Stress Test

The focus of the markets this week was on the Obama Administration’s stress tests of the nation’s nineteen top banks. Results from the tests had been highly anticipated since early February when Treasury Secretary Tim Geithner first announced they would be included in his bail-out plan for the banks. The markets have risen and fallen in line with changing speculation as to the test results.
Results from the tests were originally due to be released May 4 but were delayed until yesterday so that bank executives would have time to discuss the results (read "lobby") with the government regarding their effect.
This week stock markets opened sharply higher (with both the Dow and the S&P each about three percent higher on Monday) on trader optimism that banks would not have to raise much additional capital. The markets fell back Tuesday with profit-taking, rallied again Wednesday, then slipped back Thursday when the results were finally released ("buy on the rumor, sell on the news") - the financial index fell 8.5 percent - before closing the week on an up note.
For the week, the Dow Jones Industrial Average finished the week with a 362-point gain (up 4.4 percent), while the S&P 500 Index rose 52 points (a gain of almost 6 percent).
The markets’ performance wasn’t entirely due to the stress-test results: the economy lost a less-than-expected 539,000 non-agricultural jobs in April (a loss of 630,000 had been expected). In addition, earlier in the week, numbers regarding pending home sales, construction spending, and the Institute of Supply Management’s non-manufacturing index all came in better-than-expected, reinforcing optimism that the end of the recession was in sight.
Nevertheless, the stress tests dominated trading and in this article we will try to put some perspective on the tests and their results.


Background

The failure of Lehman Brothers back in September was a major blow to the confidence of bank managers and investors alike. Banks were afraid to lend, holding on to their capital in case their assets deteriorated further, and investors, fearing other bank failures, sold bank shares accordingly.
Then-Treasury Secretary Hank Paulson tried to restore confidence through the Troubled Assets Relief Program (TARP), ultimately pumping capital into the banks to get them to resume lending. The banks took the money but they didn’t lend.
When the Obama Administration took office in January, the economy was in a tailspin. One of the Administration’s first priorities was to fix the banking system. In March, when new Treasury Secretary Geithner finally revealed a detailed bank plan, a keystone of that plan was the administration of "stress tests" to the nation’s top banks. The test would determine which banks would need additional capital (and how much) in the event the economy continued to deteriorate.
Geithner’s primary goal, like Paulson before him, was to restore the banks’ confidence and get them lending again. Secondary objectives would be to ensure the public maintained confidence in the banking system, thus avoiding bank runs ( la "It’s a Wonderful Night") and to also help bank shareholders.
The Treasury, with the help of the Federal Reserve, would send a small army of investigators into the banks and review the adequacy of each bank’s capital under a variety of adverse economic scenarios. The goal was to determine which banks required additional capital and how that capital would be attained.
The emphasis of the reviews would be on tangible common equity - basic common stock - as a percentage of total risk-adjusted assets. This was an old-fashioned way of calculating capital requirements: In 1989, the Bank for Institutional Settlements in Basel, Switzerland, had decreed that all banks would be required to maintain "Tier One Capital" equal to four percent of risk-weighted assets. Tier One Capital included common equity, but also included other categories, such as preferred shares (including those that had been issued to the treasury in exchange for TARP funds), goodwill and other intangible assets. Geithner determined that investors preferred the more conservative tangible-common-equity calculation. The stress tests required that tangible common equity would have to be at least four percent of total assets, while tier-one capital would need to be equal to six percent of assets.
In addition, since 1989, banks had learned to "game" the system: Basel determined that different classes of assets were less risky than others and were therefore subject to lower capital requirements (yes, residential and commercial mortgages were included in the less-risky category). Since 1989, banks had become very adept at finding ways to move more and more of their assets into these categories. The stress tests would require a higher percentage of capital for many of these assets.
By reducing the capital required for certain assets, the banks would increase their leverage and likewise increase their return on common equity. Before the economy went into a tailspin, US banks, on average, were leveraged at better than 25 to 1. (European banks generally operated at 40-to-1 leverage and banks in the UK carried leverage at almost 50 to 1.) Leverage magnifies returns when times are good (and asset values are increasing) but when times turn bad a small decrease in the value of assets can wipe out a bank’s capital. Once a bank’s capital is gone, it is insolvent. Requiring a higher percentage of capital (and lowering the leverage ratio) decreases the risk of insolvency.
A second objective of the stress tests was to increase so-called "transparency" at the banks - to give investors and creditors a better picture of what was going on inside the banks.


