The Results Are In!

And the winner is? Well that depends on your point of view. The early winners seem to be Goldman Sachs and JP Morgan Chase who flew through the tests with flying colors. The losers include Bank of America and Wells Fargo, the latter of whom must be particularly peeved having been lauded by no less an authority than Warren Buffet just a few days ago. Following up the rear is GMAC who seems to be the only tested bank who pulled the equivalent of an ‘F’.

So. Now what?

The banks that have been told to get capital have until June 8th to present a plan showing how they intend to do so. They then have until November 9th to raise the cash.

What if they don’t? We’ll see about that later.

Now that the whole charade is over and the dust settles what have we learned?

The tests indicate that the Treasury Department expects this group of banks to suffer a further $600 billion in loan losses through the rest of this credit cycle. Those losses are expected to stem from such things as the effects of rising unemployment and the ‘normal’ cycle in commercial real estate. This estimate is on the low side. Other organizations, most notably the IMF have forecast losses much worse than this.

In part the difference between the IMF and the Treasury may flow from the fact that the Treasury allowed the banks to do the predicting by using the banks own risk assessment models. This involvement of the banks would naturally skew the expected losses down. After all these are the same risk models that helped create the mess in the first place.

As you know I have been highly critical and skeptical of the entire testing process. I find it odd that the banks were involved so deeply in the process – it sounds more like a self-assessment than a rigorous audit. And the fact that they were negotiating the results seems just absurd. These two factors fed my naturally cynical nature, and resulted in my conclusion that the tests were run as a ‘misdirection’ play to make it seem as if we were facing the banking crisis rather than actually doing anything about it.

Be that as it may.

The tests are now done and we must all face the new reality.

So the discussion now shifts to the next few months and the consequences of the testing process.

Are the banks safer?

Well not yet. Some like Goldman and JP Morgan Chase are already chaffing at the bit to repay TARP money so that they can get on with their business without government interference. I don’t blame them. We should all recall that the banking landscape has been re-written over the past few months. There are far fewer major players and some of those left standing are ineffective players at the moment. I can imagine the guys at the healthy banks want to get stuck into the game: they will make hay over the near tern while their weak competitors do lazy eights as they raise capital. Expect profits to rise sharply among the healthy. Not only is the competitive landscape ripe for profit making, but loan spreads are high, the yield curve has been twisted in favor of lenders, and cheap government bailout money is lowering the cost of doing business. In short if you are a ‘healthy’ bank things are truly looking up. The government is doing all it can to give those banks a leg up.

Meanwhile: the weak banks will wallow around. Their spreads and so on will also improve. So their profits will be better. Loan losses will cripple any efforts to expand lending, but that has become secondary. Public policy, which at the start of this crisis was focused on getting lending going again, is now more focused on keeping the weak banks alive long enough that they can thrive on their own. The second objective is to keep the out of pocket cost to taxpayers as low as possible.

An interesting problem may emerge later in the year when, and if, one of the weak banks fails to raise the capital the government has ordered it to. Right now the Treasury Department is indicating that it will forcibly inject more capital at that point. I doubt it. One of the administration’s goals in the test process was to punt the problem forward. By November with banking conditions slightly improved and the economy gradually rising from recession, both of which are certainly possible, the politically smart move would be to punt again. Since the administration seems to have been driven by politics rather than economics so far I would bet on another punt.

Plus I expect lost of discussion to surround that part of a bank’s capital called Tangible Common Equity [‘TCE’]. As I have said here many times that ratio can be fixed more easily than broader measures of capital such as Tier 1 Capital. Geithner has been hugely successful in switching our attention to TCE so there is no reason to change now.

One of my yardsticks for the testing process would have been the level of howls from the industry. Normally a strict audit will elicit predictions of dire consequences and imminent disaster. So far the reaction has been more one of confusion. The stock market has bid up then bid down the stocks of the weak banks, largely due to the flood of rumors we have suffered through. Now that the facts are before us the market should settle down. I would expect banks that are deemed healthy to attract investors, while those who are weak will have a harder time raising private funds: who would want to invest in an organization that the government has on life support? So an outcome of the testing is that the weaker banks, who need to find capital, may find it harder to do just that. The best avenue for capital growth will then be from the sale of subsidiaries and lines of business. Look for hedge funds and private equity funds as well as the healthy banks to attempt to bulk up by acquiring bits of their weaker competitors.

This really is a case of the rich getting richer and the poor getting poorer.

In the end I am glad the process is over. I am sure you are too, given all my venting over it.

But the concerns remain. We should be leery of declarations of success. The second wave of losses is coming, and the structure of banking remains the same. If anything there are some too big to fail banks that will now be much bigger.

Saving banks is one thing. Fixing them so they can’t screw us all up again is another.

So I will leave you with this:

My concern has always been with the structure of the industry: it needs to be reined in so that we are not exposed to its excesses again. As I watched the administration deal with the immediate issue of saving the weaker banks I used it as an acid test of their ability or desire to take what I perceive to be tough action to downsize or limit the power of the industry. The stress test process leaves me highly skeptical. The government seems to be unable or unwilling to face the banks down. Whether that results from hard nosed political calculation or from simple cowardice I don’t care. The result remains the same. Until the banking industry is severely restricted and its major players reduced so that they can fail without destroying everything around them our economy remains at risk: from the undue influence of financiers and from the very high prospect of another asset bubble resulting from easy credit.

So my confidence is high that the banks will be saved. And it is low that they will be fixed.

Too bad.