A New Kind of Bank Stress Test

Includes: DIA, SPY, XLF
by: John Lounsbury

The process of the Geithner plan is to provide investment vehicles involving government-private equity partnerships to buy troubled assets from banks. The assets will be purchased with 6.67 to 1 leverage using loans from the FDIC. This provides the partnerships with an upside potential of possibly several hundred percent and a downside potential of 100%. The potential win/loss ratios are 2/1, 3/1, 4/1 or even higher.

Other writers have suggested there are possible problems with the Geithner plan. James Gailbraith has a negative outlook (The Geithner Plan Won't Work).

Under the plan, 7.5 percent of the purchase price would come from private sources as equity. The same would come from TARP—that is, from the Treasury—also as equity. Eighty-five percent would come from the FDIC, as a low-interest, non-recourse loan, meaning that if the loans default, the FDIC gets the assets but nothing else.

If the assets prosper, then public-private partners make money and the FDIC gets paid. If the assets default at high rates, then Treasury and the private investors are together wiped out. The FDIC would get the securities and sell them; its losses would depend on the price it can get. In this game, the banks benefit from a high price, the FDIC from a low one, in the initial sale.

Adam Schram envisions three possible scenarios for the Geithner plan:

1. The toxic assets will attract only few bidders, while most investors decide they are not a good investment at any price, even with Treasury's inducements, since those asset are not just illiquid but actually hopeless.

2. The Geithner plan will attract only few banks, because they fear their assets will receive only very low bids, forcing banks to take further write downs and thus eroding their capital even more. This will tear the mask from the banks' balance sheets and spell their doom. Because of that risk, many banks may choose not to participate. This scenario also renders the plan ineffective.

3. The plan's participants buy most assets from the banks at prices that leave the banks solvent. In this case, the plan works well but would amount to effectively subsidizing the failing banks, transferring their losses and risk to the taxpayers via the Fed's balance sheet.

The intended consequence of the Geithner plan is increased liquidity for banks with improved balance sheets, while the long-term potential for troubled assets is transferred to the public-private partnerships. However, one should always look for possible unintended consequences.

One that has occurred to me is to consider the possibility that the plan will define a new and different kind of stress test. This test will determine whether a price for troubled assets can be determined that is both (1) sufficiently high to rescue bank balance sheets and (2) sufficiently low to attract investors. This stress test has simultaneous advantages and disadvantages. It will hasten the determination of which banks can be rescued and which must be restructured. This is an advantage because it brings an end to some of the uncertainty that has plagued the financial sector. It is a disadvantage to the extent that it may fail to recognize, in the event that the stress test is failed, the possible longer-term value in the troubled assets.

Another advantage of this stress test is that it does not depend on using estimates of future economic activity, as do the stress tests previously initiated by the Treasury. This stress test involves the FDIC (and ultimately the taxpayer) supporting the determination of a new “market” price for troubled assets. I say “ultimately the taxpayer” because, even though the FDIC is a “private” entity, it is a GSE (Government Supported Enterprise), like Fannie (FNM) and Freddie (FRE). If the FDIC goes under, the government will handle it the same way as it handled the bankruptcy of Fannie and Freddie – take it over.

The final analysis for me is that the private partners have a 2/1, 3/1 or 4/1 (or even more) potential win/loss ratio. The taxpayer has a corresponding potential win/loss ratio of 1.2/1, 1.3/1 or 1.4/1. (In making this estimate, I used worst case that if the purchased assets failed to sustain the investment partnerships, they would decline to zero value.) If the FDIC were able to regain at least 50% of the original purchase value in the event of investment partnership failure, the risk ratio (maximum possible gain divided by maximum possible loss) would be approximately doubled (1.4/1 would become about 1.4/0.42).

So if the Geithner plan is an unqualified success, the taxpayer would stand to make $200M to $400M for every billion dollars of assets relieved from the banks. If the Geithner plan is a total failure, and 50% of the purchased asset value is ultimately recovered, the potential taxpayer loss is about $420M for every billion dollars.

Obviously this is not a good investment risk/reward ratio for the taxpayer unless the odds are significantly skewed toward success of the plan. It is not clear to me that positive skew is warranted. The plan does have the advantage of likely forcing the issue of solvency (for the most troubled financial institutions) to be resolved sooner rather than later.

Incidentally, an informal poll by the Huffington Post (can be seen in the Schram article) showed 66% of respondents (at the time of writing) believed the Geithner plan will work. There were over 17,000 respondents. I was one of the 14% who responded “Not Sure”.

Nouriel Roubini is also is hopeful for the Geithner plan. This is a vote of confidence from one of the bank nationalization proponents. On the other hand, another nationalization proponent (Paul Krugman) is not supportive.