Monday, March 12, 2012

Shockingly, the latest round of stress tests to show banks almost fully recovered

As the annual exercise of the US government guaranteeing all bank depositors, debt holders and equity investors for another year draws to an end, speculation grows that the Fed is going to announce that the results of its latest stress test show the banks are almost fully recovered from the financial crisis.

Regular readers know that the stress tests morally and intellectually bind the policy makers and the regulators to insuring that no bank depositor, debt holder or equity investor suffers a loss as a result of the insolvency of a bank.

This is the direct result of and inescapable conclusion from the simple fact that the stated purpose of the stress test is to discover if the banks are adequately capitalized (ie, solvent) in the face of difficult economic conditions and increased losses on their loan portfolios.

After all, how can the policy makers and regulators not step in and prevent bank depositors, debt holders and equity investors from suffering a loss after using the regulators' information monopoly to determine that the banks are solvent?

As for the meaningless results of the latest stress tests, a NY Times article provides more details on the expected conclusion.

In another milestone in the banking industry’s recovery from the financial crisis, the Federal Reserve this week will release the results of its latest stress tests, which are expected to show broadly improved balance sheets at most institutions.... 
Hence the US government guarantee!
Still, while unpleasant surprises are possible, analysts are counting on the Fed to find banks largely healthy....
Due to the fact that current bank disclosure leaves them as 'black boxes', analysts don't have access to the data necessary to disprove the Fed's findings.

More importantly, if analysts had access to the necessary data, analysts could run their own stress tests and the Fed would not have to announce the result of its stress test.  By not announcing the result, the Fed would end the explicit and implicit government guarantee.

After all, if analysts working for market participants can independently assess the risk of the banks, then market participants become fully responsible for all gains and losses on their exposures.

And all it would take for analysts to have the necessary data is to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off balance sheet exposure details.
“Everybody wants to avoid headlines,” said Chris Kotowski, an analyst with Oppenheimer. 
“People are angry at the banks, and both the banks and the regulators just want to do something to show we’re working our way back towards normalcy. That’s what everyone is craving.”
Actually, what everyone is craving is the disclosure of the bank data so that the risk of each bank can actually be independently assessed.

It is only when market participants have the data needed for doing their homework that normalcy can return.
The examination is not merely an intellectual exercise....
True.  It is a reaffirmation of the US governments pledge to bailout the banks and make sure that depositors, debt holders and equity investors do not lose money.
Under the tests, Federal Reserve specialists are trying to predict how capital levels at the 19 largest banks would withstand an economic downturn even more severe than the one that followed the Lehman collapse....
Your humble blogger never ceases to be amazed at the hubris involved in the stress tests.  Apparently Federal Reserve specialists are better at assessing the risk of banks than the market which includes the banks themselves and all of their in-house experts.
Regulators are walking a fine line: if they permit the banks to return too much capital now, that might leave the industry vulnerable in the event of a downturn and lead others to think the industry was returning to its risky ways. On the other hand, a raft of negative results would alarm investors just as calm seems to be returning to the markets. 
“It’s going to end up being a compromise between regulatory constraints and what the banks desire,” said Kamal Mustafa, chairman and chief executive of Invictus, a consulting firm in New York that focuses on the financial sector....
No it doesn't.  As RBS's Stephen Hester's confession showed, regulators are already blessing banks hiding losses on and off their balance sheet.

The stress tests are limited to showing the level of losses that the banks can absorb without interrupting the flow of bonuses to bankers.
“The industry is on much firmer ground than it was three years ago,” said Jason Goldberg, an analyst for Barclays. “This will show how much progress the banks have made in cleaning up their balance sheets.” 
“It was painful to get here in some instances,” he said, referring to institutions like Bank of America and Citigroup that had to sell billions of dollars’ worth of new stock to raise capital, lowering the value of the stock held by shareholders and leaving their shares well below precrisis levels. “But we did get here.”...
Think of the pain of the bankers endured from having their bonuses cut back marginally from their 2007 peak.

Excuse me, but is it possible that if the regulators had not blessed hiding losses that banker bonus would have been zero for the last several years?
Federal Reserve officials, led by Daniel K. Tarullo, a Fed governor, have pushed to make more information public about underlying conditions, despite opposition from bank executives.
In this case, the Fed will release figures like the potential drop in revenues, expected losses, and capital levels in the event of a sharp downturn.... 
Wall Street's Opacity Protection Team applying de minimus pressure and the result is the Fed releases only numbers invented by the staff of these banks with the explicit intent of the invented numbers being to convey solvency.

Institutional Risk Analytics, a firm that specializes in valuing banks, provides its own unique twist to the stress tests in its latest weekly letter:
[In] terms of the Fed stress tests this week, it is hard for us at IRA not to yawn. These stress tests are a complete fabrication, more a political process than a true risk management exercise. 
The Fed's mishandling of large bank supervision and these ersatz stress tests just proves why the central bank should be stripped of all legal responsibility for supervising large financial institutions. 
The fact that the Fed has allowed banks to pay dividends and, more important, reduce reserves over the past 18 months pretty much shoots the Fed's credibility on this issue in the head. If large bank charge-offs show signs of rising in 2012, then look for a bull stampede out of large cap financials when the high-beta finally crowd gets the joke. There are few real investors in these top-four names, so make sure to stand clear of the door when the first earnings reports roll out.

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