Stress Tests: Banks vs. Bond Insurers

When Geithner announced the stress tests for banks, I assumed that they would be comparable to what the rating agencies do when evaluating the prospective solvency of bond insurers. After reading the brief description found on the Treasury website, the tests that Bank of America (BAC), Citigroup (C) and other large banks will undergo seem extremely lenient compared to what the likes of MBIA (MBI) and Ambac (ABK) are subjected to. Because many of the same assets are involved, there is food for thought in comparing the two approaches.

First, here is Treasury's description of the process from a White Paper (.pdf) on their website:

A key component of the CAP is a one-time forward looking supervisory assessment of the 19 largest bank holding companies (BHCs) (those with risk weighted assets of $100 billion or more). Supervisors will use the results of this exercise, along with their considerable specific knowledge of the financial institutions’ portfolios and management strategies, to assess whether the BHCs have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.

To conduct this exercise, supervisors have constructed two economic scenarios for BHCs to use to estimate expected losses over the next two years. The “baseline” economic scenario represents a consensus outlook and is based on the most recent forecasts available from professional forecasters. In particular, the baseline assumptions for real GDP growth and the unemployment rate for 2009 and 2010 are assumed to be equal to the average of the projections published in February by Consensus Forecasts, the Blue Chip survey, and the Survey of Professional Forecasters. The alternative “more adverse” scenario for the path of the U.S. economy, by design, reflects a deeper and longer recession than in the consensus baseline.

The agencies will provide real GDP growth, the civilian unemployment rate, and changes in residential house prices for 2009 and 2010 for the baseline and more adverse economic scenarios. BHCs will be asked to analyze their loan and securities portfolios, as well as off-balance sheet commitments and contingencies, to determine expected future losses under each of the scenarios. The BHCs will also forecast internal resources available to absorb losses, including pre-provision net revenue and reserves. The BHCs will report their estimates using a standardized template provided by the agencies, and will provide firm-level information to support their estimates.

An important part of the process is that the agencies will meet with each financial institution to review their loss and revenue forecasts. Based on those discussions, the agencies will determine the amount of a regulatory capital necessary for each institution to hold today in order to remain well-capitalized under the more adverse scenario as capital is drawn down.

There are two scenarios, the “baseline” and the “more adverse” or stress case. BHCs will do the analytical work and then the regulators will review the information and determine how much capital will be needed to meet the more adverse scenario. Note that the base case is the average of a number of consensus projections and the stress only looks at the next two years.

Compare that to what S&P does to the bond insurers, taken from a description of their methodology found on their website:

Generally, it is assumed that three years of growth are followed by a four-year depression. During the growth years, new business is assumed to expand at an aggressive pace—the greater of the insurer's business plan or 15% growth in written premiums for municipal and 25% for structured finance. Once the depression starts, no new business is assumed to be written.

Under current conditions, what S&P does is assume the Depression just started, so they put the bond insurers through an immediate 4 year Depression as their stress case. So, after already enduring a year of meltdown, the insurers are required to be able to withstand another 4 years of the same.

Maybe that's not enough: what we need is a 7 year Depression, to make sure they are really up to it. After all, Pharaoh had a dream, seven fat years followed by seven lean years, and prepared himself accordingly. In this modern day and age, can we do any less?

More from S&P:

The primary output of the model is the ending statutory capital position of the company. While significant on its own, this key value provides greater analytical insight when expressed in the context of the scale of the company, particularly the level of claims expected during the stress years. The margin of safety accomplishes this by relating total claims-paying resources (ending statutory capital plus losses) to losses. Thus, a margin of safety of 1.25x signifies that ending capital exceeded losses by 25%. Stated another way, losses could have been 25% larger without driving the statutory capital to zero.

The minimum margin of safety for 'AAA' rated bond insurers is 1.25x. For 'AA' and 'A' rated insurers the minimums are 1.0x and 0.80x, respectively. These minimum values may be adjusted slightly lower where the insurer is owned by a single high-rated entity that has expressed continued support for the company.

A margin of safety of less than 1.0x suggests the possibility that the insurer will become insolvent before all claims are met in the event of an extremely severe period of economic stress.

In many ways the rating agencies are the regulators of the bond insurers, since they set capital requirements. The difference is, if a bond insurer can't prove it can survive a 4 year Depression with 25% left over, it is compelled to raise capital under a firestorm of short-selling, CDS manipulation, libel, slander and calumny. Banks get it a little easier, at least under Treasury's new program:

Capital provided under the CAP will be in the form of a preferred security that is convertible into common equity at a 10 percent discount to the price prevailing prior to February 9th.

Note the price protection afforded to shareholders, they will not be diluted by the issuance of common stock at less than a 10% discount from the 20 day average price prior to February 9^th, when Geithner announced the plan.

Now would be a good time to bring in S&P's statement made when they downgraded MBIA to BBB+. Following MBIA's announced split into separate municipal and structured finance insurers, S&P is talking about the structured finance entity:

MBIA's retained exposure will total about $233.5 billion of global structured finance and international infrastructure insured par. Through the use of Standard & Poor's capital adequacy test, MBIA's margin of safety is 0.9x–1.0x, which we view as strong. Analytical adjustments made to the model included:

· No new business written.

· Stress period of model starts immediately and lasts for four years.

· No refundings.

· Expenses are held constant for all four years.

You could say: wait a minute, a margin of safety from 0.9x-1.0x would be AA or A, not BBB+. You could say it, S&P would not listen.

Here's the point: MBIA can take a 4 year Depression, according to S&P. If any of the banks can take that much adversity, it will not be revealed by their stress tests, which only look forward for two years under a “more adverse” rather than a Depression case.

