Stress Testing: What's Your Bank's AQ? 26 comments
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The Federal Reserve will not be releasing the results of its stress tests of the nation's biggest 19 banks until Thursday, and undoubtedly there is some element of folly in daring to beat the Fed to the punch. After all, according to The New York Times, the tests have been in the works for two months and have involved more than 150 regulators who, in addition to poring through voluminous bank data, have had the benefit of the banks' analyses of how various hypothetical situations will affect their loss rates.
Still, one can't help but wonder if there are other tools at hand that can get the job done properly without taking so long. In fact, I introduced such a tool in my last post – a bank’s asset quality (AQ) index. It enlists an engine of analysis that dwarfs even the Fed's 150 regulators -- namely the equity and debt markets. Quite simply, it compares a bank’s share of market capitalization to its share of revenues -- the interest it earns on producing assets plus fees for banking services. This provides a quick insight into how the share of value investors assign to these institutions compares with the share of revenues they earn on assets, which constitutes a direct measure of their investment quality.
When share of market capitalization exceeds share of revenues, it suggests that a bank may be holding the amount of common stock necessary to absorb future losses; when the reverse is true, it suggests that it may not. Doing the calculations doesn’t take two months and 150 regulators, although it does focus on something that the Fed defines as essential to banks' health -- the amount of capital represented by common stock.
CALCULATING YOUR BANK'S AQ
Calculating a bank’s AQ score is a simple two-step process:
Step 1 is to decide on a sample of banks: three or more banks over ten or more periods.
Step 2 is to sum their total capitalization and revenues and calculate the percentage of the total represented by each bank. Then take the difference and standardize it. Statistics 101 shows us how to do this in units called standard deviations, which are measures of how far a bank’s AQ score is from the mean. This is the bank’s AQ – Asset Quality.
Bank AQ scores above the mean are positive and those below the mean are negative. Statistics 101 also teaches us that for any Bank AQ value in this sample greater than +1.7 the chance that has troubled assets is less than 5%, whereas any value lower than -1.7 means that chance is greater than 95%.
THE GOOD BANKS
In terms of the Federal Reserve’s criterion, less than a 5% chance of holding troubled assets means it is highly likely these 40 banks have enough capital in common stocks to absorb future losses as the recession wears on.
For comparison, the April 24, 2009 DealBook story “Judgment Day for Big U.S. Banks” concluded that U.S. Bancorp (USB) and JP Morgan Chase (JPM) “probably have put the bulk their troubles behind them.” These conclusions are supported by their AQ scores of +4.15 and +1.81 respectively -- these banks almost certainly have put the bulk of their troubles behind them.
THE MIDDLE BANKS
Based on their AQI the 32 middle banks in this list had a greater than 5% but less than 95% chance of holding troubled assets in their portfolio in the last quarter of 2008.
In terms of the Federal Reserve’s criterion, the banks in this list have an increasing chance of holding troubled assets. This means it is highly likely that those banks near the top of this hold enough capital in common stocks to absorb future losses as the recession wears on. Those near the bottom of this list likely do not. Banks in the middle have around a 50/50 chance.
That DealBook story also concluded that Bank of New York Mellon (BK) and State Street Corporation (STT) probably have put the bulk of their troubles behind them. Based on their AQ both of them are on the cusp between the good and middle banks with scores of +1.66 and +1.36 respectively giving them just a 0.05 and 0.09 chance of having future troubles as the recession wears on.
THE UGLY BANKS
Based on each bank AQ the 20 institutions in the following list have a greater than 95% chance of holding a significant proportion of troubled assets on their balance sheet.
DealBook also concluded that a number of regional banks are “strong candidates for needing additional money.” The story fingered Sun Trust Banks (STI) with an AQ of -2.14 and Regions Financial Corp (RF) with an AQ of -2.93. These AQ scores are associated with a 0.98 and 0.99 chance of needing additional capital.
