Stress Tests and Distressed Assets

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Includes: BK, GS, MS
by: Bullish Bankers

The government is faced with another significant challenge in propping up the U.S. banking system, and it cannot fail this one. The health of the financial system and confidence of investors hinges on whether or not the new administration gets this right. The results of the ’stress tests’ that officials plan to conduct on U.S. banks determine if these banks need additional capital. However, if the assumptions for economic conditions used by officials are too optimistic, the government might be forced to make another string of bailouts. This would surely cause investors to lose confidence in the ability of the Treasury and the Fed.

Unrealistic Assumptions

U.S. banks are being tested for capital adequacy under two different scenarios. The worst scenario predicts that the economy will shrink 3.3% in 2009 and that unemployment could reach 8.9%. The government foresees a bottoming out in the second quarter of the year. However, the economy is actually in much worse shape currently than what was originally forecasted, with revised data for the fourth quarter of 2008 showing a 6.2% contraction in the U.S. economy compared to the original figure of a 3.8% decline. So, if the government’s worst scenario isn’t quite bad enough, they stand to have to inject more money into institutions in the future to cover worse than expected losses. Clearly worse than forecasted, economic conditions, especially higher unemployment, could result in an increasing number of consumers defaulting on loans. That means banks would need more capital to offset the higher losses.

Not only does the government need to execute these tests effectively, but they need to complete them quickly as well. These looming tests have created a lot of uncertainty in the markets. Additionally, the banks are not allowed to repay their TARP funds until the tests are finished. Many of the banks, especially Goldman Sachs (NYSE:GS) Morgan Stanley (NYSE:MS) and Bank of New York Mellon (NYSE:BK) have stressed that they want to pay back the funds as soon as possible.

Say Good-bye to the Bad Assets

Instead of continuously injecting money into these banks and watching their market values tumble, a better solution may be to rid the banks’ balance sheets of bad assets. Instead, banks plagued with troubled assets waste more time trying to avoid further losses. The banks typically offer more support to troubled borrowers than those who might actually repay their loans. The sooner the banks get soured assets off of their balance sheets the better. The government originally pledged to facilitate this with TARP, but then shied away from it. The main reason was difficulty in pricing the assets; if the government paid too little it would cause banks to have deeper writedowns, but paying too much would mean wasting taxpayer money. Instead, we are now dumping exorbitant amounts of taxpayer money into the system anyway, because the first capital injections were not adequate.

The sooner the banks can take their attention away from bad assets and the fear of losses, the more they will be able to devote time to making loans that keep the economy growing. This is where the altered “bad bank” structure that the government is proposing comes in. A purely “bad bank” concept would mean only the government would purchase bad assets, but the leading idea proposed by Obama’s team is slightly modified. The proposal is a private public funding partnership which would have different funds run by private investment managers. The managers would put up a certain amount of initial capital, and the rest would come from the government, which would share in any profit or loss. The funds could possibly raise capital by selling government-backed debt, but plans have not been completely fleshed out for how the government will stimulate investors to buy the assets. The new idea will hopefully solve the issue of pricing the tricky assets. The government will seek to have private investors, such as pension funds to buy the assets in a way that would help markets determine prices for assets that currently do not have any public forum for valuation.

Pushing Forward

This liquidity and lending issue is going to continue to loom over the banking system. The massive increase of government involvement in the private sector will undoubtedly have negative effects. It is safe to say that a major downside to the intervention will be inflation; with much of the government action unprecedented, it is difficult to predict what the other effects will be. After the economy recovers, the largest challenge for politicians will probably be pulling the government out of the markets when major industries depend on it.

However, the U.S. will eventually recover and emerge stronger than before. Many people who have not lived through the Great Depression, world wars, and multiple recessions tend to forget that we have experienced much worse pain as a country. The health and resiliency of a nation is really based on its ability to recognize and learn from mistakes and then make changes and move forward. In the words of Warren Buffet, “the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

-Taylor DeStefano

Disclosure: The mutual fund the author is associated with is long GS and BK.