Bank Stress Tests. Begin with Treasury Secretary Tim Geithner's NY Times op-ed explaining how & why the banks were stress-tested. Here are the money paragraphs:
The effect of this capital assessment will be to help replace uncertainty with transparency. It will provide greater clarity about the resources major banks have to absorb future losses. It will also bring more private capital into the financial system, increasing the capacity for future lending; allow investors to differentiate more clearly among banks; and ultimately make it easier for banks to raise enough private capital to repay the money they have already received from the government.
The test results will indicate that some banks need to raise additional capital to provide a stronger foundation of resources over and above their current capital ratios. These banks have a range of options to raise capital over six months, including new common equity offerings and the conversion of other forms of capital into common equity. As part of this process, banks will continue to restructure, selling non-core businesses to raise capital. Indeed, we have already seen banks, spurred on by the stress test, take significant steps in the first quarter to raise capital, sell assets and strengthen their capital positions. Over time, our financial system should emerge stronger and less prone to excess.
Banks will also have the opportunity to request additional capital from the government through Treasury’s Capital Assistance Program. Treasury is providing this backstop so that markets can have confidence that we will maintain sufficient capital in the financial system. For institutions in which the federal government becomes a common shareholder, we will seek to maximize value for taxpayers and enable these companies to attract private capital, thereby reducing government ownership as quickly as possible.
Some banks will be able to begin returning capital to the government, provided they demonstrate that they can finance themselves without F.D.I.C. guarantees. In fact, we expect banks to repay more than the $25 billion initially estimated. This will free up resources to help support community banks, encourage small-business lending and help repair and restart the securities markets.
A WSJ economics editor explains the three things the tests will show. They are: how much more money the government expects to lose; (2) which banks are strong & which are weak; (3) how banks will fill the capital holes. He offers some key numbers:
The latest International Monetary Fund estimates put total losses at a stunning $4.1 trillion for all financial institutions worldwide, counting known losses and those not yet acknowledged. The stress-test tally is narrower: as-yet-unacknowledged losses the 19 U.S. banks face in the next two years under bad but not catastrophic conditions. Private estimates range from about $300 billion to $1 trillion; the comparable IMF figure is about $400 billion. The government tally likely will fall in the middle, probably toward the lower end of the private range.
That's the first headline number: total potential losses beyond those the banks already have taken. Subtract that sum from banks' existing capital, add profits they'll make this year and next, and you get the second headline number: the total capital the government wants banks to raise in the next six months. That sum, Mr. Bernanke assured Congress this week, will be manageable; that's reassuring, as long as the estimate is credible.
Here is a description of the new class of preferred stock the banks will issue. (Preferred stock is a hybrid security, part equity & part debt: like common stock, it represents ownership equity; like bonds, a holder stand in line as a creditor, ahead of common shareholders in event of bankruptcy.)
Bank Numbers. Now let's look at the numbers to date for the Troubled Assets Relief Program (TARP), launched last fall by the Bush administration and Congress: $750B available, $590B pledged to date, $393B actually spent, $160B not yet pledged. Bank of America needs $35B added capital, per the stress test results. BOA stock is now valued at $70B, with $45B of government funds already invested. BOA must either raise capital outside, or turn to the government to convert more of its preferred shareholding to common stock, to meet the new requirement. One private appraiser estimates that BOA needs $46.7B to reach the 4 percent capital reserve level. Two analysts recommend at least $65B in capital to shore up big banks. Here is an interactive graphic chart they prepared. The government estimates $75B is needed, but Goldman Sachs & JP Morgan Chase are exempted, as are 7 other of the 19 largest banks. The total potential losses, should the economy under-perform, could run $599B.
What to Do. Two finance mavens argue that market discipline must be applied to insolvent banks. Referring to Austrian economist Joseph Schumpeter's dictum that capitalism could not survive social chaos and intellectual discontent, they write:
Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.
Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialised risk. Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?
One possible reason is the “Lehman factor” – the bank runs that would occur as a result of a big failure. But we have learnt from the Lehman collapse and know not to leave the sector high and dry when a systemic institution fails. Just being transparent about which banks clearly passed the stress tests would alleviate many of the fears.
