25-to-1 Leverage Earns Banks an 'A' on the Stress Test

According to the WSJ, the stress test wanted banks to have a 25-to-1 common equity to tier 1 assets leverage ratio. A 25-to-1 tier 1 common equity ratio, in some sense, understates the risk regulators are signing off on. Tier 1 assets are less than book assets. This means that the Fed thinks it is acceptable for mega banks 30-to-1, 35-to-1, or 40-to-1 leverage ratio based on book assets and book common equity. It is good that regulators are focusing on common equity, but they should require the mega banks to hold more of it.

If one looks at market prices or the stress test results, Goldman Sachs (GS) seems to be one of the healthiest of the top TARP recipients. Nevertheless, from my calculations on pages 20 to 21 of "The Goldman Sachs Warrants", Goldman Sachs' assets had a 5 percent standard deviation from January 1, 2008 to May 1, 2009. (On May 1, 2009, GS had a 15-to-1 leverage ratio of book assets over the market value of common equity.) Other mega banks probably had more volatile asset values over that period.

At more leveraged banks, a 5 percent standard deviation of assets means that there is a substantial likelihood that their assets will be worth less than their liabilities plus their preferred stock obligations. It is too bad that the Fed also believes, judging from its actions with regard to Bear Stearns and AIG, that it will make emergency "loans" if these banks turn out to be insolvent and in need of emergency help.

Disclaimer: I only have positions in financial stocks and bonds in long-only, broad-based index funds. This is not investment advice.

Comments

[Jasper M:]

Very good material concept density in this short article.

May 10 10:16 AM

[BloggingBanks:]

25 to one is not unreasonable if you have a traditional bank that gets deposits at up to 3% and then lends them out at 6%.

May 10 02:15 PM

[CautiousInv...:]

Since Treasury did not release the stress test in a form that permits replication of the underlying math, we are left to rely upon comments and assurances from Treasury.

And since they have possibly conflicting objectives, I do not believe everything said by Treasury officials can be taken at face value.

Having had time to think about the outcomes of the stress test, it's very clear the test was designed in such a manner so as to allow banks to maximize projected earnings and minimize potential losses, permitting the banks to earn themselves out of this mess.

Under consolidated results, banks will offset 60% of expected losses through projected earnings for the years 2009-2010.
By keeping TCE at 4% as opposed to 5%, it allows banks to use more of projected earnings to offset potential losses while at the same time remaining in compliance with the "strict capital ratio standards" imposed by Treasury, FDIC, OTS and COC.

May 10 02:18 PM

[Obi-Wan:]

Amen. Just like all the leaks that occured prior to the final results being released. Talk about spoon feeding the markets what they want to hear.....I take the tests with a BIG grain of salt. Today's market results are BEARing that out as well....it's a false security.....

May 11 09:50 AM