About the stress tests by the Treasury Secretary

Happy Friday everyone!

I am heading out to see the new Star Trek movie! Oh yeah! I’ll let you all know how it is…early reviews all love it.

For today’s post I wanted to copy yesterday’s op-ed piece by U.S. Treasury Secretary, Timothy Geithner. I will quote a paragraph and then provide an explanation of what his words mean so that we can all understand this sort of thing better in the future. Sound good? By the way, thanks to one of my “followers” for pointing me to the piece and for the suggestion to translate.

“May 7, 2009
Op-Ed Contributor
How We Tested the Big Banks
By TIMOTHY GEITHNER

Washington

THIS afternoon, Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve will announce the results of an unprecedented review of the capital position of the nation’s largest banks. This will be an important step forward in President Obama’s program to help repair the financial system, restore the flow of credit and put our nation on the path to economic recovery.”

Commentary: These are the four big officiating agencies of the banking industry and that all four of them were on board is a good sign of inter-agency cooperation. Lest we feel that this was not a political process there is an immediate mentioning of Barack Obama. This first paragraph is all about establishing authority for the stress-tests. So not much to explain here.

“The president came into office facing a deep recession and a damaged financial system. Credit had dried up, forcing businesses to lay off workers and defer investment. Families were finding it difficult to borrow to finance a new house, buy a car or pay college tuition. Without action to restore lending, we faced the prospect of a much deeper and longer recession.”

Commentary: That first sentence is trying to check expectations and potential criticisms of the President – “Bush did it!” The rest is just explaining the situation and again, the need for the stress tests. Part of why the need has to be established is that the stress tests were widely criticized when announced.

“President Obama confronted these problems with dramatic action to address the housing crisis and to restart credit markets that are responsible for roughly half of all business and consumer lending. The administration also initiated a program to provide a market for legacy loans and securities to help cleanse bank balance sheets. These programs are helping to repair lending channels that do not rely on banks, and will contribute to fixing the banking system itself.
However, the banking system has also needed a more direct and forceful response. Actions by Congress and the Bush administration last fall helped bring tentative stability. But when President Obama was sworn into office in January, confidence in America’s banking system remained low.”

Commentary: What Geithner is talking about here is the drastic measures that needed to be taken to restore trust in the markets where debt is traded, aka the credit markets. What happened is that so many loans were defaulting and causing losses for banks that banks stopped trusting one another. This is because it was impossible to know what kind of diligence your counterparty in a trade had endeavored to do when underwriting a loan. So the Feds stepped in to buy these loans. That, in turn, injected money into those markets, thus lubricating them. Again there is some of that, “Bush did it!” that is designed to mitigate criticism of the current Administration.

“Because of concern about future losses, and the limited transparency of bank balance sheets, banks were unable to raise equity and found it difficult to borrow without government guarantees. And they were pulling back on lending to protect themselves against the possibility of a worsening recession. As a result, the economy was deprived of credit, and this caused severe damage to confidence and slowed economic activity.”

Commentary: Same-same as above. There was not enough public disclosure of the assets on bank balance sheets which led to further mistrust amongst potential counterparties in credit market trades. Why does it matter if the economy is deprived of credit? The primary reason is that there are two ways to raise money if you have a great business idea: equity and debt. The problem with equity is that the required returns owed to shareholders is much higher than that for debt. In a recessionary environment where every dollar counts capital preservation is essential. Additionally, it is very hard to convince current shareholders that every time you need money as a business that they should endure dilution of their interests – which is what happens when new equity is issued. Consequently for short-term money needs most businesses prefer to raise money from big banks. The capital can be raised quickly – in less than a day – and the interest rates are very low. But why would businesses need these kinds of funds? The reason is that businesses are like the body of a human being. The heart correlates with executives. The limbs correlate with business plans put into place. But the blood is money. What happens when there is no blood circulating through a body? Atrophy and death. But why don’t they just use their own cash internally generated by operating the business? The reason is that businesses hate cash – it is a non-earning asset. Most businesses prefer to invest their cash in assets such as additional product, product research, employees, marketing, etc. Those investments earn high returns, whereas cash does not. That’s why a shutting off of credit was so detrimental to business and the economy. Can you see that the whole enchilada rests on trust? This is why ethics ARE an economic issue.

“We could have left this problem as we found it and hoped that, over time, banks would earn their way out of the mistakes they had made. Instead, we chose a strategy to lift the fog of uncertainty over bank balance sheets and to help ensure that the major banks, individually and collectively, had the capital to continue lending even in a worse than expected recession.
We brought together bank supervisors to undertake an exceptional assessment of the strength of our nation’s 19 largest banks. The object was to estimate potential future losses, and ensure that banks had enough capital to keep lending even in the face of a deeper recession.”

Commentary: The idea behind the stress tests was to provide an unabashed worst-case scenario for financial market investors to digest. There was so much fear and so much uncertainty amongst capitalists everywhere. What’s more, banks were reluctant to publicly disclose just how bad their situation was because if the stock market then sold off the stock, thus driving down share prices, then banks would have to raise even more equity. There was a real potential for a downward spiral. So a third party was needed to come in an examine the books and then communicate to the market what was going on. Does this make sense?

“Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.”

Commentary: not much to say here

“The Federal Reserve marshaled hundreds of supervisors to spend 45 days rigorously reviewing the banks’ detailed loan data. They applied exacting estimates of potential losses over two years, along with conservative estimates of potential earnings over the same period, and compared them with existing reserves and capital. The results were then evaluated against strict minimum capital standards, in terms of both overall capital and tangible common equity.”

