Bank Stress Tests

The administration has announced that it will release the results of those infamous stress tests next Thursday. That’s a little later than originally planned. But the more interesting news is that they will now release more than summary findings. Instead we will be treated to a much more detailed set of results. That presents a problem for some, but is unequivocally in the best interests of the public.

Naturally the weaker banks will spend much of the next week protesting that the tests radically underestimate their strength. The Federal Reserve Board published the test methodology last week, and having read through it, I would argue that the tests are fairly modest. The toughest scenario puts s great deal of emphasis on the effects of unemployment rising beyond roughly 8% which the Fed assumes will trigger a burst of credit card losses. I was disappointed not to see a parallel emphasis on a potential melt down in commercial real estate, since in my opinion that has already begun, and will certainly end up causing the big banks heavy losses over and above those in their credit card portfolios.

It is this next wave of losses that represents a more normal credit cycle. Banks always suffer loan losses during recessions and those losses tend to lag behind the onset of the downturn. The reason is obvious: businesses and individuals are still able to pay their loans on time early in a recession, it is only as the downturn continues that cash gets tighter and the defaults start to pile up.

By now you’re all bored with my constant harping on the unusual nature of this cycle: it started as a banking crisis, so we are now entering the ‘normal’ phase of the credit cycle with already severely weakened banks. That’s why we are nowhere near done with potential bank failures. In fact I think this next wave of losses will probably be too much for at least one, if not two, of our biggest banks – neither Citibank nor Bank of America has sufficient capital, either at the Tangible Common Equity [‘TCE’] or Tier 1 levels, to weather much of a credit storm over the next few months.

It is this information I expect to emerge from the stress test release next week.

Then what?

There are a couple of things to bear in mind as this starts to unfold:

• The weaker banks will see their stock drop quite quickly. Or at least they should. No one will want to hold the equity of a failing bank and so the rush to sell will start as soon as we hear leaks of the test details. And creditors may start to unload their holdings as well. The value of Citi’s debt has already tumbles ahead of the release. I expect that trend to continue.
• The probability of a bank failure will rise. Not due to the actual loan losses I just mentioned as being on the way, but in reaction to the loss of market confidence. Some of these banks have been dead on their feet for months now, and have been struggling to raise equity back to anything approaching sensible levels. Their impending status as ‘weak’ will hamper these capital raising efforts even more, which will force them to start a fire sale of their businesses and assets. Citi has already managed to raise about $8 billion by dumping some of its Japanese operations. We will most likely see more of this kind of capital raising.
• Even so, I doubt that the weaker banks will have sufficient time to fix their capital levels before a combination of lost market confidence and reduced capital raising opportunities force them into the arms of the government. I think we are at the beginning of an inexorable slide towards some form of government control and forced reorganization for both Citibank and B. of A.
• Which raises an interesting point: by releasing the results of the tests the government is actually restricting its own policy options. As long as the results are vague there is always leeway for various interpretations, consequences, and therefore courses of action. Once the situation is clear, and the market reacts, the set of policy choices starts to narrow quickly. The weak banks will be tied ever tighter to the purse strings of the Treasury Department as alternative sources of cash dry up.

So whether by accident, or by design, next week’s news should start the next phase of bank bailout. And this time the opportunity for the government to avoid direct control will be restricted by the lack of privately available options.

I don’t know whether this was the plan all along, but direct control will accelerate the cleaning up process. Since that’s what I’ve been advocating from the beginning I have to admit that I am looking forward to next week.

As for Citi and B. of A..

Well they probably have a very different perspective.

Tough.

Addendum:

The Financial Times reports that the cause of the delayed release of the stress tests is the ongoing tussle between some of the banks and the administration. Apparently the weaker banks are arguing that they don’t need extra capital. I hope the Treasury Department holds the line on this argument. The last thing we ned is a bunch of crippled, and therefore useless, banks cluttering up the economy just as we need an infusion of credit from our banking system. As we are all aware by now, these so-called ‘zombie’ banks are worse than failed banks because they live on but serve no economic purpose.

Still, the release alone should cause the weaker banks to crumble quickly. Already the market is humming with rumors. Can a takeover be far away? I hope not.