Stressing the Bank Tests

Perhaps we have it easy in the life insurance industry. Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent. Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason: in life insurance, there are detailed rules for performing cash flow analyses. With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details. Did the banks get relief from the scenarios? It seems so. Why? When I first saw the adverse scenario, I said to myself, “Not adverse enough. Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions. There is no immediate good answer, so how did the US government simplify matters? We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing. This is a process that is in its early phases. Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptions of the stress test into usable credit loss data. Reasons:

• Differences in bank lending practices makes uniformity tough.
• Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way. Also, company specific loss estimates lack credibility.
• Loss estimates on new lending classes also lack credibility.
• Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes. We don’t have enough data.

Now, I have done stress tests at life insurance companies. You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods. You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses. That has its troubles, but it is better than nothing. The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests. They were easy tests to pass for many because:

• The stress scenario isn’t that severe. I give it better than 50% odds of occurring. A real stress test has perhaps a 5% chance of occurring.
• The stress scenario isn’t very prolonged, like the Great Depression.
• Creating the models that connect the economic assumptions to the loss costs is problematic. Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks. Remember, their is a large number of people who think this panic is merely confidence/liquidity, and not solvency. (Then why are we raising capital or selling assets?)
• There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable. We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system. This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle. Remember 1989-92? The degree of overbuilding now is greater than then. The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test. That means underweighting:

• Bank of America (BAC)
• Citi (C)
• Fifth Third (FITB)
• GMAC (debt, there is no public common)
• Keycorp (KEY)
• Morgan Stanley (MS)
• PNC (PNC)
• Regions Financial (RF)
• SunTrust (STI)
• Wells Fargo (WFC)

At least, this will be worth watching as a basket from May 8 on. It may give us clues to the economy as a whole. I expect that it will underperform, but I am more certain that it will co-vary very highly with the market as a whole. Let’s see what happens.

Comments

[Larry House:]

Thanks, David. It is indeed going to be interesting to see what happens. I think the debt of these companies should be okay with the government's willingness to back them up. I do not want to own their common or preferred stocks at all.

May 12 02:04 PM

[Mark Bern:]

I very good and deliberate article that underscores the lack of reality used in developing and executing the stress tests. The use of the word "stress" within the phrase is more than a little inappropriate. There really was no stress included in the tests.

Regarding your final recommendations I agree that such a basket should be very interesting to watch. However, due to what I suspect is coming out of our government, I can only wonder if we shouldn't be more aggressive buyers of the downtrodden. Under normal circumstances I would agree completely with your analysis. But these are not normal times.

While I don't agree one iota with how the PPIP is planned to work, I have to say that it appears that the plan is to make the bad banks whole at the taxpayers' expense. If that is the case, the banks on your list will come out of this crisis in better shape than they have seen in over a decade. Let me expain.

The banks will be allowed to "invest" in the PPICs, or the individual investment entities created under the PPIP, by using some of their assets as collateral contributing those assets to the PPIC. Talk about putting the foxes in charge of the henhouses! And they need to invest only a small portion of the capital to be used. The Treasury and FDIC will put up the lion's share and assume almost all the risk.

Second, the PPICs will bid on assets owned by the troubled banks which will provide capital to the banks in exchange for toxic assets. This provision would allow the banks to bid up the prices on each others toxic assets and result in the assets being repriced from 30-50 cents to upwards of 70 or 80 cents on the dollar (or higher if they think they can get a way with it). The banks, having already written down the worst of the assets to somewhere in the new range will not need to take any further write downs. They will sell only the worst of their assets and the remaining assets will be repriced upward to the new standard set by the Kabal (excuse me, I meant the PPICs).

Now, after all that, the banks have plenty of capital and far fewer assets that pose any further downside risk. They can now put the new capital to work at the bottom of the economic cycle and ride it to the top with growing profits and lower risk.

Now, this is all predicated upon my understanding of how the PPIP actually works. But I have a hard time believing, at this point, that it will develop in any way that is not extremely favorable to the banking industry, especially the very large banks on the list along with Goldman Sachs. Why else would some of these institutions have gone out and bought up more toxic assets a month or so ago? They plan on profiting from the PPIP! And the taxpayers will foot the bill for another $ Trillion.

May 13 11:01 AM