Another reason is counterparty risk, the fear of being on the other side of a transaction with a failed bank. But unlike with Lehman, the government can stand behind any counterparty transaction. This will become easier if a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.
That leaves the creditors – depositors, short- and long-term debt-holders and preferred shareholders. For the large complex banks, about half are depositors. To avoid runs on these deposits, the government has to provide a backstop. But it is not clear it needs to cover other creditors of a bank, as the failures of IndyMac and Washington Mutual attest.
Three economics mavens argue in a WSJ op-ed that the FDIC should take over insolvent banks. The first $254B of TARP funds covered toxic assets worth but $78B--31 cents on the dollar. They estimate that for Geithner II--the Public-Private Investment Plan (PPIP)--taxpayers will ante up $2 for every $1 the private side antes. The authors recommend splitting troubled banks into "good" and bad" banks: the bad bank takes the toxic assets, long-term liabilities and a loan from its "good" twin; the "good" bank is then freed from the TARP program.
Fortune Magazine sees 8 signs of economic recovery--"green shoots." Given recent long-term stock market cycles (1966 - 1982 bear, 1982-1999 bull, 2000 - present bear) it is hard to share Fortune's sunny side. Banks had better pray that green shoots are indeed sprouting amidst massive global financial asset deleveraging.
AEI financial maven Peter Wallison says that increased federal regulation benefits Congress, but not the economy. He notes that government lacks the competence to determine which firms pose systemic risk.
Judge Richard Posner, vastly schooled in economics, blames regulators above all for causing what he calls a "crisis of capitalism". He also blames economists who pushed for cutting interest rates to boost the economy. Posner sees two early lessons (my underlining) from the mess:
First, businessmen seek to maximize profits within a framework established by government. We want businessmen to discover what people want to buy and to supply that demand as cheaply as possible. This generates profits that signal competitors to enter the market until excess profit is eliminated and resources are allocated most efficiently. Financial products are an important class of products that we want provided competitively. But because risk and return are positively correlated in finance, competition in an unregulated financial market drives up risk, which, given the centrality of banking to a capitalist economy, can produce an economic calamity. Rational businessmen will accept a risk of bankruptcy if profits are high because then the expected cost of reducing that risk also is high. Given limited liability, bankruptcy is not the end of the world for shareholders or managers. But a wave of bank bankruptcies can bring down the economy. The risk of that happening is external to banks' decision-making and to control it we need government. Specifically we need our central bank, the Federal Reserve, to be on the lookout for bubbles, especially housing bubbles because of the deep entanglement of the banking industry with the housing industry. Our central bank failed us.
The second lesson is that we may need more regulation of banking to reduce its inherent riskiness. But now is not the time for that: There is no danger of a renewed housing or credit bubble in the immediate future. The essential task now is to recover from the depression. That requires, as John Maynard Keynes taught, a restoration of business confidence. Investment is inherently uncertain, and it is even more uncertain in a depression. Anything that amplifies this uncertainty slows recovery by making businessmen more likely to freeze and hoard rather than venture and spend. Reregulating banking, hauling bankers before congressional committees, passing laws tightening credit-card lending, and capping bonuses all impede recovery. All that is for later, once the economy is back on track. For now such measures are just distractions.
Moreover, it is unclear how banking should be regulated. Banking in the broad sense of financial intermediation (borrowing capital in order to lend or otherwise invest it) is immensely diverse. It is also international. If one nation reduces the riskiness of its banking industry, business will flow to other nations, just as a bank that decides to be cautious will lose investors to its competitors because of the positive correlation of risk and return. So international regulation of banking is needed in principle, but international regulation tends to be lowest-common-denominator regulation and so may be ineffectual.
Bottom Line. Clearly the toxic asset problem continues to bedevil regulators. To be fair it is a devilish problem, and understanding is called for. Identifying healthy and unhealthy banks should have been done last fall, and delaying same only amplified the destructive uncertainty and asset value opacity that has proved so crippling. Massive federal infusions ultimately will have a beneficial effect. But problems for the future are being laid in the government's serial improvisations.
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