Note the banks are expected to keep on lending and making money, but the bond insurers are not expected to be able to write new business, even at the extremely profitable rates that would apply during times of economic duress.

The Treasury's stress testing regime is a one-time deal. What the bond insurers go through is an ongoing ordeal, every time they report earnings the goal posts get moved again. Every time Case Shiller comes out the stress test assumptions get revised, not to mention every month the mortgage servicer reports come out and whatever the current default trend is it is extended by linear regression into infinity.

What amount of economic stress should a financial institution be able to handle in order to be considered secure? There is no perfect security: there will always be wars and depressions; panic, plague and pestilence; disease, disaster and destruction; fire, famine and flood. With due diligence and dispatch I could extend the list further but I have made the point. Keep calm, cool and collected, it will all work out in the end.

How about a deep 3 years recession? Sort of a compromise, meet in the middle. Let the government set up the assumptions for what stress will be, rather than leaving it to the discretion of either company management or the rating agencies. Institutions large enough to create systemic risk should not have the opportunity to underestimate risk and leave the consequences to be dealt with by taxpayers. Regulatory powers should not be relinquished to private sector, for profit institutions such as credit rating agencies.

What if things turn out worse? At some point, in the wake of a common disaster, the only solution is for all members of society to pull together and rebuild. That would be big government and big government programs. Sorry to have to say that. In the interest of fairness and the avoidance of moral hazard, we need to determine in advance how much each individual, business and local or state government can and should be able to handle without assistance before the Federal government will become involved. Federal Institutions need to be established before they are needed and funded in advance by a tax or insurance premium on those who are to be protected from the contingencies anticipated. The FDIC would be an example. For more complicated businesses such as financial guarantees, the Federal Government should come in as a re-insurer and prudential regulator, leaving market forces and the profit motive in place to control costs and encourage responsible competition.

Disclosure: Long MBI, no position ABK, C, or BAC

Comments

[texalope:]

Excellent post. Thank you.

Feb 27 06:02 AM

[Boon:]

This goes to show how lenient the government is being with banks that it is essentially bailing out with taxpayer's money.

On the other hand, perhaps the bond insurers are being held to too high a standard?

Feb 27 09:56 AM

[ROLEXROLEX:]

What swims on top of the water, when markets tank?

Feb 27 10:34 AM

[J. D. Swampfox:]

Yup, great post. If a writer of CDS's like MBIA is able to make good on its obligations, maybe not all CDS's are created equal. Hmmm, I guess it would be nice if all those CDS's that are not on JPMorgan's balance sheet (but should be) were obligations of MBIA...

Feb 27 10:58 AM

[Stock Marke...:]

Agreed about JP Morgan...what a web we weave!

Feb 27 11:55 AM

[texalope:]

Tom , I too own MBIA. The stock seems to go down daily. Do you have any thoughts on why the market is so negative on this company.

The CEO claims adjusted book value is $40. As I write theis the stock is at $2.67.

There is something seriously wrong. It seems like a competitor would snap this up.

Feb 27 02:56 PM

[Tom Armistead:]

Its closest competitor, Ambac, just announced earnings that brought its adjusted book value down to a negative number, as I recall it was -3.94.

MBIA is a little different in that after the trouble started it raised more capital than Ambac did by several billion and has not been forced to take total losses on CDO^2 like Ambac did. I think their CDO underwriting was better.

MBIA has concentrated on building shareholder value by whatever means were possible, buying back a few shares, buying back some of their debt at extreme discounts, and hopefully they have done some commutations.

I think Ambac's horrible quarter has made people fearful of what MBIA will report. Also, there are questions as to what losses actually will be over the long haul, and how MBIA can increase its share price unless it can actually start selling insurance again. The new "National" muni-only should solve that problem.

I sold off most of my MBIA at prices above 5.00 and today I bought the shares back at prices under 3.00, because I believe earnings will be an upward surprise, perhaps leading to a quick rise in share prices. I also have some March 5.00 calls which will pay off well if there is a real surprise.


On Feb 27 02:56 PM texalope wrote:

> Tom , I too own MBIA. The stock seems to go down daily. Do you have
> any thoughts on why the market is so negative on this company. <br/>
>
> The CEO claims adjusted book value is $40. As I write theis the stock
> is at $2.67.
>
> There is something seriously wrong. It seems like a competitor would
> snap this up.

Feb 27 03:21 PM

[pcyhuang:]

Hi, Tom:

>"a margin of safety of 1.25x signifies that ending capital exceeded losses by 25%. Stated another way, losses could have been 25% larger without driving the statutory capital to zero."

Now let's look at ABK's liquidity ratio:

siliconinvestor.advfn....

Cheers,

Feb 27 11:04 PM

[NC Trader:]

Great article, this is why I keep coming back to SA.

Feb 28 04:37 PM

[Tjemme:]

A key question is what the scenarios imply for financial markets, as the scenarios are only about 'fundamentals' (thanks for William Ding for raising this issue). Theoretically, the basic scenario (market-conform forecasts) should be accompanied with 'market conform forecasts' for US Treasury yield, US Dollar, commodities (i.e. use implied forward rates) - perhaps correcting for historical risk premia. As for the alternative scenario, not much guidance is provided for financial markets at all. If I look at the graphs (Fed site), the economic trough falls this year for both scenarios, and unemployment has peaked at the end of 2010 for the alternative scenario. It seems to me that both of these scenarios will most likely be accompanied by a significant rally in equities and in commodities and a significant fall in bond prices. Does that mean the market is inefficient? My guess is that the market discounts more significant risks than this. But you can't really expect the Fed to present corresponding scenarios at this time.

Mar 01 07:45 AM