Most critics of the Stress Test have missed the point of the tests and underestimate the Obama Administration’s cleverness in helping banks raise capital. The Stress Tests weren’t about regulatory supervision and certainly weren’t an excuse for the Obama Administration to nationalize the banks. The tests were designed to provide standardized benchmarks, assumptions and projections for private investors to evaluate banks and decide whether or not to participate in recapitalization transactions.
Obama’s ploy to help investors help themselves invest in banks seems to be working. Since the Stress Test results were announced the unthinkable has happened. Two banks, Morgan Stanley (MS) and Wells Fargo (WFC), executed public offerings of stock that went well. And, the bank everyone loves to hate, Bank of America (BAC), was up more than 60% for the week making it possible for them to sell common equity to private shareholders.
For each bank that was “stressed,” investors have been provided a government sanctioned set of financial forecasts to debate, criticize and analyze. Without government prodding and help this information never would have made it into investor hands because of legal risks and securities law restrictions. And, even if the information was provided, banks lacked credibility so that investors wouldn’t have believed the results. The Stress Tests provide a government sanctioned and verified safe harbor for bank managers to give shareholders “what if” scenarios without being ridiculed or sued. Even better, the Stress Test results are quickly turning into the centerpieces of bank equity offerings which are necessary to recapitalize the industry.
A big problem that the Obama Administration had to deal with when they took office was a failure of investor confidence in banks, management teams and financial statements. After having been “WAMU’ed” to the tune of hundreds of billions of dollars, bank investors were understandably reluctant to put new capital to work in the banking system. In January, investors were convinced that buying bank stocks was the investment opportunity of a lifetime; that is the opportunity to lose a lifetime’s worth of savings in the blink of an eye. Back in January any bank executive that stood up and made a prediction that his bank was solvent was publicly ridiculed. If the public could have tarred and feathered bank CEOs, we would have witnessed a bunch of middle aged guys looking like big fat chickens as they ran around in circles squawking about their lousy jobs and low pay.
When it took office, the Obama Administration quickly realized that if they couldn’t figure out a way to get private investors to recapitalize banks the nation faced the real prospect that most of industry would be nationalized. No business can survive the capital drought that the banks were experiencing. Obama’s economic advisors understood that they needed to immediately change the rules of the game. “Self regulation” and non-enforcement had created a mixture of mistrust and failure that had to go.
Bank management teams were rapidly running out of options. In January investors didn’t trust bank managers to tell the truth about easy stuff like the current condition of their institutions or about current period earnings. And, if investors didn’t trust managers to tell the truth about facts that could be quickly verified, they certainly weren’t going to listen to management’s opinions about tough things like future performance of their institutions based upon esoteric and complicated economic and financial assumptions. Managers knew that if they tried to offer multiple sets of projections with sensitivity analysis for different economic assumptions they would have been immediately mocked in the media and sued by shareholders.
I remember when I was a young professional, working first as a lawyer and then later as an investment banker, the equivalent of stress tests were a pretty important issue in bank recapitalizations. I started my career in the 1980s during what seemed to be a decade of one bank and thrift crisis after another. And, most of my clients were trying to recapitalize to cover for mortgage related losses. Investors were always asking me what the regulators were saying about how much capital my clients really needed and how they were calculating the deficiency. My professional responsibilities prevented me from answering the question but I still believe that many deals happened because behind closed doors management told leading institutional investors what the government thought was needed to fix their institution.
The Stress Test results are the Obama Administration’s answer to the disclosure problem that I faced 25 years ago. But now how much capital the government thinks is needed and how the deficiency was calculated is an open topic for discussion. By providing transparency into what the government is thinking Obama is restoring faith in the system. While almost no one agrees with the assumptions used in the Stress Tests (everyone has their own opinion and is convinced that their assumptions are the only correct ones), there is enough information out in public for every investor to rerun the calculations and come to his/her own conclusions.
Even better, Obama has manipulated the media into becoming his unpaid shill to promote the Stress Test results. Using marketing techniques that rival the best propaganda campaign of any government regime (current or past and good or evil), the Obama Administration orchestrated political theatre that transformed a boring and esoteric banking topic into front page news. TV and radio talk show hosts that last month couldn’t balance their checkbooks became overnight bank experts and started debating Stress Tests with the same conviction and knowledge that they regularly debate politics, abortion, torture and sports. A few nights ago I knew that the Obama propaganda engine had really succeeded when an airport limousine driver recognized me as a guy who is on TV a lot and asked me which banks I thought were going to pass and which banks I thought were going to flunk the Stress Tests. But, before I could answer he told me which banks he thought were “keepers” and which stocks he was shorting. By the time I got dropped off at my hotel I not only knew what he thought but also knew which stocks most of his relatives were buying.
Obama has made it safe for investors to buy bank stocks and participate in the recapitalization of the banking industry. Bank executives have a way to explain their business plans and the risks in their institutions without being belittled. And, investment bankers are practically giddy about their new government sanctioned tool to help them sell bank stocks. Of course, the investment bankers are also grateful for the fees that will be generated from raising billions of new equity for the industry.
Pundits that underestimate the Obama Administration do so at their own peril. Unlike TALF which hasn’t worked, execution of the Stress Tests was brilliant, intuitive and creative. But, then again, not everything that the Obama Administration tries is going to work. The Stress Tests are a big win for the new administration and the nation.