– Christopher Swann is a Reuters columnist. The views expressed are his own –

People can be divided into three classes, it has been said: the haves, the have-nots and the have-not-paid-for-what-they-haves. The prevalence of the third category may be the biggest single source of vulnerability for the U.S. recovery.

A stress test of the consumer could reveal more distressing results than the one conducted on the banking system.

Debt is at high levels — 130 percent of disposable income, or more than twice its peak in the late 1980s. A slide in net wealth has reduced the collateral Americans can draw upon for emergency loans. Finally, it is now harder to borrow money for new consumption or to roll over existing debt.

Like a compromised immune system, this weakness makes consumers extremely susceptible to further shocks. Traumatic as the recent bout of retail restraint may have felt, worse may be in store. After all, consumption rose by 18.5 percent in the seven years to 2008. So far it has only fallen back by less than 2 percent.

There are several potential mishaps that could swiftly undermine consumer spending and set the recovery back to square one.

Among the most likely problems would be a continued slide in house prices. Even on the conservative measures used by the Federal Reserve, the value of residential real estate has fallen 18 percent since 2006.

With signs of recovery still tentative, a further 10 percent slide is well within the realm of possibility — inflicting a further blow on the balance sheet and sense of well-being of American households. (If nervousness over swelling government debt pushes up bond yields, the outcome could be still worse.)

Homeowner’s equity, already down to 40 percent from close to 60 percent, would plunge to 35 percent. This would send household wealth down to its lowest level since the mid-1980s. While Americans can’t immediately rebuild the $12 billion of net worth lost over the past 2 years — equivalent to more than a year’s worth of consumption — further losses will heighten their sense of caution.

A second threat is also looking increasingly likely — wage cuts. Fifteen percent of employers surveyed by the Society for Human Resource Management reduced pay in the past six months, a threefold increase from earlier this year. It is no longer implausible to imagine nominal wages starting to decline on a nationwide basis.

The Employment Cost Index is already rising at its slowest rate since the early 1980s. Wage deflation would make it even harder for Americans to repay the $10.5 trillion of mortgage debt they hold or the $2.5 trillion of consumer credit.

Martha Olney, a professor at Berkeley, envisages disproportionate cuts in spending if wages dip. “For households that are paying 60 percent of their income in mortgage and credit payments a 10 percent pay cut does not mean a 10 percent fall in disposable income,” she says. “It’s a 25 percent fall.” This is the danger of leverage.

Even under a rosy scenario it could take years for American consumers to repair their finances. If the savings rate rises to 8 percent of disposable income — about $860 billion a year — it will now take four years for debt to return to its 2002 level. This steady drain alone is equivalent to almost 10 percent of consumer spending.

After such a substantial loss of wealth, Americans will be pressed to be even more frugal. Along the way American will be hyper-sensitive to any jolts from weaker than expected employment, house prices or financial markets.

Consumer spending may not merely stagnate as most economists expect. It could yet decline more sharply. And like the banks, consumers will almost certainly need more support from the central bank and government before this economic malaise is over.

– Mark T. Williams, who teaches finance at Boston University’s School of Management, is a former Federal Reserve bank examiner. The views expressed are his own. –

The market has anxiously waited over two months.  With the stress test results in, we now have our work cut out for us.  Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One.  They were problem banks before the tests and they continue to be.  But this painfully drawn-out process has spawned four tangible benefits worth discussing.

First, the stress test results raise an important policy question:  Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry.  In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.

Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards.  Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.

It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities.  Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.

Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table.  Doing so will help to separate higher risk-taking banks from lower risk-taking banks.

Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking.  Not long ago, the term “stodgy” was used to describe a bank or banker.  Today it’s more accurate to use “risky.”

Fundamentally, banks attempt to make money only three ways — interest loans, fee-based products and services, and proprietary trading.  Each has a varying degree of risk.  What makes one bank willing to take more risk than another is driven by management risk appetite, the perception of risk being taken, and the amount of capital to support such risk taking.  A bank with lower capital is a boat that needs to stay close to shore.  Banks with higher capital have greater ability to go out to sea, take risks, and weather a financial storm.

As expected, some bankers see an inherent conflict with large capital reserves as this can reduce their perceived returns.  While bankers have no control over the economy, they have absolute control over the level of risk that they take and the capital levels they deem as adequate.  Ideally, bankers should take these factors into account as they continue to recalibrate their risk-taking activities to match the level of capital needed.

