Fed Finds a Way to Use Stress Tests to Screw Bank Shareholders One More Time

The Obama administration’s war on bank shareholders continues. This morning, the Wall Street Journal reports that the Fed, in putting the finishing touches on the administration of its misbegotten stress test on 19 big banks, now says that, no, banks that need to raise new capital can’t use their own estimates of the first three quarters’ worth of pre-tax, pre-provision net revenue to fill their holes. They have to basically use the Fed’s own, much more conservative PPNR estimates, instead.

Oh, brother. If what the Journal is reporting is true, the Fed has succeeded in making a truly asinine, costly regulatory process even more asinine and costly than it was before. Which is saying something.

First of all, if history is any guide, regulators’ loss assumptions for the next two years will end up being way too high and its estimated PPNR for the banks way too low. Yet despite these overly conservative assumptions, regulators are still requiring that banks build capital to levels that are materially in excess of what the Fed says it believes constitute “well-capitalized.” Don’t ask me why the government keeps insisting on moving goalposts. The stress test is best understood if you simply assume that everything the government does is irrational, or soon will be. The whole idea behind the stress test, and banks’ post-test action plans, has never made sense. This latest change, if true, makes the process crazier than ever.

When the Fed announced the tests’ results on May 7, you may recall, ten of the 19 banks were deemed to be short of Tier 1 common equity (don’t get me started on that!). The Fed then gave those ten institutions until June 8 to develop a plan to “fix” their shortfalls. They have until November to implement their plans.

At the time, managements were told they could count as prospective new capital their own forecasts for PPNR for the first three quarters of the year, rather than assuming the Fed’s own, more conservative forecast. That made total sense. The first quarter is already done, and the second quarter almost done. Results for the third-quarter, which begins in five weeks, are highly visible.

So the companies have a pretty good idea how business is going. Yet in many instances, the differences between the companies’ assumptions and the Fed’s PPNR assumptions aren’t small. In the first quarter alone, for instance, the Fed’s forecast was $2 billion, or 25%, less than Wells Fargo’s estimate!

Now, though, says the Journal, as banks make up their capital plans, the Fed will only allow them to use better-than-Fed-estimate PPNR to make up just 5% of their capital shortfalls.

Which means that a number of banks might have to unnecessarily dilute their shareholders by even more than they’ve had to unnecessarily dilute them already. Wells Fargo, for instance, would be limited to using just $685 million if above-Fed PPNR in its plan. Which is nuts, especially considering that in the first quarter alone, the company’s PPNR $2 billion higher than the Fed had estimated!

If the Journal’s report is true, and Wells Fargo (WFC) has to issue even more common equity than it already has in order to fill its “hole,” shareholders would be diluted by another 4%, at current prices. It would be more totally useless dilution!

Here’s my prediction: By the end of 2010, the consensus view of the investment community will be that the 19 stress-tested banks are overcapitalized and carry excessive loan loss reserves. This will be a direct result of President Obama’s faulty premise that the banks aren’t lending enough, and that the way to get them to start lending is to force them to raise new capital as a buffer against feared losses. Phooey. The academics and economists who put this notion in the President’s head simply weren’t looking at the data. The unhappy result: value destruction for bank shareholders on a grand scale.

Comments

[User 286074:]

As long as the banks have any taxpayer money, it is better to err on the side of the caution. They have previously demonistrated poor discreation having toxic paper.

May 28 03:29 PM

[buyforeclos...:]

sounds like you went long banks way after the run...


FASB is something to consider ..I buy puts and calls no long position on any

May 28 03:39 PM

[lyonhead:]

If the government hadn't been around then all the financial institutions would have failed and the shareholders would have gotten nothing. If another meltdown occurs the government should buy all the common shares for a penny or so before steping into help.

May 28 04:16 PM

[captainccs:]

Bear Stearns shareholders got $10 of taxpayer money as a gift from the NY Fed.


On May 28 04:16 PM lyonhead wrote:

> If the government hadn't been around then all the financial institutions
> would have failed and the shareholders would have gotten nothing.

