Wednesday, November 23, 2011

Market analysts confirm their interpretation that stress tests are backed by Fed guarantee of bank solvency (update)

A Reuter's article confirms that market analysts think that banks which are subject to stress tests have their solvency guaranteed by the Fed.

The analysts know that they do not have access to all the useful, relevant information like the Fed.  As a result, stress tests do not promote market discipline, but rather reliance on the Fed.

Even if the analysts believe the 100+ PhD economists at the Fed who are supervising the stress tests are clueless, the analysts know that by publishing the results of the stress tests, the Fed takes on the moral responsibility to bailout any investors in the banks.

The fact that the Fed is explicitly saying the banks are investment in them is safe from any solvency problems...creates this moral obligation to bailout investors.

Only a regulator that is committed to hiding something from market participants or protecting the banks from market discipline would ever acknowledge that they were doing stress tests.

Regulators who are committed to bringing market discipline to the banking industry would require banks to provide on an on-going basis ultra transparency.  Banks would disclose their current asset, liability and off-balance sheet exposure data.

With this information, market participants, including competitors and analysts, would assess the riskiness/solvency of any bank.  The result of this assessment would be an adjustment of the amount and price of the market participant's exposure to the bank.

The U.S. Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health. 
The Fed said it will publish next year the results of the tests for six banks that have large trading operations... 
"They are clearly worried about the issue of Europe," said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. "In a time of risk aversion and concern, you need transparency."... 
The Fed will use the review of bank's capital plans to determine whether the banks are robust enough to raise dividends or repurchase stock, or whether they need to obtain additional capital.
The moral obligation to bailout investors.
The Fed plans to release more information than it did last year about the tests' results. The regulator said it is doing so to "foster market discipline."
Market discipline would result from banks being required to provide ultra transparency.  What market discipline could possibly occur after the Fed says the banks are solvent and can pay dividends?
The Fed said it will disclose the estimate of revenues, losses and capital ratios of the 19 biggest banks if they were to suffer a market shock. 
This type of disclosure could give investors and markets more certainty about the strength of U.S. banks at a time when there are deep concerns about their European counterparts. 
"Eventually, this will be viewed as a positive, and a lot of people will focus on this as a way to verify the viability of these companies," said Matt McCormick, portfolio manager at Bahl & Gaynor investment counsel in Cincinnati...
Yes, the stress tests will verify that the Fed is obligated to bailout the banks should any solvency problems arise.
"I don't think anyone could say that this is anything but an extremely stringent stress test," said Karen Petrou, managing partner of Federal Financial Analytics. "It will really put the burden on the affected bank holding companies to prove they can make a capital distribution, not on the Fed to block it."
I will say that this is not an extremely stringent stress test.  An extremely stringent stress test would look at what would happen if all the credit default swap contracts did not payout.  In Europe, the regulators are spending great amounts of time making sure that debt restructuring is done is such a way that the contracts do not payout.  So, what would happen to the big six banks if their CDS hedges aren't a hedge?

A Bloomberg article provides many more analysts chiming in and confirming that the Fed has a moral obligation to bailout the banks subject to the stress test.

The Fed imposed a tougher capital test on the 31 largest U.S. banks yesterday, releasing the criteria for measuring their wherewithal if the U.S. economy sours and major trading partners default on their debt. 
Lenders need to prove they have the capital to withstand a “severe” U.S. recession with 13 percent unemployment and an 8 percent decline in gross domestic product before they can increase dividends or repurchase shares... 
Remember, passing the stress test, even if it involves raising a de minimus amount of capital puts the Fed on the hook morally for bailing out investors.
The Fed limited banks to returning 60 percent of their retained earnings to shareholders in 2011, split evenly between dividends and share repurchases. Glenn Schorr, an analyst at Nomura Holdings Inc., said banks may possibly be restricted even further, to about 40 percent, under the more adverse scenario.

“The tighter you stress and the more extreme you stress, the more careful you’ll be in terms of letting banks return capital,” Schorr said in a phone interview. 
The Fed’s stressed scenario calls for unemployment to hit 12 percent by next year and 13 percent in 2013. It also tests banks’ performance in an economic decline that begins this quarter and bottoms in the first quarter of next year, with real gross domestic product falling 8 percent and home prices dropping 20 percent during the next two years. 
“An 8 percent decline in GDP, that’s a disaster,” Miller said. “That’s not a recession.”...
So if a bank can pass this test, it must really be solvent...
The test also subjects the trading operations of the six biggest U.S. banks -- JPMorgan Chase & Co. (JPM), Bank of America, Citigroup,Wells Fargo & Co. (WFC)Goldman Sachs Group Inc. (GS) and Morgan Stanley -- to portfolio “shocks” based on asset price moves in the second half of 2008. 
“This is similar to what we saw them do in the original stress tests in 2009,” said Andrew Marquardt, an analyst at New York-based Evercore Partners Inc. “That will be more painful for those banks. In 2009, that was a particular point of contention.”...
Wait a second, didn't the banks pass these portfolio 'shocks' in 2009?  Oh, this is analysts saying these stress tests are so rigorous "we don't need to do any homework on the banks ourselves ... end of market discipline" and "we really like having the Fed on the hook for bailing out investors for any bank solvency problems".
“At the end of the day, a stress test is to demonstrate to investors and the marketplace that the banks are strong and can withstand problems in their portfolios,” said Fred Cannon, a bank analyst with KBW Inc. in New York. “It’s all about credibility.”
And the fact that once a bank passes the stress test, analysts can come back to the Fed should the bank encounter solvency problems and point out the Fed's moral responsibility to bailout investors.

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