The NPV Test: A Line in the Sand on March 4

Housing and Urban Development Secretary Shaun Donovan has promised to announce a “standardized net present value test” for the troubled mortgage sector on March 4, 2009. The specificity which Secretary Donovan seeks to bring to President Barack Obama’s effort to help nearly 10 million American families facing foreclosure is laudable indeed; investors have been waiting for months for somebody in authority to reveal a credible asset valuation methodology. But in today’s environment, that specificity is likely to spread chaos beyond the housing market, to banking and insurance, and even across the broader American business spectrum.

I have already ascertained sufficient cause to retain a decidedly short bias in five key financials: Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), Morgan Stanley (MS) and Wells Fargo (WFC). So the announcement of the standardized NPV test will merely provide an incentive to increase the size of short positions. But it is those who are holding on to bank shares who need to be concerned about the potential for equity values going to zero. Treasury Secretary Timothy Geithner is supposed to unveil details about his rescue package shortly; but whatever the nature of the details made public, the March 04 NPV test will serve to challenge certain core assumptions relating to the pricing of bank-issued preferred instruments and common shares the government has been buying, and plans to buy during the first half of this year.

By its very nature, a net present value assessment of an asset is predicated on two fundamentals: (1) the future earnings the asset can generate and (2) the interest rate, e.g. the “risk-free” rate, at which the future earnings are discounted to arrive at the present value. Quite clearly, the ability of home-owners to service their loans over an extended period will be a crucial component of the NPV test, as far as the Obama Mortgage Plan is concerned. But, perhaps unintentionally, the constituents of the NPV methodology will provide a fresh window into the value of hundreds of billions of dollars worth of Level 2 and Level 3 assets (per FSAS 157) on the books of Wall Street’s banks.

The impact of the NTV test on the valuation of trillions of dollars of derivative contracts may not be direct; but the dire need to provide for default risk in this highly uncertain global economic environment will become more than evident. Lawmakers have been debating the viability of the mark-to-market mechanism, in terms of price, in the current conditions for many months now. The NPV test should turn the focus on marketing counterparty risk to the market, a formidable proposition for those still engaged in escapism.

This writer is of the opinion that an honest appraisal of the level of counterparty risk on bank books will make a conclusive case for bank nationalizations. Unless, of course, one is targeting to keep the global financial system alive, somehow, for it to rectify itself at some point in the future. In simple terms, the Obama Mortgage Plan is a bet on the housing market bottoming out by late 2009. Timothy Geithner’s bank bailout package will surely reflect a similar bet.

The problem is that, thus far, nobody is sure of the pricing considerations which are being applied to the trillions of taxpayer dollars being invested in bank-issued instruments, regardless of the nature of the bet. One version of events is that the Treasury is reluctant to disclose a valuation test, somewhat similar to the one which is scheduled to be announced on March 4, for banks and financials in the event that the results create widespread panic. The second, and more plausible, version is that regulators never intended to go beyond the framework established by existing accounting and SEC guidelines in any event. “The one rule in a crisis of such magnitude is to stop digging yourself deeper into a hole,” one senior European hedge fund manager told this writer recently. “The more you try to know, the less you end up knowing.”

Perhaps we all will know less about the problems in housing when we start applying Secretary Donovan’s NPV test to mortgages. But, most certainly, many of us will stop asking any more questions about the health of our banks by that time.

Disclosure: Short BAC, C, JPM

Comments

[MattZN:]

Not to point out the obvious, but you do realize the government is going to devise the test such that J.P. Morgan, Morgan Stanley, and Wells Fargo will pass it, don't you? In fact, I would go as far as to say that they would devise the test such that BofA would also pass it. Citi is already a zombie so it doesn't need to pass the test.

There's a simple reason for this. The government can't put any of the above four banks into receivership. If they do they would have to directly realize hundreds of billions of dollars in losses because not a single other bank will touch their loan portfolios at anything better then $0.30 on the dollar for sub-prime and $0.80 on the dollar for prime. Citi's inability to absorb Wachovia has pretty much proven that the big banks can't really absorb other banks put into receivership as whole entities, so that avenue is closed to the government now. The era of banks like BofA buying Merrill whole, and Wells buying Wachovia whole... that era is over.

-Matt

Feb 19 02:56 AM

[apppro:]

The bigger question is WHY do you even want to?? Just repeal MTM and in the normal progression of things, the banks will work this out. This NEED to have IMMEDIATE GRATIFICATION, doesn't work in the financial arena.
The only reason the allow these banks to so-called fail, is to allow narsarssitic short sellers like the above author to get richer on everyone elses back.
Golden Rule 4:
Institute a WINDFALL Capital Gains Tax of 65% on ALL SHORT sales retroactive to 01/01/2008.

You'll all see how fast things get better!!!!!!!!!!!!!

Feb 19 06:47 AM

[morph366:]

I think you may have insulted the author by calling him narsarssitic.

