The 'Stress Test' Challenge: Transparency and Intellectual Integrity

Includes: BAC, C, JPM, XLF
by: Rakesh Saxena

FDIC Chairman Sheila Bair said Monday that the “stress test” would help the government determine how the big banks will fare in the event that the economy worsens. But before we get to any forward-looking measurements, the investing community deserves an update on the current status of the balance sheets of Wall Street’s once-elite financial institutions. As one critic of the banking stimulus plans in the UK questioned over the weekend, “how can the regulators decide whether the banks need to be nationalized or not without a publicly verifiable valuation methodology?” To which, this writer should add: Does anyone in authority have the audacity, since audacity is what is required now, to define a comprehensive methodology, in written form, in the first place?

For all practical purposes, the stress test to be revealed, in one form or another, by Treasury Secretary Timothy Geithner will turn out to be a Trojan Horse, deflecting the market’s attention away from the factual reality of today to a set of “what-if” assumptions derived from forecasts on the domestic and global economy.

The constituents of stress on the financial system are well-known at this juncture: (1) a sharp deterioration in counterparty risk; (2) trillions of derivative contracts which defy any mark-to-market quantification; (3) collapsing asset values right across the investment spectrum; and (4) hopelessly inadequate loan-delinquency provisions. So what is required is comprehensive disclosure on the health of balance sheets within the context of facts as they present themselves today, not on the basis of what may or may not happen in the future. In fact, it is difficult to figure out how the Treasury, the Fed and the FDIC priced investments in, and guarantees for, troubled financial institutions in the first place.

“It is impossible to find one document which clarifies, in mathematical terms, the fundamentals upon which regulators spent taxpayer dollars in buying common shares and preferred instruments in recent months,” said a trader who has been shorting banks for a New York hedge fund at the close of trading on Tuesday. “In the absence of details, why should anyone be buying Bank of America (NYSE:BAC) and Citigroup (NYSE:C)?”

Tuesday’s buying of bank shares may well have been, in part, technical in nature. But, by all accounts, Wall Street is also hoping that Secretary Geithner’s announcement yesterday calms the nervous and sets the stage for near-term stability in the financial sector. The problem is that, whatever that stress test turns out to be, the key systemic risk deeply embedded in the financial system, i.e. leverage, will not be addressed, let alone acknowledged. Because if leverage is fully recognized, shares in some of the major banks are actually worthless, and taxpayer funds are being spent on the back of serious, even irresponsible, over-valuations. What the future brings to the equation is a totally different story altogether, a subject for another forum.

On another significant note, it is apparent that financial journalists have been rendered ineffective in a climate where government officials keep changing the rules of the game by the hour and attempt to bring a sense of false complexity to the situation. For example, nobody challenged Ms. Bair when she said that the “stress test will help policy makers to determine what type of additional capital investments the government may need to make.” What exactly have regulators been doing thus far? As another example, no member of the press pool appeared willing to push White House spokesman Robert Gibbs for specifics when he stated yesterday that the “Obama administration is going to help the banks through the crisis, but nobody imagines nationalizing banks.” If the members of the financial think-tank inside the Obama administration are still not sure about the results of the stress tests, how can they “imagine” anything at all--nationalization, partial nationalization or simply a partnership with private capital?

For many months, this writer has held the view that the bank rescue exercise is, in its entirety, a fatally-flawed, trial-and-error process lacking in transparency and devoid of an understanding of what a properly structured de-leveraging entails. Now the writer is convinced that it also lacks intellectual honesty. At the risk of sounding repetitive, the stay-short-financials recommendation remains intact. Watch for rallies (to sell) as long-term value investors find cause for optimism in the stress-test declaration later this morning, and in positive interpretations of that stress-test in forthcoming days.

Disclosure: Short BAC, C, MS, XLF.