More Clarity Needed on Bank Stress Tests

Over the past few weeks there has been a great deal of noise about the future of banking in America, and while just a few months ago the idea of nationalizing any of the large banks seemed out of the question, this stance seems to be softening. Oh sure, officially the Obama administration insists that nationalizing is a last resort, but nationalization is still a possibility. The problem is that it is not clear under what conditions privatization is in play. To address this, the Treasury Department introduced new so-called “stress tests” to evaluate these banks but this has only added to the confusion.

On February 25th, the Treasury Department announced that all financial institutions with over $100 billion in assets would be required to undergo the new assessment. These tests are intended to determine the capability of each bank to remain solvent based on economic scenarios defined by the Treasury Department and must be completed by the end of April in order to qualify for funds through the Capital Assistance Program (CAP).

The tests are based on two scenarios that project the state of the economy over the next year and a half. The first scenario – called the “baseline” – reflects what the regulators call a “consensus expectation” held by private forecasters, while the second scenario is referred to as the “more adverse” scenario and this is the standard by which the banks will be evaluated.

The “more adverse” scenario assumes that the economy will contract by 3.3 percent for the year and remain flat for 2010; house prices meanwhile, are projected to plunge another twenty-two percent in 2009. With respect to employment prospects, the test case calls for unemployment to rise to 8.9 percent this year, and 10.3 percent next year. This is all very good, but most critics feel that despite the “more adverse” moniker, this projection is entirely too optimistic in its outlook and the economy will actually deteriorate at a much faster and deeper rate than this scenario allows.

This criticism is hard to dismiss when you consider that GDP has already contracted 6.2 percent from October to December 2008 and with no appreciable effect from the economic stimulus plan expected for several months at least, there is little reason to believe the current quarter will be any better. This makes a yearly decline of just 3.3 percent for the entire year seem very aggressive – actually it makes it next to impossible. And is there anyone out there that honestly believes growth will merely be “flat” for 2010?

Even the unemployment prediction of 8.9 percent this year seems unlikely. For the last six weeks in a row, the number of jobs lost has exceeded 600,000 bringing total unemployment to 8.1 percent and there is nothing in the immediate future to suggest this trend won’t continue.

Surely the regulators – and even the politicians for that matter – must realize that the standard by which the banks will be evaluated will likely bear little resemblance to reality, so why go through with this? According to Christopher Whalen, Managing Director at Institutional Risk Analytics, the reason is simple:

“The stress test is about politics,” Mr. Whalen said. “The OCC and the Fed already know the answer. The answer is that we’re going to have to come to a decision: are we going to put in more equity [to keep the banks afloat] or are we going to resolve the banks through bankruptcy?”

I won’t deny Mr. Whalen his opinion but the first question I have is even more basic “what happens to a bank that fails the test”? And this is where things get confusing.

According to the original press release, if the test for a particular bank suggests that it’s capital would be depleted based on the scenario explained earlier, the bank has up to six months in which to raise sufficient funds to bring its capitalization up to the level needed to pass the stress test. If the bank can not raise the money itself, it can then turn to the government but must exchange a stake in the bank’s ownership for any cash received.

This sounds like nationalization without actually saying nationalization and serves only to raise another series of questions. First off, what realistic chance does a bank that has just failed its government-mandated stress (i.e. “survivability”) test have in convincing other institutions to lend it money? Probably about the same chance it would have in attracting outside investors – zero.

Here are some more questions – if the government lends a bank money in exchange for a piece of that bank, will it assume majority ownership? What will happen to existing shareholders? And how badly does the bank have to do in the testing process before the government decides it is beyond redemption and allow it to simply fail? Is this even an option or is the government prepared to prop-up any and all of these banks?

Confused? If so, you are not alone – so is Warren Buffet.

In a blunt comment directed not just to the question of bank privatization but the government’s overall economic plan Buffet was quoted earlier this week saying that the government has sent “muddled messages” that has only confused the public.

“The message has to be very, very clear as to what government will be doing,” said Buffett in an interview on Monday, March 9th. “I think we’ve had—and it’s the nature of the political process somewhat—but we’ve had muddled messages and the American public does not know. They feel they don’t know what’s going on, and their reaction then is to absolutely pull back.”

There are some bold ideas being put forward by the government but the delivery is lacking and until this is addressed, the message will continue to be lost. After all, if one of the most successful investors in history finds the message “muddled”, what chance do the rest of us have.

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