Commentary: This is just outlining the methodology of the stress tests. The idea was to ask hypothetical questions of the assets on the various banks’ balance sheets. What if unemployment rises to x, and what will that do to the number of loan defaults, and what will that do to your equity, and what will that do to your debt to equity ratio, and what will that do to your solvency, and what will that do to your ability to lend more money?

“The effect of this capital assessment will be to help replace uncertainty with transparency. It will provide greater clarity about the resources major banks have to absorb future losses. It will also bring more private capital into the financial system, increasing the capacity for future lending; allow investors to differentiate more clearly among banks; and ultimately make it easier for banks to raise enough private capital to repay the money they have already received from the government.”

Commentary: We’ve discussed most of this already. However, note the unspoken link between greater transparency and information bringing more private investors’ money into the financial system. In other words, it is implicit to the thinking that more information equals less risk and thus equals more investment. I bring this up because this is a point I have been making since the first posting on the blog last year.

“The test results will indicate that some banks need to raise additional capital to provide a stronger foundation of resources over and above their current capital ratios. These banks have a range of options to raise capital over six months, including new common equity offerings and the conversion of other forms of capital into common equity. As part of this process, banks will continue to restructure, selling non-core businesses to raise capital. Indeed, we have already seen banks, spurred on by the stress test, take significant steps in the first quarter to raise capital, sell assets and strengthen their capital positions. Over time, our financial system should emerge stronger and less prone to excess.”

Commentary: OK, so what’s the damage? Geithner is trying to give us a sneak preview of the results. He then is trying to quell the fears of the market by saying that the banks who need additional capital have half a year to raise it. Also, he reveals that the stress tests have made banks refocus on banking – “selling non-core businesses to raise capital.” One of the things that happens to cause all recessions is that business is going so great that most businesses end up with more money than they can possibly hope to reinvest productively somewhere else. So businesses start investing in jackass things rather than return the money to shareholders as dividends. It happens in every boom cycle and it is talked about in business school and it is a part of the lore of capitalism so why do so many do it? Who the hell knows?

“Banks will also have the opportunity to request additional capital from the government through Treasury’s Capital Assistance Program. Treasury is providing this backstop so that markets can have confidence that we will maintain sufficient capital in the financial system. For institutions in which the federal government becomes a common shareholder, we will seek to maximize value for taxpayers and enable these companies to attract private capital, thereby reducing government ownership as quickly as possible.”

Commentary: Worst-case scenario, you and I are going to become owners of these failing institutions. But relax regulators are great business people and we will manage your money wisely for you. OK, that’s a bit facetious, but this is an option no one wants to see exercised.

“Some banks will be able to begin returning capital to the government, provided they demonstrate that they can finance themselves without F.D.I.C. guarantees. In fact, we expect banks to repay more than the $25 billion initially estimated. This will free up resources to help support community banks, encourage small-business lending and help repair and restart the securities markets.”

Commentary: What this means is a bit ambiguous to me. I think Geithner is saying that some banks are paying back some of the bailout monies and that regulators are going to turn around and invest it back into the System. Interestingly, the reason that $25 billion is being repaid is because businesses hate the idea of the government looking over their shoulders while they conduct business. Good, I hope that they are uncomfortable and I hope that this exercise never happens again. The problem is that the experiencers of catastrophe eventually die and their lessons only live on in the form of an abstraction – a war story. Thus, 90 years from now it is likely this sort of greed-induced silliness will likely repeat itself all over again. Argh!

“This crisis built up over years, and the financial system needs more time to adjust. But the president’s program, alongside actions by the Federal Reserve and the F.D.I.C., is already helping to bring down credit risk premiums. Mortgage interest rates are at historic lows, putting more money in the hands of homeowners and helping slow the decline in housing prices. Companies are finding it easier to issue new debt to finance investment. The cost of borrowing for municipal governments has fallen significantly. Issuance of securities backed by consumer and auto loans is increasing, and the interest rates on these securities are falling. The Federal Reserve reports that credit terms are now starting to ease a bit.”

Commentary: The first sentence totally annoys me. Yes the crisis was built up over years – so why the hell didn’t anybody do anything about it? The fact that there was madness all over the place was obvious to many, so why was there no regulatory action taken? This is a massive passing of the buck and was the subject again of an initial blog posting. I will not reiterate the reasons for inaction. Risk premiums are the compensation received for buying a loan where the underlying credit worthiness of the borrower is worse than normal. The compensation comes in the form of an increased interest rate referred to here as a risk premium. Does that make sense? The rest of the paragraph is revealing the tangential benefits realized by the stress tests.

“This is just a beginning, however. Our work is far from over. The cost of credit remains exceptionally high, and businesses and families across the country are still finding it too hard to borrow to meet their needs. We are continuing to execute our programs to relieve the burden of legacy assets, help small businesses and community banks, and tackle the mortgage and foreclosure crisis. The ultimate purpose of these programs is to ensure that the financial system supports rather than impedes economic recovery.”

Commentary: This is the escape clause. In other words, it says: “We are diligent and we may have to act again.”

“We have not reached the end of the recession or the financial crisis, but the bank stress tests should advance the process of repairing our financial system and provide a better foundation for recovery.”

Commentary: Nothing to add.

*****

Hopefully that was helpful. If there is good feedback about this exercise then I will be happy to do similar exercises in the future.

Over and out,

Jason