The EU Sovereign Debt Crisis: A Farewell to Globalization?

Today, the Federal Reserve announced a new round of stress tests for the six largest American banks to find out how well they would withstand a market discombobulation emanating from the EU sovereign debt crisis. Translated from regulatory speak to plain English, this is a strong hint to the big banks that they straightaway ditch as much of their EU exposure as they possibly can, devil take the hindmost. Those banks that don't move with alacrity will be required to boost capital levels, an exercise detested by bonus loving bank executives (which would be about all of them).

It is ironic that the Fed would try to quietly build a firewall around the U.S. banking system. It has preached internationalism throughout the past four years as the financial markets belly flopped, and maintains generous dollar-denominated lines of credit to foreign central banks. The latter measure helps the dollar fulfill its role as the world's reserve currency, ensuring that there are enough dollars for the wheels of commerce. But encouraging major U.S. banks to offload Euro-denominated obligations de-globalizes. In effect, the Fed is saying, "Lafayette, nous allons partir."

Euro-denominated investments will face downward price pressure if U.S. banks begin casting them away. The Fed surely knows this would be bad for the EU's banking system, which is desperately reaching for any lifeline in turbulent seas. One can't help but wonder whether the Fed has concluded that the EU may not be able to pull itself out of its nosedive.

The Failure of Bank Stress Testing

The EU sovereign debt crisis has put the lie to bank stress testing. Stress tests--analyses that supposedly test a bank's ability to survive one or more hypothetical financial crises--have been used by American and European regulators in an effort to evaluate the strength of banks. The American tests weren't followed by the immediate bailout of tested banks (although TARP, bounteous Federal Reserve subsidies and credit lines, and politically driven changes in accounting rules were much more important to their survival than stress testing).

Europe's tests were embarrassingly less accurate. Weeks after passing the first round of stress tests last year, major Irish banks needed government bailouts. Dexia, a Belgian-French bank that just got a bailout, passed the stress tests twice. This summer, stress test results announced in July indicated that only eight European banks failed, having a combined capital shortfall of 2.5 billion Euros ($3.5 billion). Now, as EU leaders squabble over the terms of the next humungous bailout, current estimates of the capital shortfalls of EU banks range as high as 80 billion Euros. To go from needing 2.5 billion Euros this past July to perhaps 80 billion a period of three months is suggestive (to say the least) of flaws in the testing process.

Comically, Europe's banking regulators are about to conduct a third round of stress tests. Major European banks are reportedly trying to shrink their balance sheets and beef up their capital in anticipation. But what's the worry? Based on our experience with the past two rounds of stress tests, we already know what results will be announced. All that's need is for the EU's regulators to figure out what assumptions are necessary for them to sound Panglossian.

You can make stress tests come out any way you want, by using the right assumptions about how bad the financial markets will get and how to value assets. Europe's stress tests might provide good fodder for the opening monologue on the Tonight Show. But don't bet your badly battered retirement savings on them.

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.

Results of the Federal Government's Own Stress Test

We’ll soon know the results of the federal government’s stress tests of the 19 largest banks in America. What we already know, in a sense, are the results of the federal government’s stress test of itself.

Last week, Treasury Secretary Timothy Geithner made clear that banks participating in TARP (which would include just about all those undergoing stress tests), would not be allowed to repay the federal government’s TARP money except if the government allowed it. In other words, once a big bank is in TARP, it doesn’t get to choose the timing of its exit even if it believes it can repay the loan.

One could observe that made guys don’t get to leave the mob just because they feel like it. Indeed, some people believe the federal government is a form of organized crime. But we don’t wave telescopically sighted rifles from ridges and won’t advocate that point of view.

What this no exit (except with our approval) policy reveals is that the financial system remains fragile. If a couple of major banks leave the TARP program, that would imply that the banks remaining in TARP are weak. The latter would be vulnerable to runs, and the federal government seems to be saying that it might have an awfully hard time coping with another run on the banking system. Recall that the last run, after Lehman collapsed, required the ever-more expensive bailout of AIG. Basically, it took a blank check drawn on the United States to prop up the financial system. While members of Federal Reserve Board and other government officials have been dropping hints of the economy sprouting green shoots in a drought, the truth seems more like a Jackson Pollack splatter without the expressiveness than a clear picture.

The bank stress tests are a political event. They are being conducted under the supervision of the Secretary of the Treasury, not the independent bank regulatory process. Evaluate their results with that in mind.