More Stress Over Stress Tests

With leading economic indicators expectation to point to a continued recession through the summer, recent financial institution data may not help the situation. On the FDIC`s "Problem List," 252 institutions with assets of $0.2 trillion are considered “Trouble Banks,” and 1,816 regional and smaller institutions with total assets of $4.7 trillion are at “Risk of Failure” despite government bailouts, compared to 1,568 with $2.3 trillion in total assets in the prior quarter.

Of late, the U.S Treasury, Office of the Comptroller of the Currency, and other financial regulators continue to be at odds over how much, how to categorize and how to disclose the results from the “Stress Test” of the 19 largest U.S. banks, especially considering how damaging the potential information might be on the valuations of the weaker institutions. Up until now a "Statement of Methods” was scheduled for release later this week (April 24, 2009), with the finding to be released May 4, 2009.

There is considerable uncertainty about the level of detail that they will release. They are afraid that if they let out specific information about banks which “fail” the tests, then it would actually undermine confidence in those institutions. While the Administration has said that there will be no “failures” per se, those that are shown to be undercapitalized will have six months to raise additional capital from the private sector. If they are unable to, then the government will provide the funds.

One of the big questions is if “passing” will be based on the baseline economic scenario, or upon the “more adverse” scenario. If it is based on the baseline, then the whole exercise is just a monumental waste of time. After all, if you look at your personal budget and then assume that a magic pink pony that poops platinum arrives on your doorstep, then you should be able to meet your bills. The baseline scenario is sort of like that -- it is based on an extremely rosy economic scenario.

Even the “more adverse” case might not be adverse enough. The official position, though, is that this is a pass-fail test that no one will fail. Well, if that is the case, then it's not much of a test! If only very general aggregate numbers are released, there will be very little credibility left for the Treasury with the markets, the public and with Congress.

As one un-named administration source said in the New York Times last week, “The purpose of these tests is to prevent panic, not cause it.” That is a refreshing blast of honesty, since they were originally sold as a tool to determine just how solvent the banking system really is.

There was rumor about multiple banks failing the stress test, but the source of the rumor is questionable, at best. Furthermore, the rumor is in direct conflict with the expressed desire of many of the largest banks, including Goldman Sachs (GS) and J.P. Morgan (JPM) to get out from under the TARP as soon as possible.

It would, at first blush, also contradict the stream of better-than-expected earnings coming from the big banks -- but only at first blush. The quality of the earnings at the banks has been exceptionally poor, even if the overall levels have surprised to the upside.

For example, both Bank of America (BAC) and Citigroup (C) reported multi-billion-dollar gains from marking their liabilities (but not their assets) to market. In other words, since their bonds are selling below par, they could theoretically go out and buy them back and make a profit.

However, a bond will sell below par for one of two reasons -- either because ambient interest rates have gone up, or because there is substantial doubt about the ability to repay. With the entire yield curve near record lows, it is clearly not the former. Also, most bonds come with covenants that say the bond can not be called (i.e. paid back) before a specific date, and then only at a specified price -- which is usually above par. If such "theoretical profits” are the only thing that put you in the black, you are not in very good shape. Gee, just think about how much money they would make if they declared bankruptcy!

However, we know that there have been huge declines in wealth. A good deal of that decline has most likely been borne by the banking system, for example through foreclosures. These losses are extremely large relative to the levels of bank capital.

It seems likely that there is some truth to the report. If true, then we really do have no other real option than going the “Swedish route.” Put the banks into receivership, clean them up -- in the process wiping out the common and preferred shareholders. Bondholders would become the new shareholders and the banks would return to the private sector.

Absent that, we condemn ourselves to throwing endless federal dollars into financial black holes, "zombie banks" that are just barely alive and which will lead us to a Japanese-style lost decade.

Would we and our economy not be better served by the U.S. Treasury, Office of the Controller of the Currency, and other financial regulators would stop their ridiculous bickering and come up with a plausible plan to fix the problem? So far we have wasted the precious little time we have to correct the problem before the potential for financial Armageddon.

Comments

[doubleguns:]

Financial Armageddon seems to be what should have happened before we put all our money into this mess. Now they cant pay back the loans so we end up with stock instead of being paid back. That is my opinion as to why this discussion has come up. The stock will most likely become worthless so we are getting ripped off here and seems our leaders are all for ripping us off. The rich, connected and entitled continue to be saved at the expense of the tax payers.

