Bank Capital Inanity
There are times when I just feel like screaming. Reading the Financial Times today was one of those moments. On the front page of the Companies and Markets section was an article commenting on the surge in stock prices of major America banks. This surge was attributed to the relief spreading around Wall Street that the stress test results would be fairly benign and that any additional capital requirements could be easily managed through the private sector and not through the heavy hand of government aid.
That’s OK up to a point.
There have been so many leaks about the tests that it has become very difficult to take them seriously as being true ‘tests’. They now appear to have resembled an ‘open book exam’ with the examinee able to grade themselves. Frankly I think they have devolved into a joke. But it seems clear that the administration wanted desperately to avoid having to take hard action, so it decided to grade on a curve and take a very broad and shallow approach: it wants to have a big group of ‘weak’ banks so as to mask the truly weak within a large herd. That way we are presumably unable to pick them out.
Back to the story.
Buried towards the bottom were two quotes from anonymous fund managers that demonstrated how far the administration has succeeded in confusing analysts. Here they are:
- “… even if the banks [Citi and Bank of America] were asked to raise some $10 billion each in new equity, they would be able to do it without too much disruption by converting preferred shares held by the government and investors.”
- “If it is really just $10 billion each, that is easy. Both banks[Citi and Bank of America]have enough preferred shares to be able to do it and investors would take that in stride,” one fund manger said.
Well now. If you have paid attention to all I have been saying you will know why I fell off my chair when I read those two statements.
It is inconceivable to me that a fund manager could be so thick as to believe the Treasury’s party line on the conversion of preferred stock into equity.
So let me make this quite clear: converting preferred stock into equity does not increase a bank’s capital one iota. Not a single cent. Nada. As in zero. Perhaps even less than zero since the cost of conversion would deplete income. It is absurd to claim that such a conversion does anything at all to help the banks.
So let me make this quite clear: converting preferred stock into equity does not increase a bank’s capital one iota. Not a single cent. Nada. As in zero.
Ah! But notice the subtlety at work here: such is the Treasury’s effectiveness that they have turned the discussion from improving capital to one of improving equity. Maybe the fund manager saw this and simply shrugged and agreed. He’d be correct. The investors would swallow such a charade in a heart beat. Why? Because it helps protect their own investment by bulking up the bank’s equity, which even at the cost of dilution of their ownership, is worth it because … well misery loves company. Especially at the bottom of a weak bank’s balance sheet. It also signals that the government is not about to move hard against the bank. And it gets rid of some of that pesky preferred stock which earns interest and therefore costs the equity holders money. Besides, from a fund mangers point of view why does he care if the Treasury Department wants to rip off taxpayers in order to bail out failed shareholders within whose ranks he numbers himself. He can be nonchalant and toss off fatuous comments like the above. It’s the reporter who should be taken to task for not getting beyond the Treasury’s misdirection play.
And my point?
By quietly switching the discussion from being about fixing bank capital ratios to being about fixing bank equity ratios the Treasury Department has laid the groundwork for emasculating the entire stress test effort. The exercise becomes utterly pointless.
Any fund manager worth his or her salt should have been asking the obvious and much more interesting question: what are we going to do about getting capital ratios improved? Is that not what we are supposed to be doing?
Apparently not.
The conclusion I come to is that the administration never intended to ‘stress’ the banks. It wanted to bend over backwards to avoid taking action, and it bought the bank’s story that they simply need time to heal themselves.
Hey. That all might be fine. The banks might be just dandy in a few short months.
Let’s hope so. If not you and I have just been sold a massively expensive bill of goods.
Conversions!!
Bah humbug.
Addendum:
Ah! Now I get it. According to this later FT article, the stress tests sort the banks into four categories:
- Those that need new capital right away
- Those that need new equity, but not more capital
- Those that don’t need more of either equity or capital
- Those that have ‘surplus’ capital
Plus it seems as if the weaker banks are going to be given plenty of time to raise capital, even if they appear to need it now. Citibank, for instance, wants time to complete the sale of some of its businesses which should yield it a profit and thus add to its capital base.
Apparently most banks will fit in those two middle categories.
Which returns me to my main argument: it is a shortage of capital that is the major issue. Not what form that capital takes. Conversions of preferred into equity are pointless and distract us all from the larger goal.
I feel ‘stress test fatigue syndrome’ setting in.
