megabanks, consider the proposed exchange offer for GM bondholders, which would leave current GM shareholders with a 1% equity stake in the “new” GM. Why any professional can justify investing client capital in such megabank stocks is beyond my understanding.

The market’s reaction to the stress test – in the form of soaring bank stocks – tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers – only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

The stress test’s estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital). Here’s the illustration I used in the March 27 Strategic Short Report alert:

“Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that’s cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators allow the water level to fall to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There’s a risk that if the optimists are wrong about the amount of new water coming in, we’ll be stuck with a Japanese-style “zombie bank” situation.

After this week, I think the risk of the zombie bank scenario is much higher. We’ll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) – rather than write new commercial or consumer loans.

Regards,

Dan Amoss
for The Daily Reckoning