May 28 04:23 PM

[ralph schauss:]

The FED exercise with the stress tests , supported by Tim G, has been a screwball affair all the time, Regulators constantly undertake stress tests, so what's new anyway ?, then goalposts are changed all the time , by the hour, the same day, newsleaks are being planted in papers to achieve " desired results", then the "change of hearts " from Tier 1 to Com Equity, there s no extra cash, just an eyewash, paper accounting, and only cash revenues absorb LL. Therefore this has been a public disgrace, the result is not more stability but rather more uncertainty, the last thing which we need. It will screw shareholders for the next five years, not Wall Street partners. As is the French saying " the mustard has been getting up my nose " since March 2009, cheers from London UK to a screw-up

May 28 04:47 PM

[Rollerball:]

It's a tiny slap on the wrist for what they've gotten away with thus far, and a safety net for whatever they'll scheme next. Why anyone would play Russian Roulette with these money changers is beyond me. Announce an earnings surprise, then a secondary in the same breath. No thanks. I'd leap-straddle every one of them from now until doomsday. Except maybe GS. Long GS would be like a fiduciary trust buying BRK-A (minus the trust and the fiduciary).

May 28 05:06 PM

[truthteller:]

I am a long-term investor, who buys at attractive prices and holds securities for the long-term. Amazingly, I avoided a big loss in value from this recession with a little fancy footwork and a whole lot of luck. Now, I didn't make any money, but I didn't lose any money by gambling on options. I own BAC in my portfolio because of its future earning power and very attractive price, even with current dilutions and it's primary risk the U.S. Government.

I invested in this stock, probably using many of the same assumptions you used, with an understanding of the real risk, the fed and the U.S. government. I don't agree with the approach the fed is using right now and I take comfort that I am not alone. Even Warrent Buffett discussed the stress tests at Berkshire's recent shareholder meeting and concluded a "one size fits all" approach doesn't make much sense.

The government, using its regulators, wants to punish banks, because they know Congress doesn't have the resolve and/or the stomach to go against powerful banking lobbies. I believe the underlying reason for these actions are to keep the crisis going as long as possible. Think about the administrations message: We are going to fix healthcare, because this will help the economy. Or we will create more regulation, rather than fixing the ones that don't work, because this will the economy. And many more examples, I could go on for awhile.

Now, I voted for the guy, but he's going too far to the left too fast. In the mix, he's hurting the folks, who can restore confidence in the system again, shareholders. Take Bank of America, the company had good intentions, because they were saving Merill and the system, with an expectation the government would make it whole again after the recession. However, they forgot a cardinal rule in business: In God we trust, ALL others MUST SIGN.

BAC just didn't follow-through and get committments in writing. Munger at Berkshire says both the U.S. government and BAC acted correctly, which I mostly agree with him. However, the bank should have gotten assurances in writing and demanded insurance against losses, instead of government investment for the Merrill deal.

I believe these banks, especially Bank of America, known for conservative loss estimates, have over-reserved. The whole reason for BAC to do the deals it done was to take advantage of opportunities to boost earnings. And now they can't even use the boosted earnings to meet, new capital requirements.

I believe the stress tests are requiring them to raise too much capital, which will become apparent in the second half. And the biggest risk to my assumptions about this investment are coming to fruition, government interference/lust to punish the banks. I believe the government is doing this to push its own social agenda, and have a foothold in major banks, so they can break them up later.

They can probably get by with this, just maybe but they won't be able to do it without shareholders. Just look at bondholders at GM & Chrysler, who won't bend to the government's demand to be treated like junior creditors, when the law says they are senior creditors. It is a gratutious play, giving a major contstituency, namely labor unions, a grab for cash, not supported by the corporate bankruptcy laws. Anyways, just my thoughts....