THE SAMPLE
In the American Bankers’ list of the top 150 institutions with the most deposits, 112 were public companies. Twenty of these failed to report in one or more of the 32 quarters ending with the last quarter of 2008. The final sample of 92 “Bank and Thrift Holding Companies with the Most Deposits Q3-2008” was used in this study.
CONCLUSIONS
One might call this method of assessing a bank’s health no more than taking its temperature. But, even if temperature doesn't provide complete information of the health of a bank, it does sort out the ones in need of triage.
As always, your comments are welcome.
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This article has 26 comments:
The "job" is obfuscating the banks' vulnerabilities, so "taking so long" is not a negative from their point of view.
I like the analysis in this article, but I think I note a weakness - the use of the companies' capitalization is highly dependent on its stock price. If financial shares get drawn down by a general market downdraft, the banks measurements will decline, perhaps significantly, independent of any actual change in their operations.
The model relies on "efficient market" theory, which makes it hopelessly unreliable. You are assuming that investors, collectively, know the true value of these banks' assets. If that were true, we wouldn't have a problem to begin with.
Big banks have been obfuscating their asset quality and trying to pull the wool over investors' eyes for at least a year. Some, presumably, have been more successful than others.
Since there's no evidence yet that Treasury has done a truly thorough and honest examination, it could still be months before we really know what's going on.
But it's been going on for more than a year; arguably any banking enterprise operating in a fractional reserve system pretty much Has to obfuscate at least a bit, as the trumpeted Fact that their actual liquidity is (profitably) low would invite destruction whenever the public mood turned conservative.
I suspect that by the time "we really know what's going on", events will have outrun the Treasury's efforts, and we will be talking about other things, Far more pressing.
"Banking has suffered a not-sufficiently-ackno... loss of know-how on the lending side. Back in the stone ages when I got an MBA, there were a few fellow students from big commercial banks like Chase (and no former investment banking analysts, the two year posts for college graduates) and they had all gone through credit training. But by the mid 1980s, the big end of town was fascinated with automated models and expert systems. American Express was considered the sophisticate of the crowd, allegedly with the most finely tuned program.
"Fast forward 20 plus years, and the credit card issuers formerly seen as most savvy, Amex and Capital One, now are sporting credit losses not markedly different than their peers. FICO based mortgage lending has proven to be a train wreck.
"The problem is that there isn't a good substitute for knowledge of the borrower and his community. Does he understand what he is getting into? How stable is his employer? What are the prospects for the local economy? Those are important considerations, and they require judgment. That may still in the end be used as an input to a more structured decision process. but overly automating borrower assessment has resulted in information loss. It's hardly a surprise that the quality of decisions deteriorated."
You said:
"If financial shares get drawn down by a general market downdraft, the banks measurements will decline, perhaps significantly, independent of any actual change in their operations."
Since the critical inputs to the AQ are a bank’s share of value and share of revenue, rather than dollar values, there will be a change in a bank’s AQ score as a result of market downdraft only under two conditions: either the bank’s price runs counter to the market or there is a significant change in the long-run volatility of the difference between its share of value and share of revenue.
Thank you for raising this important question. It’s one that may concern other readers.
~V
In your comment you concluded:
“The model relies on ‘efficient market’ theory, which makes it hopelessly unreliable. You are assuming that investors, collectively, know the true value of these banks' assets. If that were true, we wouldn't have a problem to begin with.”
I would like to clarify these issues.
First, the AQ score couples the risk-adjusted effects of investor decisions (on a bank’s market share of capitalization) with those of management decisions (on market share of revenues) over the long term. No where in efficient market theory will you find mention of either company revenue or market share. It is precisely because markets are inefficient that I developed this round-about model of assessing a bank’s asset quality.
Second, please review the previous post in which I track the AQ index over the 36 quarters ending in 2008 for Goldman Sachs, Morgan Stanley and JP Morgan. The risky asset problems sleeping in the balance sheets of these three firms were reliably revealed by their AQ index years before they burst into the headlines. Investors clearly didn’t know about this problem.
