Failure is the only success in stress test

April 24, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

The stress test of banks now underway in the U.S. is one exam in which failure will be the only true measure of success, at least in terms of speeding a recovery.

The U.S. will release some information about the methodology of the stress test of 19 major banks on Friday according to reports, with results slated for release in some form on May 4.

What is far from clear is if this will be some sort of self-deluding exam in which all of Treasury Secretary Tim Geithner’s children are judged to be above average or whether the U.S. will take this opportunity to take real and difficult remedial action with banks that are too insolvent to play their role in the economy.

Injections of equity for those which need it should be made at the common equity level — anything else at a severely undercapitalized bank just scares off other equity investors.

This is a good step for some banks, but sadly may not be enough for all, in which case the U.S. should simply take the time-honored route of taking the zombie bank into government conservatorship, wipe out shareholders and top management, and set the stage for a controlled dismemberment of what is left.

This is preferable to simply upping government support and stakes because it is clear and limits not just the benefits to those who’ve made bad decisions in the past but also the power of the state. In the current situation, no one really has any idea how or when the U.S. will increase, exit or manage its stakes in banks. It is all too easy for the government to become subject to special interest pressure in the current situation.

A conservatorship, along the lines of what has been done in the past for Continental Illinois, actually limits the potential for government abuse, such as politically motivated lending, even though it is a greater use of government power. Once that state admits that a bank has failed, it pretty much has to dispose of the assets, which is cleaner and easier to oversee and protect from abuse.

And even putting aside issues of government control, capital will not flow to banks in the current situation. Geithner, appearing before Congress on Tuesday, said that the “vast majority” of banks have more capital than then need, a statement that was; very likely true, greeted with joy by equity investors, and almost entirely beside the point.

It is not that most banks may fail, it’s that some very large ones quite possibly should.

VOICES IN THE WILDERNESS

Far more germane, and of more concern, was a report by the International Monetary Fund, which upped its estimate for global write-downs by banks and other financial institutions to $4.1 trillion.

Assuming that U.S. banks take their leverage ratio, in this case the relationship between tangible common equity and total assets, to 16-1 or so, as against 25-1 before the deluge, the IMF is forecasting that there is still a need for a half a trillion dollars of more capital.

“The current inability to attract private money suggests that the crisis has deepened to the point where governments need to take bolder steps and not shrink from capital injections in the form of common shares, even if it makes taking majority, or even complete, control of institutions,” the IMF said.

The IMF further said that bank earnings will only partially offset credit losses, so a policy of keeping the banks alive and allowing them to earn their way out of the hole is fraught. They forecast loan charge offs to peak at 4.2 percent in the U.S., about double the worst seen in the recession of the early 1990s but thankfully below the 5 percent plus levels seen during the Depression of the 1930s.

This could be a wrong analysis, but if it is not there is a disturbing chance of an extended downturn similar to Japan’s experience with its lost decade.

All told, when the risks, both of what amounts to corruption and economic damage, are compared to the difficulties of seizing the worst banks, it seems a fairly straightforward decision. But of course in reality it is not, and I can’t predict what the U.S. will do.

“These ‘too big to fail’ institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions,” Kansas City Fed President Thomas Hoenig told Congress earlier this week.

This is quite a statement for a sitting central banker to make in the current circumstances.

His point about the political influence of large institutions is well made and disturbing, and applies not just to future plans for regulation but to the current state of play.

It is not just the banks which will pass or fail this test.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

12 comments

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Who got stressed? The stressed “little Timmy” Geithner stressed after his stress test that nationalization isn’t the goal. Still the stock owners got stressed.

Although “Stress test” may seem an interesting term but boiled down it’s nothing more a biding time gimmick. Even Bernanke himself said: “The outcome of the stress test is not going to be fail or pass. The outcome of the stress test is how much capital does this bank need in order to meet the credit needs of borrowers in our economy.”

For now the mainstream media learns how to make good news out of bad. The good news, the economy met our expectations. The bad news, we expected the worst of the worst.

Bernanke’s testimony on Fed’s monetary policy
http://www.reuters.com/article/ousiv/idU KTRE51N3Q520090224?virtualBrandChannel=1 0480&sp=true

Posted by Youri Carma | Report as abusive

Here’s the early call on the stress test. The big inolvent banks ( mega zombie banks) will be given the all clear. Smaller probable solvent banks ie the regionals will be asked to come up with more capital, there share price tank and the mega zombie who will get a share price boast from the stress test pick up the regionals for a song. Helping improve there capital ratios. Tim’s mission complete consolidation in the banking industry, greater stability, no failure of too be to fail zombie banks.
Pity the share holders and bond holders of the regionals. Tim’s. is this really US capitalism at it’s best ?

Posted by gd | Report as abusive

I keep hoping to see reports about job creation in the media, and not seeing them. If unemployment continues to rise, of course banks will be stuck with piles of bad debt. Job creation was promised; where is it?

Posted by sea scapes | Report as abusive

Private banks are not going to lend into a deepening recession. Their job is to preserve capital in such times, not actively solicit more losses. They’re pro-cyclical, in other words.

In contrast a National Bank can be counter-cyclical. If Citi is taken over, for example, the government immediately gains its infrastructure and 100,000 plus employees to help carry out the counter-cyclical lending and other financial support much of Main Street now needs.

