The Hard Part of the Stress Tests Now Begins

Like so many other staged events in Washington, the bank stress tests results looked good when first announced. The numbers were less alarming than some of the worst case thinking. Bank stocks, which have led the two-month rally, helped to lift the market to yet another positive week.

Then, the press hounds began sniffing around. Ever since Richard Nixon declared he wasn’t a crook, the Washington press corps has made hay by taking the shine off government pronouncements. Now we learn from the Wall Street Journal (on Saturday 5/9/09) that the Federal Reserve’s initial conclusions from the stress tests were considerably more negative than the announced results. At least several banks were asked to raise more capital than their final quotas. Citigroup reportedly was told it needed an additional $35 billion, a number that shrank to $5.5 billion by the time it was made public. Bank of America’s number was supposedly more than $50 billion at first, although jawboning reduced it to $33.9 billion. All told, it would seem that the banks talked the Fed down more than a total of $50 billion in additional capital.

Those banks asked to raise more capital need to come up with a total of $74.6 billion. That figure would have been over $125 billion if the Fed hadn’t improved its grading. But what the hell. This is America, the land of grade inflation where students’ basic math and grammar skills are declining even as everyone is placed on the honor roll.

The stress test are just talk--talk therapy, at best. So far, not a penny of additional capital has been infused. Not a dollar's worth of toxic assets has been transferred. Not a single penny of additional loans has been made. We're supposed to feel better because the government told us that we should feel better. If this really worked, Bernanke and Paulson could have simply appeared on a few Sunday morning talk shows and by their mere words lifted the economy from the doldrums.

As things stand, the less healthy banks will have to raise almost $75 billion in the next six months. That’s a lot of capital, considering how crippled the financial services industry is. Recently, the U.S. government had a little trouble with a $14 billion 30-year bond auction, with rates going higher than expected. If the best borrower in the world is hitting potholes in the money markets, think about the problems banks on the dole might face. They’d have to price their stock very cheaply in order to attract investors. That would dilute existing shares and push secondary market prices down. And if they sold preferred stock to raise capital, the downward pressure on common shares would be comparable. The preferred stock would have to pay an appealing dividend to attract investors; and that would take earnings away from common shareholders. Just as bank stocks have led the market’s two-month rally, dilution of their shares could cap and even reverse the rally.

Another problem is that interest rates are at historic lows. If, as Fed Chairman Ben Bernanke predicted this past week, the economy begins to recover late this year, the Fed will have to start raising interest rates and withdraw some of the trillions of dollars of liquidity it has flung at the credit markets in the last year or so, lest it run the risk of serious inflation. Banks would find their profit margins shrinking. The stress tests made certain assumptions about banks' future earnings (which, if in fact attained, could be added to the capital buffer needed by the banks). Rising interest rates would probably decrease those future earnings, thus undermining the assumptions.

With the real economy still in decline, banks will want to horde their capital in order to stay within stress test projections. That would mean they won’t err in favor of increased lending. The stagnation in the larger economy, with its rising unemployment, increased mortgage and credit card defaults, and rising numbers of bankruptcies, would likely continue. Although there are signs that the rate of the economy's decline is slowing, banks continue to tighten credit standards in an effort to save themselves ahead of anyone else. It's one thing to stop an economic decline and another thing to instigate a recovery. The recovery doesn't necessarily follow from the end of the decline (see Japan).

The stress testing process may have encouraged banks to take advantage of recently relaxed accounting standards for the toxic assets that have so badly bedeviled them. They may have booked high values for these assets and chosen to keep them on their books instead selling them to the government’s PPIP program. As long as banks’ balance sheets remain toxic, the banking industry cannot truly recover, and neither can the economy. Thus, the stress testing process may delay or even preclude a true cleanup and recovery for the banks and the nation. One wonders whether the FASB’s relaxation of accounting rules made it easy for the Fed to justify lower capital requirements. If so, the Fed may be papering over the problems.