By the way I did not include GS and MS in this analysis of 92 firms because they were not then included as bank holding companies in the American Banker's Q3-2008 list ... and my previous post focused on them anyway.
Thank you for the opportunity to clarify these issues.
~V
One might take a gander at Rick Ackerman's site " Rick's picks " to get his anaysis for major banks , including GS . Rick was a former market maker on the Pacific Exchange . He is well known + respected by pros in the financial field . Check out his web site . Previous articles are listed on left
You are correct !
I have been wondering through this whole crisis . Where are the State banking auditors and regulators.? My opinion is hiding facts for Corrupt State legislators, congressmen, Commercial real estate developers. And Governmnet Contractors.
Anyway, my guess is that the best opportunities for an investor lie in the middle group, be it long or short.
Your comments highlight several relevant issues. I will try to address them one at a time.
“The distortion of value and the relatively small importance of market cap. as a representative of quality invalidate this type of comparison.”
By “the distortion of value” I assume you mean transforming the dollar value of capitalization into the market share of capitalization. If so, this does not “distort” value it just creates a linear transform of it. The correlation between a bank’s dollar value and share of value over the 32 quarters is exactly one. Also, market cap and bank revenue have equal importance in this representation of asset quality.
“It would seem that problems of scale would give the very large banks, (overall), a skewed result.”
Scale has no effect on a bank’s AQ score for two reasons. First, the unadjusted AQ score is calculated by subtracting share of revenue from share of market cap. This eliminates the scale effect: 25 minus 23 returns the same unadjusted AQ as does 5 minus 3. Second, these differences are normalized through division by the standard deviation of each bank’s 32 quarterly differentials. A bank's 32 quarter series of AQ scores averages zero with a standard deviation of one. So, there is no skew.
“Also, due to the illogical volatility in the banking industry in the last six months I doubt that this ranking will be accurate as to how the real banks read on the real ‘stress test’ list.”
Whether the recent volatility in the banking industry is illogical or not has nothing to do with a bank’s AQ score. The combination of transforming the dollar data to market shares and normalizing the differences has the effect of leveling the playing field. Whether the AQ will be more or less accurate then the real stress test is an interesting question. I share your doubt on this issue. But remember, these scores are based on real data for 92 real institutions over 32 quarters. Management has very little wiggle room on two of the three data inputs (number of shares outstanding and revenues) and no influence on the third (closing stock price).
One of my objectives in designing the AQ index is to “wash out” the effects of politics and manipulation. I don’t know if the AQ will succeed in this regard. But I do wish I had bet on that 50 to 1 long-shot in the derby!
Thank you for the opportunity of address these important issues.
~V
Is their rank being distorted in the AQ by the recent run up in their share price? Is there something about their underwriting standards that is not being capture by the inputs to the AQ test? I think it's a combination of the two. I personally think that Wells pretty much ring fenced the potential damage from acquiring Wachovia. I think the stress testing done by the government was probably skewed towards further downside cases on real estate, particularly commercial, and Wells is and has been primarily a bank focused on commercial real estate. However, Wells has traditionally been a conservative underwriter on commercial real estate and may be getting painted with the excesses in lending that went on in this area. It's a tough call to make unless you had access to the details in their books.
On May 04 12:00 PM Vikingblood wrote:
> Wells Fargo is under your Good Bank list ... last time I looked,
> they were asked to raise an additional 10 Billion in Capital.
They are using your money to gable. I can see everyone 401K will be raid again in the near future. It is a good way to stimulus the economy. Good luck!!!
www.chron.com/disp/sto...
who wants to bet that Standford isn't an aberration?
Now that you bring it up, I think it's likely a combination of bank transparency and investor perspicacity. The largest possible positive gap is created between share of market cap and share of bank revenues when investors are confident in their judgments and banks are forthcoming in their reports.
Good insight! Thank you.
~V