May 28 05:12 PM

[Dr. Roberts:]

As a long time WFC shareholder, this latest reporting by the WSJ is the last straw. First, Paulson forces WFC to take a TARP injection. WFC takes the Wachovia 50 billion dollar toxic asset portfolio off the Government's hands by raising private capital and receiving a 25 billion dollar favorable tax ruling. Anyway one slices that deal it certainly benefited the Government. Then "Tiny" Tim imposes (no doubt as Obama commanded) a heretofore unannounced stress test which found WFC undercapitalized by around 13 billion using the absurd Tier 1 statistic. Chairman Dick Kovacevich called the stress test "asinine" and considered filing a suit although that idea was shelved. With this latest idiotic ruling, WFC should do the entire financial services industry a big frickin' favor and say enough is enough. This shareholder encourages Kovacevich and CEO Stumpf to get an injunction and fight these bastards all the way to the Supreme Court.

May 28 05:19 PM

[user396040:]

As long as the banks have FDIC insurance, the federal government will have a legitimate interest in being sure they are solvent. And, unfortunately, the government will be maladroit in exercising that interest - other areas of federal regulation are not encouraging in this respect. It may be worthwhile to consider an intermediate solution in which various tiers of deposit insurance are made available at different rates. For example, a lower deposit insurance rate and less regulatory supervision might be appropriate if a bank accepted 90% deposit insurance(depositors would get 90% of their deposits from the FDIC in the event the bank failed and would be at risk for the rest). I don't know if this could work but we should be exploring alternatives. After the events of last Fall, banks will not be willing to go without deposit insurance for a long time. The insurance program should be designed creatively to permit the free market to play some role in replacing regulation as a control on banks' leverage and risk taking.

May 28 05:47 PM

[Stone Fox C...:]

Good stuff. Keep posting though its impossible to invest in this sector based on the moving rules.

May 28 06:25 PM

[sether:]

Bank shareholders should have been completely wiped out by now. Any value remaining in your 'investment' is by the grace of the taxpayer. Be thankful, instead of posting petulant and asinine gripes, you freckled grinning bastard. We could all give a sh*t about your gambling losses.

May 28 07:10 PM

[Kipling:]

Y'all just don't get it!
The Obama administration's goal is to destroy
the banking system as we know it.
Once it fails, all else is easy to destroy and then they can bring in
SOCIALISM!
Get IT?

May 28 07:38 PM

[Allamad:]

Bank shareholders deserve to be screwed, they voted in these inept managements! It's the banks that went to the taxpayers whining for help last September after they engaged in all the reckless lending practices.

May 28 10:44 PM

[Hot Richard:]

"The Obama administration’s war on bank shareholders continues."

The Obama administration’s war on shareholders continues.

Fixed it. Wealth redistribution thru obliteration.

May 28 11:00 PM

[Hot Richard:]

"Bank shareholders deserve to be screwed, they voted in these inept managements! "

Americans deserve to be screwed, they voted in these inept Congressmen.

Fixed that one, too.

May 28 11:01 PM

[phubaiguy:]

Yeah Hot Richard...now fix all that's wrong with your own nation.
Dang foreigners out there with nothing to do!

May 29 01:03 AM

[jhawkinstx:]

Oh yes, lets damn Chase, BofA, and Wells Fargo shareholders....last time I looked those were the well run banks that cleaned up the crap of Countrywide, Merril Lynch, Bear Sterns, WAMU, and Wachovia at minimal cost to the taxpayers......at the shareholders expense......... The constant colpaining about the TARP is disgusting........ the minutes of the meeting between the Sec Tres, Fed, and heads of the 19 TARP banks were released a couple of weeks ago showing that the banks were mandated to take the money......money that cost the governemnt 1.8% to borrow via bonds and that the TARP banks are paying 5-8% dividends to the government on.......last time I checked.....18 of the 19 TARP banks showed multi-billion profits in 2008(except citibank). This whole thing has been a bunch of crap to distract the "sheeples" in America away from point their fingers at the government who caused this mess....... For 2000 years it has been convenient to blame the bankers......it has worked again.......


On May 28 07:10 PM sether wrote:

> Bank shareholders should have been completely wiped out by now. Any
> value remaining in your 'investment' is by the grace of the taxpayer.
> Be thankful, instead of posting petulant and asinine gripes, you
> freckled grinning bastard. We could all give a sh*t about your gambling
> losses.