With this experienced labor pool we don’t need to rely on one-size-fits all, hamhanded efforts by Treasury and the Fed to pump money aimlessly down the pipe.

Citi can lend aggressively to its existing clients while, as the national bank, work to funnel lendable funds to local banks (at low admin costs because the national bank is not interested in making a big profit just to touch the money), who will be responsible for the loans created.

Geithner has endorsed just such a plan for the world, by giving the IMF (an international policy bank) more money to lend counter-cyclically on a country by country basis. In an article at FT yesterday, Geithner showed how the new IMF has already received $80 billion in loan requests from several countries, including Mexico.

Systemic risk is now not such a threat. The trillion or so of toxic assets already removed from bank balance sheets has lessened that problem dramatically. But one or more of the big ones still are insolvent, either on a liquidity or a capital basis.

So take one down and nationalize it. Let the others stumble around until the economy recovers.

Go to Congress, get $500 billion to establish a National Bank to jump start the economy. Otherwise we’ll just end up paying $500 billion, or more, for several banks’ dodgy capital and bail out not Main Street, but bank creditors instead.

These creditors, by the way, in a real capitalist system are supposed to be the “cops” on management. They dropped the ball, and in a real capitalist system it’s their losses, not the taxpayers. Since when did we start insuring private capital investments?

Ridiculous.

The scope of greed mismanagement is far greater than we are willing to admit. The IMF’s bank loss forecasts are probably vastly underestimated due to the the general lack of transparency and due diligence in these institutions. I am unlikely to believe anything the government tells me good or bad. There is always an agenda.

When the house is crumbling one should inspect the foundation first to see if refurbishing it is worthwhile. The foundation of any thriving society is comprised of liberty, integrity, tolerance, thrift, education, responsibility and honest commerce both publicly and privately. In short a society should substantively exhibit a decent respect for the welfare of all generations present and future.

Perhaps we all should examine closely the foundation of our nation before we decide to repair what we have or build anew.

Posted by Anubis | Report as abusive

If we supposedly have a US Constitution, why are we conceding monetary regulation to the IMF, the WTO, and the private corporation known as the Federal Reserve. We broke up the JP Morgan, Chase, and Rockefeller monopolies in the Industrial Age, and yet here they are again consolidating wealth at the expense of the taxpayers. Now, instead of breaking them up, we are encouraging them to partake in the global economy. Can anyone really act surprised at this economic crisis? Everyone in Washington saw it coming, it’s just a sad fact that 95% of them are working for Wall Street and the other 5% get censored and demonized by the media. Unless we go to an isolationist model (obviously not many peoples’ favorite choice) it’s inevitable that we will get more of the same consolidation of wealth in the hands of a few oppressors, elimination of smaller (and actually solvent) banks, and eventually a global currency. We must vote yes for HR1207, and we must mandate that US Corporations do not employ non US Citizens. Otherwise nothing is going to change, and the wheels of the New World Order will keep on turning.

Posted by Thomas Jefferson | Report as abusive

I’m sure that you, Mr.Saft, know more that you are stating actually about BANKING.Big banks CANNOT go underwater and HAVE to be rescued in whatsoever means.Mony is not a problem, the place where to drop the greenbacks is from the chopper

Posted by bimbo | Report as abusive

Any whiff of nationalization will trigger an exodus of all but the least-trained personnel from a bank. Scratch said bank. Anyone who suggests something like this (the loudmouth media for one) doesn’t know what they are talking about. For the highly trained people who run today’s behemoth banks, there will be plenty of jobs in many industries. They WILL NOT take orders from peons, period.

Posted by JayB | Report as abusive

Bottom-line is that most of the big banks are insolvent(and have been for some time) and the only thing keeping them alive is creative accounting. Throwing money at it doesn’t help, much like a bank wouldn’t lend someone money to help pay off other bank debts without HUGE conditions – conditions that can’t possibly be met.

Also I think it’s worth mentioning that it is widely reported that this recession America is mired in began at the end of 2007… unfortunately no one reported that fact until Lehman went kaput. Those 9-10 months before Lehman the public was constantly bombarded with the ‘all is well’ chant from gov’t and media while (apparently) they knew we in recession already. How can anyone believe that the “results” of these stress tests will be at all different? It’s just a giant confidence scheme, one so big that no one wants to believe it.

Thanks for bringing the rest of the world down the toilets with you America.

Posted by Richard | Report as abusive

It got even worse today:

“The Fed said the tests conducted at major banks are aimed at ensuring the institutions have enough capital in reserve to continue to lend in potentially bleaker conditions, and are not a measure of banks’ current solvency.”

I repeat: “NOT a measure of banks’ current solvency.”

“U.S. Treasury Secretary Timothy Geithner announced plans to cleanse toxic assets from banks’ balance sheets.”

I repeat: “PLANS to cleanse toxic assets”

FROM: U.S. sketches out bank tests, more capital needed by Mark Felsenthal and Karey Wutkowski – Washington (Reuters) ; 24 April 2009:
http://www.reuters.com/article/ousivMolt  /idUSTRE53N5FZ20090425?sp=true

Posted by Youri Carma | Report as abusive

LOL bank stress test…. What a joke. It’s amazing what the feds get away with.

Posted by jason | Report as abusive

Keep Dreaming..

Maybe if we all click our heels together in our magical ruby slippers we can resurrect the american middle class from the destruction of the last ten years.