Fourth, the government’s very public stress-testing blitzkrieg elevated general awareness of the benefits of using such risk-management tools in evaluating and planning around possible adverse financial outcomes.  And while stress testing has been used for decades by banks and regulators, the fact that banks overdosed on risk over time and not overnight suggests that such tools were infrequently used or ignored in the pursuit of seeking excessive profits. Also, more aggressive model assumptions can and should be applied. Going forward, with elevated awareness of stress testing, bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.

Some banks have a greater propensity to overdose on risk, regardless of the initial size of their boats.  Many, such as BofA, Citigroup, Wells Fargo, and Capital One, are out to sea in a financial typhoon and now must be brought (or towed) back to safe harbor.  Stronger capital requirements, better regulatory risk oversight, and bankers with a stronger handle on fundamental risk-management principles should help reduce the chance of another banking meltdown.

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

The most revealing verdict on the results of the U.S. banking stress test was delivered not by shareholders but by the vigilantes of the bond market, who shunned an auction of 30-year government debt.

This makes sense: if the U.S. is letting banks off too lightly it will be taxpayers and the people who lend the U.S. money who will have to pick up the bill.

The stress test, which showed that 10 large banks will need to raise about $75 billion in capital, was greeted with euphoria by bank shareholders, despite being heavily leaked.

That’s no surprise, the stress test is useful not so much as a set of forecasts about the economy or bank losses, those being arguably too optimistic, but as a signal from government to capital about the rules of the game. It matters not because it is true but because of who is saying it.

Think of it as a term sheet in which the U.S. seeks junior minority investors to take some of its exposure to its banking system. The message is we will give you enough rope to try to earn your way out of your hole; if it works the rewards will be huge.

The U.S. has already said that none of the 19 banks would be allowed to fail, and if the past year has taught us anything it is that banks are creatures of government, the corollary being that that government has to pick up the pieces if banks fail.

So how do we interpret the very poor debt auction, or the fact that 30-year bonds ended the day yielding about 25 basis points more than in the beginning, a very large move when yields are only a bit over 4.3 percent?

It’s possible that this is a green shoots story, that bond market investors are looking for a healthy pick up in growth and inflation, but I doubt it.

More likely is that it is a combination of unease about budget indiscipline, about the amount of debt the U.S. will have to sell and about the bills that will come due if the stress test gets an F from reality.

— 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.–

– Margaret Doyle is a Reuters columnist. The opinions expressed are her own –

By Margaret Doyle

Barclays has avoided the dead hand of state shareholding and, on Thursday’s evidence, it looks as though it will escape completely.

Barclays Capital has enjoyed a storming first quarter — so good it is hard to see it being sustained — which has allowed the bank to make more big write-downs and still report a 15 percent increase in pre-tax profit.

The key question is whether its provisions against so-called level 3 (hard to value) assets are sufficient.

On the face of it, they do not appear to be, because they have provided for a write-down of 24 percent on an alphabet soup of American junk assets. That compares to a write-down of 75 percent taken on a bunch of similar assets by Societe Generale, which unveiled an unexpected first-quarter loss.

Both bought insurance against a deterioration in the value of these assets, in Barclays’ case, 27 billion pounds-worth, from “monoline” insurers.

Analysts have questioned the value of such insurance, as the survival of the monolines themselves has been called into question. Barclays’ defence is straightforward: it says the likelihood of being hit by both a default on the underlying asset and on the insurer is very low. And it is taking more write-downs with each quarter’s results.

But are these haircuts just big enough to be comfortably covered by Barclays’ profits? Is it simply trying to earn its way out of the credit crunch?

It is, of course, in Barclays interests to play a long game. It gave Middle Eastern state investors great terms on a capital injection last autumn in order to avoid having Her Majesty’s Government on the share register.

I-shares, only recently considered to be a core asset, was also ditched in order to help it pass a British stress test. Had it failed, it would have had to buy insurance on punitive terms from the government.

Shareholders have bought the story. The stock price has risen six-fold from its January low. Whether it will continue to rise depends on whether BarCap can continue to turn in profits faster than its American junk goes bad.

– 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. –