Apr 20 05:04 PM

[levin70:]

"However, a bond will sell below par for one of two reasons -- either because ambient interest rates have gone up, or because there is substantial doubt about the ability to repay. With the entire yield curve near record lows, it is clearly not the former. Also, most bonds come with covenants that say the bond can not be called (i.e. paid back) before a specific date, and then only at a specified price -- which is usually above par. If such "theoretical profits” are the only thing that put you in the black, you are not in very good shape. Gee, just think about how much money they would make if they declared bankruptcy!"

Nothing stops a company from going out into the marketplace and buying the bonds. That is why they can be marked at the lower value, not because of put or call features. By buying back the bond at a lower price, they get to book a gain. If the market is liquid for the Company's bonds then they can record them at fair value just as if they are not liquid, they can't.

Regards

Apr 20 05:24 PM

[Yohei:]

Looks to me like a Thimblerig game.

Those of you too young to find my metaphor clear, Wikipedia has a good article on the Thimblerig game, also known as "the shell game".

Apr 20 06:08 PM

[Sicall:]

Very well written article with plenty to think about. It does seem highly unlikely that anything negative will be revealed to the market in the "stress test".

I think there will be one set of results for the market and another for the Fed.

Apr 20 07:39 PM

[punditobserver:]

How long are the pundits and analysts going to keep up this charade they have sold to these idiots who now believe that, for instance, a bank that loaned $183 billion in just the past 3 months alone is insolvent?

The article dismisses a rumor started by - in the article's own owrds - a questionable source, then bases its conclusions on assuming the article is true!

This is getting ridiculous.

Apr 20 07:47 PM

[Fitz919:]

Come on...get real...do you honestly expect anything this Government does to be "the right thing"?

First they leak the plan to relax mark to market rules to a few big banks who suddenly announce that they were profitable in January and February. And based on relaxed mark to market rules they can all mark up the value of troubled assets, so Geithner's big public/private partnership plan was a load of bull. It was never intended to work, and never will, it's DOA. And now all the banks with troubled assets can show paper profits again. Not real profits, just paper profits.

The stress tests are hogwash. The Government has designs on controlling our biggest banks, and it will do it, whatever the cost, and whatever the consequences.

GM will be forced into bankruptcy, all pensions and healthcare will be gone for their retirees. This pattern is just like what happened with the airlines.

We have a very smart group running things in Washington right now...and they will get what they want.

Apr 20 08:01 PM

[loko:]

Legal Cover-Ups, Flim-Flam and Sham
In the Big Bank's "Glowing"
First-Quarter Earnings Reports

Wall Street is aglow with the latest "better-than-expected" earnings reports by major banks. But take one look below the surface, and you'll see three of the most egregious accounting gimmicks in recent history.

Gimmick #1. Toxic asset cover-up. In their infinite wisdom, global banking regulators have now agreed to let banks cover up their toxic assets by booking them at fluffy-high values, bearing little resemblance to actual market prices. Like magic, the bad assets are suddenly worth more, as hundreds of billions in losses are defined away.

Gimmick #2. Reserve flim-flam. Every quarter, banks are required to estimate their losses and decide how much to set aside in loss reserves. If they deliberately guess too much in one quarter and too little in the next, they can shove all their bad earnings into earlier P&Ls and make future P&Ls look rosy by comparison.

Gimmick #3. The great debt sham. Consider this scenario: A financially distressed real estate developer owes the bank $4 million. His revenues have plunged. He's lost a fortune in his properties. And he's on the brink of bankruptcy.

Therefore, in the secondary market, traders recognize that loans like his are worth, say, only half their face value, or about $2 million. So far, a very common situation, right?

But now imagine this: He walks into the bank one morning and claims that he really owes only $2 million. Why? Because, in theory, he says, he could buy back his own loan for that price, thereby reducing his debt in half.

In practice, of course, that's a pipedream. If he actually had the cash to buy back his own loans on the market, then he wouldn't be financially distressed in the first place. And if he weren't financially distressed, his loans wouldn't be selling on the market for half price.

The reality is that he can't buy back his own debt and never will. And even if he could someday, he will still be on the hook for the full $4 million unless and until he files for bankruptcy and the bankruptcy judge decides otherwise.

