How the US govt fixed the bank stress tests

“Never in the history of the world has there been a situation so bad that the government can’t make it worse” -Henry Morganthau, former US Treasury Secretary, said in 1939
“Now that you are back, how do you plan to get a job?” I asked M, sipping coffee in the morning.

“For the next few weeks, I really don’t plan to do anything. Spending some time with you would be fun, I guess,” she said. “Now tell me what this stress test of banks and financial institutions in the US is all about?”

“It is technically termed as the Supervisory Capital Assessment Program. It essentially involved the US Federal Reserve, the US central bank, assessing whether 19 banks and financial institutions with assets greater than $100 billion have enough capital to withstand the financial turmoil the US and the rest of the world is facing,” I said.

“What do you mean by the capital?”

“Well, banks raise money as deposits, and give out that money as loans. They work on the assumption that people who have put money in the deposits will not turn up all at once to demand their money back, because if they do, any bank, no matter how well-run, would be in trouble. The difference between the interest rate the bank pays on its fixed deposit and the interest rate it earns on the loans it gives out is the money the bank makes. But in difficult times such as these, there is a danger of loans going bad. But the bank still needs to repay the deposits it has raised. For this, the bank needs to put aside some money, which is referred to as capital, so that even if some loans go bad, it is in a position to repay its deposits.”

“OK. So what did the stress tests find?”

“Well, the stress tests were carried over a period of six weeks, after which it was announced that 10 out of the 19 banks needed to raise an additional $74.6 billion in total, to be able to stay in business. Of this, the Bank of America alone needs an additional $33.9 billion, Wells Fargo an additional $13.7 billion and Citigroup an additional $5.5 billion.”

“Do they need the money immediately?”

“From what the US government has been saying, all the banks currently have enough capital. In the stress tests, a worst-case scenario for the US economy was assumed to figure out how much more money the banks would need in that case. On June 8, the banks which need to raise extra capital have to tell the government what their long term viability plans are.”

“You know what? For a change, you haven’t had anything negative to say till now,” she said.

“Oh, I was coming to that. Since this is a rather complicated topic, I thought I’d explain the basics first,” I said.

“Not again.”

“I can’t help it my dear. I say it as I see it.”

“OK, go ahead.”

“Basically I wanted to say that the worst case assumptions are really not worst case. The worst-case rate of unemployment for 2009 has been assumed to be at 8.9%. In fact, as of April end, the rate of unemployment, as released by the Bureau of Labour Statistics, a government agency in the US, was already at 8.9%. Again, for 2010, the worst-case rate of unemployment has been assumed to be at 10.3%. Now, even if job losses in the days to come slowdown a little, the rate of unemployment should be at that level in the next few months. What makes the scenario even scarier is that 80% of the states in the US are already bankrupt. So they will also start laying off their employees pretty soon. This becomes even more important given that the government has been the only one creating jobs, lately. The private sector has seen major layoffs. Some 5.7 million Americans have been fired since the beginning of 2008. And remember, the government rate of unemployment is always lower than the real unemployment, which is currently estimated at 15% in the US.”

“But why is this rate of unemployment so important to the stress test?” she asked.

“For the simple reason that more job losses would mean more loan defaults, which in turn would mean that banks would need more additional capital to stay afloat. Buoyed by their results for the three months ended March, most banks are confident of being able to raise this extra money. In fact, some believe they can come up with this extra “regulatory capital” from their earnings. Howard Atkins, the chief financial officer of Wells Fargo, one of the bigger banks, recently said, “We think we already have a lot of capital and, with our earnings, we are accumulating regulatory capital at a very high rate.” Now, that is a little difficult to believe given that much of the increase in earnings for most of the banks was through accounting tricks, which cannot be used over and over again,” I said.

“Interesting. Any other assumption that you would like to challenge?”

“Oh yes. It has been assumed that in a worst-case scenario, home prices will fall by 22% in 2009. The Case-Shiller Index, which is a measure of which way the real estate prices in the US are headed, tells us that prices have fallen 5% in the first two months of 2009 (the latest data available). Other than this, a large number of states had put a moratorium on the foreclosure loans that borrowers had defaulted on. In the months to come, it is expected that the number of foreclosures will go up dramatically. As more foreclosed property hits the market, real estate prices will crash even more. Given this, an assumption of 22% fall for real estate prices for the entire year is really not the worst-case scenario. Also, remember that home loans in the US are non-recourse loans, meaning the lender can seize only your collateral, which in case of a home loan is the house bought with that loan. The lender cannot seize the other assets of the borrower or the money lying in his bank account. So if prices continue to fall, people who had bought homes as investment will default more. This would mean more home loans would go bad for banks and financial institutions.”

“Hmmm… So the pessimist is back.”

“What you call pessimism I call realism. And I am not done yet. The stress tests assume that credit card defaults will touch $82.4 billion by end-2010, which is again not the worst-case scenario. In the old days, if the going was not good, people first defaulted on their credit card outstandings and then on their home loans. But the home loans that Americans have taken over the last few years are largely zero down-payment loans. So there is no big financial attachment to the homes purchased. This and given that home loans are non-recourse, it made more sense to default on the home loans first. But as the rate of unemployment continues to go up, the credit card defaults will go up, much beyond what has been assumed. According to Oliver Wyman, a management consulting firm, credit card losses in the US could go to as high as $141.5 billion by end-2010. In fact, most of the assumptions made for the stress test can be easily challenged and we can safely say that banks will need much more capital to survive than is being made out.”

“But, if you can punch so many holes into the argument sitting here in India, why doesn’t the US government realise all this?”

“I am sure, they do. But governments cannot always be realistic. If they had taken the real worst-case scenario, there could have been a bank run on the weaker ones. The government may have had that in mind.” 

“So what do you think will happen on June 8, when these banks have to submit their plans?”

“Well, I don’t have a crystal ball, but my best guess is that banks will say they can come up with the required capital from their future income and the government will agree. Yet, as James Bibbings writes in his column ‘Stressed out’, “When they say this don’t believe it. Neither Wells (Fargo), nor the government, has been able to “anticipate the worst” in the past and this time around will be no exception.””

References: 19 Stressed Banks Must Raise $75 Billion, Addison Wiggin, May 9, 2009, www.dailyreckoning.com; Stressed Out!, James Bibbings, www.commoditynewscenter.com, May 6, 2009; Banks Brace for Credit Card Write-Offs , Eric Dash and Andrew Martin, May 10, 2009, www.nytimes.com; Credit card losses are the new bad mortgages, TraderMark, www.seekingalpha.com, May 11.2009; Wells Fargo Is Broke - Poor Forecasting Slays Another Giant, James Bibbings, www.safehaven.com, May 11,2009; America, You Have Been Outright Lied To! Bamboozled! Swindled! Hoodwinked! The Worst Case Scenario, Reggie Middleton, May 12, 2009, www.safehaven.com.