Criticism of these stress tests run deep and wide, if you avoid the headlines and soundbites from MSM. The results appear to be little more than a PR stunt aimed at “restoring confidence” in the bad banks which is merely code or a euphemism to provide false assurances to the unwashed masses.
First, the worst-case scenarios Treasury came up with were hardly “worst-case” at all, and so were not very stressful at all. Second, the bank regulators relied on the banks themselves to provide balance sheet details and one to two year projections, rather than do a thorough examination themselves.
Third, the regulators allowed the bad banks to negotiate with them. In short, as Option Armageddon’s Rolfe Winkler observed, in “dealing with the devil,” the Fed was browbeat into providing bad banks much more generous terms after two weeks of “intense negotiations.” Instead of using the TCE ratio (tangible common equity), the bad banks fought to use the “less stringent” Tier 1 common capital ratio. The difference between the Tier 1 and TCE ratios is that the Tier 1 metric allows the bad banks to strip out goodwill and netted out unrealized losses and gains.
Netted out, the Tier 1 metric reduced the amount of required capital raises by roughly 48%. Tier 1 allows bad banks to understate assets and overstate capital, says Option Armageddon’s Rolfe Winkler. According to RBC’s analyst Gerard Cassidy, the 19 banks’ cumulative shortfall would have been more than $68 billion deeper if the government had used the latter TCE metric, which accounts for unrealized losses, reports Naked Capitalism’s Yves Smith.
Worse, Geithner and Bernanke “have concluded that banks will be fine in the future with 25-to-1 leverage using 4% Tier 1 (equal to 4% of risk-weighted assets)” reports Barron’s Alan Abelson. A loss of confidence that creates even a minor bank run on one of these govt sponsored entities would be a giant problem.
According to FT, the govt has also, with a wink and a nod, given assurances “they will be allowed to raise less than the $74 billion in equity mandated by stress tests if earnings over the next six months outstrip regulators forecasts, bankers said.” This bit of news prompted Naked Capitalism’s Yves Smith to ask: “How many other winks and nods were there between the Treasury and banks that weren’t leaked to the press?”
More importantly, market participants need to realize that the bad banks have just been incentivized by the government to positively skew and game their earnings over the next two quarters. This ensures that market participants won’t be able to trust earnings as reported by these government sponsored enterprises for several more quarters yet. These latest government assurances, as with pretty much everything else they do, will surely work against their goal of “restoring confidence.”
Now that we all know what a sham these stress-tests truly are: just how comfortable should a common stock bank investor be after these announcements following this enormous two month rally in the financial sector? I’d be one nervous Nellie myself, market risks are great even without the dilutive risks of raising more capital even if the charade of “recovery” for these banks persist for another quarter of earnings.