That's why the government would never let real estate developers — or hardly anyone else, for that matter — mark down the debts on their books and still stay in business. But guess what? The government lets banks do precisely that!

It's the ultimate double standard: The banks get away with inflating their toxic assets. But at the same time, they're allowed to mark to market their own debts, which happen to be trading at huge discounts on the open market precisely because of their toxic assets.

Accountants call it a "credit value adjustment." I call it cheating.

Finding all of this hard to believe? Then consider ...

How Citigroup Mobilized ALL THREE of These
Gimmicks to Create One of the Greatest Accounting
Shams of All Time in Its First-Quarter Earnings Report

I'm outraged. But I'm glad to see that someone besides us is speaking out:

* Meredith Whitney, one of the few no-nonsense analysts in the industry, says that the banks' latest reports are, in essence, "a great whitewash."

* Jack T. Ciesielski, publisher of an accounting advisory service, calls it "junk income."

* And Saturday's New York Times, picking up from their research, lays out precisely how Citigroup has transformed a massive loss into what appears to be a fat profit ...

First, Citigroup deployed the Toxic Asset Cover-Up. By inflating the value of the bad assets on its books, it was able to beef up its after-tax profits by $413 million.

Second, Citigroup used the Reserve Flim-Flam gimmick: By (a) shoving most of its bad-debt losses into last year's fourth quarter and (b) greatly understating its likely losses in the first quarter, the bank legally rigged its books to look like it had made major improvements. Even assuming no further deterioration in its loan portfolio, I estimate this gimmick alone bloated profits by at least another $1 billion.

Third, Citigroup went all out with the Great Debt Sham, marking down its own debt and creating an additional $2.7 billion in purely bogus profits from this maneuver alone.

So here's Citigroup's true math for the first quarter:

So-called "profit"

$1.6 billion
Gimmick #1

$0.4 billion
Gimmick #2

$1.0 billion
Gimmick #3

$2.7 billion
Total gimmicks

$4.1 billion



Actual result:

$2.5 billion LOSS!

And all this despite the fact that Citigroup's loan portfolios actually deteriorated further in the first quarter. Based on its Q1 2009 Quarterly Financial Data Supplement, we find that:

1. Net credit losses in Citi's global credit card business surged from $1.67 billion at year-end 2008 to $1.94 billion by March 31. And compared to March 2008, they surged by a whopping 56 percent! (Page 9 of its data supplement.)

2. Foretelling future credit card losses, the delinquency rate (90+ days past due) on those credit cards jumped from 2.62 percent at year-end to 3.16 percent on March 31 (page 10).

3. Credit losses on consumer banking operations jumped from $3.442 billion on December 31 to $3.786 billion on March 31. And compared to the year-earlier period, they surged 66 percent (page 12).

By almost every measure, Citigroup's first-quarter numbers are worse than they were just three months earlier and far worse than they were 12 months before.

My forecast: Citigroup's effort last week to twist this into an "improvement" will go down in history as one of the greatest banking deceptions of all time.

But Citigroup is not the only one. Nearly all other major banks are suffering similar surges in their credit losses and delinquency rates. Nearly all are using at least one of the same gimmicks to bloat their first-quarter profits. And every single one is destined to see massive new losses, driving their shares to new lows and the banking system as a whole into a far more severe crisis.

Apr 20 08:32 PM

[mac123449:]

The stock market when not manipulated always shows what an economy is doing it is merely a mirror. Where the stock market is now is not representing reality it will however fight it's way to where it needs to be Dow 3000. Remember the stock market follows the economy the economy does not follow the stock market.

Apr 20 10:03 PM

[THofler:]

The author does not know his history of the "Swedish route." The Swedes wiped out the common shareholders but made all preferred and bondholders 100% whole.

In Ioko's incredibly long comment, Gimmick #3 is precisely the methodology proscribed in the original SFAS 159. In fact the entire accounting process ridiculed by the Zacks author is exactly to mark-to-market methodology that we had before any recent FASB modifications. So do you folks still love mark-to-market? (Cause this is it!) Or do you now realized what a joke it was to begin with?

(Mark-to-market never required banks to mark all assets to market under SFAS 157. There always has been & probably will be, an exempt Tier 3.)

Apr 21 12:37 AM

[schlumpf:]

Six months to raise additional capital from the private sector??
Goldman has done it.

Apr 21 07:39 AM