Stress Test Bargaining: Just a Deal With the Devil?

May.10.09 | About: SPDR S&P (KBE)

WSJ reports that after “intense bargaining,” the Fed “significantly scaled back” its estimates for banks’ capital shortfalls. Indicative of this was the unexpected change in its methodology for measuring bank capital. Instead of tangible common equity, the Fed used a less stringent measure it calls “Tier 1 Common Capital,” heretofore (virtually) unknown.

As seen in the table below, using “Tier 1 Common” makes banks appear healthier than they really are.

Click to enlarge.

The point of such measures is to gauge leverage. Does a bank have sufficient capital to offset potential losses on assets? The measurement used in the stress test—”risk-weighted assets” / “Tier 1 Common Capital”—is more favorable because it understates assets and overstates capital.

If the goal of the stress test had been to credibly measure banks’ financial condition, the more stringent leverage metric—TCE—would have been appropriate.

But the exercise was more PR stunt than honest bank examination. First, the administration didn’t have the time, staff or inclination to dig very deep. Second, judging from continued deterioration in house prices and unemployment, the “adverse” scenario used to measure bank losses was not adverse enough. Third, the administration’s estimate for future bank earnings, and therefore the capital coming available to reinforce balance sheets, is too optimistic.

Geithner’s hope is that he can subsidize banks long enough for them to earn their way back to health. But the public isn’t keen on more bailouts, so Geithner’s challenge is to convince us that banks are solvent. That way he can sell bailouts as temporary measures to help banks through a rough patch.

The problem is that many banks are insolvent, their balance sheets like dams sprouting a new leak every other month. First it was subprime, then Alt A. Soon it will be jumbo prime, credit cards and commercial real estate. After that leveraged loans. Until banks are properly reinforced—via debt-for-equity swaps—nothing is gained with bailouts. Taxpayers might as well pour their money down a drain.