Anticipation

For the past two months, anticipation before the results was mixed. Bank executives were unfailingly optimistic. Jamie Dimon, Chairman and Chief Executive Officer at JP Morgan Chase, was confident his bank would not need additional capital. So was Lloyd Blankfein, head of Goldman, Sachs. In addition, Blankfein wanted to repay his company’s TARP funds as quickly. Executives at Bank of America and Citigroup, while trying to remain outwardly positive, appeared less confident.
Some observers, like Warren Buffett, whose company. Berkshire Hathaway is a major shareholder in Wells Fargo (Wells Fargo is Berkshire Hathaway’s second largest holding, behind Coca Cola), dismissed the tests, saying he believed one instead had to focus on a bank’s "dynamism" and its ability to attract depositors. He didn’t believe Wells Fargo needed any additional capital (it turned out it did).
The International Monetary Fund took a more pessimistic view of the world’s economy. It believed the global economy was in worse shape than that considered under the worst-case scenario in the stress test. The IMF forecast that, world-wide, banks would eventually have to write down a total of $4,400 billion. US banks would need an additional $275 billion worth of capital to bring leverage ratios down to 25 to 1. The IMF also stated it felt the chances of raising this type of capital in the private marketplace was essentially zero.
Some observers, like Nouriel Roubini, a professor at New York University also believed the scenarios considered by the stress tests were not stringent enough. He especially believes that unemployment will surpass the Treasury’s worst-case estimate.


Results

Results of the stress tests were much better than most observers feared. Geithner had earlier said that the results would be a "reassuring" picture for investors. In the end, ten of the nineteen banks tested were determined to need additional capital totaling $74.6 billion. Bank of America would require the most -- $33.9 billion. Wells Fargo was second on the list, needing $13.7 billion, followed by GMAC, at $11.5 billion. Citigroup would require an additional $5.5 billion in capital.
By Friday, several of the banks had already taken steps to raise the additional capital they needed. Wells Fargo, on Friday, sold $7.5 billion worth of shares, 25 percent more than they had originally planned. Morgan Stanley, which was told it needed $1.8 billion in additional capital, also sold $7.5 billion worth of stocks and bonds. Bank of America plans to sell 1.25 billion shares of stock in a shelf registration as well as an undetermined amount of debt. Citigroup will exchange preferred shares for common stock.
None of the banks want any additional capital from the government, although several of the regional banks that had smaller capital requirements (PNC Financial Services, Regions Financial, SunTrust, Fifth Third Bancorp, and Keycorp) could find it difficult to raise outside equity and may be forced to resort to government funds.


Legacy

Despite all the hoopla surrounding the stress tests, in the end, tier-one capital at the banks will only increase by $9.5 billion. Total equity will increase by $74.6 billion but most of this could be accomplished by converting other tier-one securities into common equity.
Policymakers believe the market is focused on common equity and they feel the shift into common shares should reduce bank funding costs.
Treasury Secretary Geither said, in releasing the results, "These tests will help ensure that banks will have a sufficient capital cushion to continue lending in a more adverse economic scenario."
In setting up the stress test, the Treasury’s priority was to calm panicked markets. They seem to have done that. Geithner wants to ensure that credit begins flowing smoothly. The tests may produce that result.
The banks will now turn to managing their balance sheets at whatever capital level, arbitrary though that it may be, the government desires. Their main goal will be to keep the government off their backs.
Shareholders will probably be convinced that the banks are healthy again. So far, they seem to be convinced.
On a long-term basis, there is still the prospect of $3,000 billion worth of toxic assets that may have to be written off. That problem seems to have been pushed to the back burner. Also, the stress test and pumping in additional capital doesn’t address the problems in the securitization market, which is going no where (see last week’s article).
There will be other benefits: capital will be concentrated in common equity, which the market seems to want; and the public is provided with considerably more information on the banks.
The treasury also appears to believe that the banks can remain profitable at the operating level, unlike Japanese banks following the 1997-1998 crisis, which many observers feel might provide a pattern for this crisis.
There are still many who believe that banks are considerably less healthy than the stress tests purport to show. Nouriel Roubini and Matthew Richardson, another NYU professor, in an article in Thursday’s Financial Times, argue that there are banks that should be allowed to fail. They cite economist Joseph Schumpeter, who said that "the essence of capitalism is creative destruction, that new economic structures are born from the rubble of old ones." If technically-insolvent banks are allowed to continue, it only sows the seeds of a new and larger crisis in the future.