The 'Stress Test' Challenge: Transparency and Intellectual Integrity

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 (BAC) and Citigroup (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.

Comments

[Trading to Win:]

Hi Rakesh

Any chance you could do a piece critiquing the UK's policy of insuring c.£500 billion of rubbish assets - will it work or fail?

Thank you

Feb 25 05:30 AM

[anarchist:]

Notice all the hand wringing over C in the (MSM) news but not much about BAC ? I have a feeling that there was some kind of back-room deal between the Government and BAC when the Merrill deal came down that assured BAC that they would survive. All the "stress test" nonsense is just a smoke screen to make 'saving BAC' seem like a legitimate move while the Government effectively nationalizes some of the other banks i.e. stock purchases or by other means.

Feb 25 09:38 AM

[kelm:]

Your are correct. I do not believe there is any real rigor in what they are about to do The issue of course is that if they find all the banks to be insolvent and fail the stress test then what? If they declare all of them healthy no one will believe that. The entire process seems opaque and subjective. It is also a concern that nationalization is off the table. Why? The administration really needs to come clean and state - we cannot or will not nationalize a major bank as a step to re-privatizing it because...why? It seems like they discovered something that says we can't privatize them i.e hat they are too big to save. That is worrisome.

Feb 25 09:39 AM

[Carneades:]

Alas, the measure of Tangible Common Equity has emerged from exile, and claimed the senior most role in determinations of banking system capital adequacy. Immediately following loan loss reserves, Tangible Common Equity is the first part of the capital structure to withstand losses. Unfortunately, the Crisis has intensified by orders of magnitude, the bank's losses have blown through all loss reserves, and Tangible Common Capital has been decimated. To put the matter in perspective, the eight largest US Financial Institutions have combined assets of $12.17T(GAAP reported) and only $405B in Tangible Common Equity.

We have assessed scenarios of de facto nationalization whereby the Government converts its preferred TARP stakes into Tangible Common Equity, and submit that at this point, there is little else to do. However, in the end we see this as measure that does little more than reduce the severity and speed of the decline, while ultimately prolonging the pain.

Feb 25 11:10 AM

[joes:]

The "stress test" approach seems to be a simple way of creating a standard for evaluating the banks businesses, a major step up from the Bush-Paulson approach of doing weekend deals that resulted emergency actions, increasing panic.

If I was cynical I would say that the GOP purposely drove panic as they were getting thrown out of town, they never stop campaigning, which explains why they never had time to govern.

Feb 25 11:33 AM

[abeoman:]

In light of the deregulated derivatives and CDS markets to date, how do you foresee a plan in which Banks can fortify their disclosure on valuations for their balance sheets, when in reality they seem to have misplaced the very notes( the original mortgage documentation for home owners) that serve as the underlying assets for these trillions of dollars in derivative contracts? I agree that the smoking gun is awol and the administration is buying for time....

Feb 25 08:26 PM

[SeekingTruth:]

Rakesh, a well reasoned article, and I am at least as skeptical as you are.
A major problem , is , however, a truly valid stress test is so incredibly complex, that with even perfect transparency, few, except the most advanced experts would understand it and be able to certify it as legitmate and valid. A major dilemma to be sure.
This means that we would have to trust our officials and experts. I do not trust Bernanke or Geithner, although I think they are basically good people by most standards, I think their politically (and corporate) motivated pressures and tendencies outweigh their prime objectivity in these matters.
So it looks like more of the same 'ol same 'ol relative to ever knowing the truth. Wonder how much of the taxpayers TARP money etc. will end up in Swiss bank accounts, and elsewhere overseas?

Feb 26 12:17 AM

[Rakesh Saxena:]

Dear Trading to Win: This policy of insuring bad assets is becoming an integral component of rescue plans everywhere. Essentially, taxpayer money is being put to risk. And the bet of course is that a turning tide in the economy will restore value to the bad assets. In my view, this is a dangerous, mathematically untested and trial-and-error policy. But where is the public outcry??? - Many thanks - Rakesh


On Feb 25 05:30 AM Trading to Win wrote:

> Hi Rakesh
>
> Any chance you could do a piece critiquing the UK's policy of insuring
> c.£500 billion of rubbish assets - will it work or fail?
>
> Thank you

Feb 26 02:21 AM

[Rakesh Saxena:]

Dear Seeking Truth: While I think that a valid stress test would entail a high degree of detail, I don't believe that it would be unduly "complex"--but, in any event, public diclosure of the underlying methodology would make the regulatory authorities more accountable (hopefully!!!). Many thanks - Rakesh


On Feb 26 12:17 AM SeekingTruth wrote:

> Rakesh, a well reasoned article, and I am at least as skeptical as
> you are.
> A major problem , is , however, a truly valid stress test is so incredibly
> complex, that with even perfect transparency, few, except the most
> advanced experts would understand it and be able to certify it as
> legitmate and valid. A major dilemma to be sure.
> This means that we would have to trust our officials and experts.
> I do not trust Bernanke or Geithner, although I think they are basically
> good people by most standards, I think their politically (and corporate)
> motivated pressures and tendencies outweigh their prime objectivity
> in these matters.
> So it looks like more of the same 'ol same 'ol relative to ever knowing
> the truth. Wonder how much of the taxpayers TARP money etc. will
> end up in Swiss bank accounts, and elsewhere overseas?

Feb 26 02:25 AM

[No Free Cake:]

Isn't the stress test basically a new regulatory system for banks - although implemented without the normal comment and review periods?

The concept of this test implies that the current valuation methods for regulatory capital don't work. If they did, there wouldn't be any doubt as to which banks were sound.

In the longer run, the stress test will either completely replace the current capital regulations or be a partial overlay. It will only add clarity if it becomes permanent and fairly rigid - the administration has so far not ascribed it either of these attributes

Feb 26 12:01 PM

[Rakesh Saxena:]

Dear No Free Cake: I will comment on the stress test in a bit more detail shortly as I get more information on the components of the test. Many thanks - Rakesh


On Feb 26 12:01 PM No Free Cake wrote:

> Isn't the stress test basically a new regulatory system for banks
> - although implemented without the normal comment and review periods?
>
>
> The concept of this test implies that the current valuation methods
> for regulatory capital don't work. If they did, there wouldn't be
> any doubt as to which banks were sound.
>
> In the longer run, the stress test will either completely replace
> the current capital regulations or be a partial overlay. It will
> only add clarity if it becomes permanent and fairly rigid - the administration
> has so far not ascribed it either of these attributes

Mar 02 02:35 PM