May 29 08:28 AM

[Tom Jacobs:]

You seem to write from a vacuum. These very banks negotiated to lower the bar on these supposed stress tests. Further, they have succeeded in watering down the "market values" at which they carry their assets. Finally, they generated their earnings in the first quarter from a combination of AIG using tax payer money to buy out various CDOs at par as opposed to anything like market value as well as some such as Citi booking gains buying back their own debt. Now you object to requiring that the banks not get to include their own internally generated profit projections. Again, I don't know where you are coming from...

May 29 09:50 AM

[everyotherc...:]

The date for submitting a plan is November.

So, if a bank puts a capital registration on the shelf now(to be safe), but then goes ahead and achieves its profit projections through its third calender quarter it will get that credit to its capital ratios. And probably meet Treasury's mandate. Right?

The only problem I see is that if the bank misses and goes to the market in October or November, the market at that juncture might be less attractive than right now.

What am I missing here?

May 29 10:01 AM

[hwood007:]

I will assume this writer does not vote any shares he/she owns and may not know how hard it is to vote out a board member supported by management. Hard is not the correct word, I have voted against board members and written notes on proxy cards and can not see any results for my efforts.


On May 28 10:44 PM Allamad wrote:

> Bank shareholders deserve to be screwed, they voted in these inept
> managements! It's the banks that went to the taxpayers whining for
> help last September after they engaged in all the reckless lending
> practices.

May 29 01:21 PM

[hwood007:]

During the past, a certain group of people were not allowed to own farms and other businesses to make a living in many countries. But they were allowed to loan money, which they did, and earned a place in history and in so doing that, earned the abuse of many powerful leaders for doing so. The person who took over the Weimar government hated those bankers so much, he tried to kill them all. Bankers have never been loved.


On May 29 08:28 AM jhawkinstx wrote:

> Oh yes, lets damn Chase, BofA, and Wells Fargo shareholders....last
> time I looked those were the well run banks that cleaned up the crap
> of Countrywide, Merril Lynch, Bear Sterns, WAMU, and Wachovia at
> minimal cost to the taxpayers......at the shareholders expense.........
> The constant colpaining about the TARP is disgusting........ the
> minutes of the meeting between the Sec Tres, Fed, and heads of the
> 19 TARP banks were released a couple of weeks ago showing that the
> banks were mandated to take the money......money that cost the governemnt
> 1.8% to borrow via bonds and that the TARP banks are paying 5-8%
> dividends to the government on.......last time I checked.....18 of
> the 19 TARP banks showed multi-billion profits in 2008(except citibank).
> This whole thing has been a bunch of crap to distract the "sheeples"
> in America away from point their fingers at the government who caused
> this mess....... For 2000 years it has been convenient to blame the
> bankers......it has worked again.......

May 29 01:28 PM

[cljenn01:]

"With this latest idiotic ruling, WFC should do the entire financial services industry a big frickin' favor and say enough is enough."

Dear god please have the entire financial services industry tell the Gov't where to stick it by refusing any more Fed or Gov bailouts hereby immediately cancelling TARP, PPIP, and all related taxpayer subsidies and guarantees forthwith. Let the market deal with these leeches. How long before the put-upon shareholders of many "well capitalized" institutions come back begging to be saved from the savages of reality. Capitalism is soooo cruel!!! But I'm systemically important!!! It's not fair that I have to mark down these assets!!! But I paid so much more for them!!! The market is so mean!!! Looted taxpayers who complain are so mean!!! I'm going to get my big brothers Bernanke & Geithner and then you'll be sorry!!! Waaahhh!!!

May 29 04:09 PM

[horrid:]

So, if this atricle is valid, as I believe it is, why the h--- have the banks stocks been rallying and holding so strong, as if all the news is positive, when it aint????
They look over-valued to me-esp as the stess tests were bogus, and the banks have to dilute what equity there is to "improve" their equity/capital, pay back TARP, etc..
What am I missing here??????

Jun 01 07:35 PM