Feb 19 08:08 AM

[Poor Dude:]

I like the idea of a windfall profits tax on all gains made from short positions! Except I'd probably make it 80 or 85 percent, instead of only 65 percent. Our government will need that money to shore up the banks being decimated by the short sellers. Needless to say, we don't need laws which reward people for destroying the nation's (and world's) financial systems and economies. Those people need to be punished, not rewarded.

Feb 19 11:15 AM

[Rakesh Saxena:]

Dear Poor Dude: You and "apppro" are scaring me. Can we settle at 25% on the windfall profit tax before your suggestions turn into a movement, like Obamanation? Many thanks - Rakesh


On Feb 19 11:15 AM Poor Dude wrote:

> I like the idea of a windfall profits tax on all gains made from
> short positions! Except I'd probably make it 80 or 85 percent, instead
> of only 65 percent. Our government will need that money to shore
> up the banks being decimated by the short sellers. Needless to say,
> we don't need laws which reward people for destroying the nation's
> (and world's) financial systems and economies. Those people need
> to be punished, not rewarded.

Feb 19 01:52 PM

[Carneades:]

Punitive measures against short sellers should be taken even further. Not only should short selling be made illegal, but we should retroactively punish anyone who sold a stock short at anytime subsequent to the peak of the DJIA in 2007. The punishment will be a fine of no less than 50% of the short sellers net worth. These fines will be placed into a trust account and redistributed to every faithful "buy and hold" investor who has lost money during this financial crisis. Perhaps and only then, real justice will be served in the world.

Feb 19 03:20 PM

[PROXIMO:]

The way comments are running today, I'm waiting for a poster here to advocate capital punishment for short sellers.

Feb 19 11:13 PM

[Rakesh Saxena:]

Yes Proximo, a big group of so-called "value investors" who have been believing everything dished out by Wall Street (and CNBC) are now blaming everybody but themselves. They are still blind to the reality. And, to make matters worse, they don't want to deal in facts, even at this late stage. Many thanks - Rakesh


On Feb 19 11:13 PM PROXIMO wrote:

> The way comments are running today, I'm waiting for a poster here
> to advocate capital punishment for short sellers.

Feb 19 11:28 PM

[vaughn:]

Moral hazards? Just look at what happened after the collapse of Lehman brothers, the 4th largest investment at that time, almost shut down the global finance system. Look at what the Fed did to bend forward and backward to prevent the naturalization of AIG, taking a major equity ownership while protecting all debts of AIG. The collapse of citigroup will definitely do what lehman had failed to do, the total collapse of the world finance system and with it, the USA itself. For that reason, citigroup will not be naturalized (US will suffer an immediate loss of 45 billionplus circa 250 billion guarantee loss and will cause other banks who own sub-debt of citigroup to fail all over the world which will definitely blow back to USA)

The took over of GSEs by treasury caused significant loss to banks holding preferred of GSEs which put lots of regional banks into distress, an unintended consequence which treasury will do everything to avoid.

Whereever there is a test, there is a way to pass the test. So many variables in the model, so many assumptions and so much bureaucracy involved are designed to ensure all major banks will pass the test. Even the Citigroup will pass the test. count on it.

Feb 20 02:26 AM

[Carneades:]

I apologize; I must have ran out of sarcasm before I was able to apply the final coat.

Feb 20 11:42 AM

[Mad Hedge F...:]

Wells Fargo Bank (WFC) has been in a free fall for the last two weeks, as investors bail out of the stock in fear of nationalization, or an Alt-A loan loss driven bankruptcy. The stock has vaporized 47% in three weeks, down to a new 12 year low. Veloceraptor like hedge funds have been major short sellers of the stock because it is one of the last banks with any meat still on the bone. Demand for out of the money puts is soaring. The stock is being dragged down further by big selling of bank and financial ETF’s, like the Financial Select Sector SPDR (XLF), which has WFC as its second largest holding at 8.74%.

Feb 20 12:32 PM

[PDT:]

I'm sorry, but that idea is absolutely horrible. Look at what happened following the administration's various attempts to slow/stop short selling. Short sellers perform a valuable and necessary function in the market, and typically they do their homework because the upside is limited while the downside is theoretically unlimited. Smart investors are going to back away when they see rules being tinkered with in the middle of the game. Obviously you guys aren't professionals, and I'm not knocking you for that, but this kind of nonsense is tough to stomach. What's next? Have Congress pass a bill that stocks can only go up? How about one that mandates everyone will be happy? Artificially constraining short selling is just as absurd.


On Feb 19 11:15 AM Poor Dude wrote:

> I like the idea of a windfall profits tax on all gains made from
> short positions! Except I'd probably make it 80 or 85 percent, instead
> of only 65 percent. Our government will need that money to shore
> up the banks being decimated by the short sellers. Needless to say,
> we don't need laws which reward people for destroying the nation's
> (and world's) financial systems and economies. Those people need
> to be punished, not rewarded.

Feb 20 03:38 PM

[GOPideas:]

As part of an examination fo Obama's housing plan, I have dissected the NPV test here:

www.gopideas.com/~gopideas/page/npv-te...

Jul 24 03:08 AM