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Sunday, May 10, 2009

Grades Are In -- A Banker's F

On May 7, 2009, the Federal Reserve officially released the results of the so-called stress tests applied to America's biggest banks. If you believe the Fed, the tests were intended to identify remaining vulnerabilities in banks to additional declines in the overall economy so they can shore up any minor problems and install confidence in the markets that the system is sound and capable of providing credit to businesses and consumers.

So what were the final grades? Officially, ten of the nineteen banks analyzed were found to be in need of additional capital. Not "insolvent" mind you, not in danger of an "imminent collapse", just in need of a few billion here or there so they can be counted on to lend money even if employment or GDP drop a few more percentage points. The banking equivalent of a little repointing around a few loose bricks. Sounds like the equivalent of a Gentlemen's C.

That's what you might believe from the commentary on the results from the Fed and Treasury, who tried to dance a fine line between the forgiving but stern dean clearly telling the struggling students they need to endeavor to improve their grades "or else" without panicking their parents into pulling them out of school entirely. If you analyze the true financial position of the ten in trouble and the circular logic trapping the Fed, the Treasury and (by proxy) American taxpayers into a never-ending chain of conflicting interests and self-defeating financial positions, the real grade for these ten has to be a Banker's F.

The Mechanics of Banking

Traditional banks make money by

1) attracting deposits (counted as liabilities on their books) by paying interest
2) lending money (counted as assets on their books) and collecting interest from borrowers
3) using interest payments from loans to pay interest owed to depositors
4) pocketing the difference

They also make money by charging interest rates on credit cards that make loan sharks envious, charging huge fees for using foreign ATMs, paying bills late or overdrafting checking accounts, but that's not really germane to the analysis here (smile).

If the bank is successful at managing this delicate balance and can prove it can make money with its practices, the bank can attract additional capital by selling shares to investors then loaning out a fraction of that additional money like they do the deposits to start the cycle and make even more income.

An extremely conservative bank nervous about having enough money on hand for withdrawals by depositors would keep virtually all depositor dollars in the vault but would then never make any additional money to pay the depositor's interest and would quickly go out of business. A bank that lent every depositor's dime out to borrowers would not have enough on hand to satisfy withdrawals by depositors which would quickly destroy any confidence of depositors to put their money in the bank and it would collapse.

The trick to banking is deciding how much to lend and how much to keep on hand. This balance is usually represented as the reserve ratio, the fraction of assets on hand (numerator) versus deposits (denominator). The REAL trick of banking is that this ratio is not only critical to the profitability of individual banks but it has a huge impact on the entire economy because the lower the ratio, the more fiat money is being created out of thin air for the economy to use. If the ratio isn't low enough, the money supply cannot keep up with population growth, much less economic growth. If the ratio is too low, an excess of fiat money beyond what's needed to keep pace with population growth and "safe" economic growth will be created, causing the excess to chase phantom profits and pipe dreams, producing inflation and/or bubbles in specific asset classes.

This all sounds relatively scientific but the usefulness of the ratio as a guardrail is only as good as the quality of the assets used in the numerator. Therein lies the flaw with the reserve ratio rule, the recent track record of financial regulation and the attempt to use stress test results to instill confidence in the system.

Truth or a Really Good Story?

The key takeaways from the release of the stress test results were that

* all of the nineteen banks tested proved to be solvent in the current economic state…
* BUT that ten of them would technically fall short of the desired reserve ratio…
* IF a few key economic statistics worsened by X amount

One of the key variables used in the model was unemployment which was tested at a worst-case level of 10.3 percent. How much of a "margin" is a 10 percent worst-case estimate when unemployment is already at 9 percent and has jumped 4 percent in one year? Higher unemployment will produce lower household incomes, more mortgage defaults and lower demand for homes, all of which will drastically impair the value of major asset classes counted in the numerator of these banks' reserve ratios.

Another key limit tested by the analysis was a drop in home prices by 22 percent. This actually sounds like a much more severe worst-case test than the 10.3 percent assumption on unemployment but it likely ignores a major "location, location, location" factor of the housing bubble and the compound fraud in mortgage backed security ratings and credit default swaps that fueled it. There are several areas of the country which saw home prices jump over one hundred percent over the past six to eight years. As starry-eyed homebuyers and speculators began chasing ever-rising prices, huge numbers of loans were issued against those inflated values, then fed into the MBS wholesale chop shop to be carved up and traded as high-quality rated securities among investors which then became assets on the banks of books to fuel additional fiat money expansion which expanded demand for housing in a circular loop.

The real point is that large numbers of empty homes in bubble markets won't simply drift back down to "normal" values. They are likely to decline far below that -- even to zero -- as vandalism, damage from the elements and failed models of ex-urban living drive future buyers elsewhere. In essence, what has to be modeled is not the aggregate value of all homes but the value of homes directly involved with the most risky mortgages that will default and the chain of mortgage backed securities and credit default swaps piled on top of those bad loans. That drop is very likely to be far greater than a mere 22 percent, again rendering the stress test results meaningless.

Circular Logic / Circular Firing Squad

The pattern of intervention established so far by the Treasury and Federal Reserve Bank renders the entire stress test effort pointless as a confidence building exercise. As the PR team hit the news shows to promote the test results, a subtext of the message sent to banks and the public was basically that no banks were found to have gaps that reasonable efforts in the private sector could not fill and therefore once the banks plug those gaps, that's it -- no more money from taxpayers. Unfortunately, nearly two years of haphazard public policy and private, inscrutable decision-making at the Fed have firmly planted the following ideas in the minds of bankers, investors and the public:

1) housing prices cannot be allowed to find a new floor for fear of triggering more collapses in the value of mortgage backed securities on the books of banks worldwide

2) further drops in MBS values held by banks cannot be allowed for fear of rendering many large banks insolvent under normal reserve ratio requirements

3) banks failing to meet reserve ratio requirements will further tighten credit to businesses and consumers, further accelerating economic contraction

4) banks rendered insolvent by collapsing MBS valuations and direct mortgage portfolios will trigger further payments of credit default swap contracts in amounts that none of the counterparties to those swap contracts can actually fulfill

5) the Federal Reserve is willing to print as much money required -- devaluing the dollar -- and hand it over as many formerly-non-member institutions as necessary to prevent a collapse of non-member institutions from exposing the insolvency of its members

6) the Treasury is willing to inject as many taxpayer dollars as needed to into failing automakers to defer massive job cuts that would deepen and prolong the economic slowdown

7) the more the government borrows to drop into bailouts, the more reluctant foreign holders of Treasury investments become of buying more US debt, reducing demand for Treasuries, which lowers Treasury prices which poses interest rate pressures on an economy already critically dependent on low interest rates for any recovery / expansion

8) to prop up the value of Treasury bills to satisfy foreign investors, the Fed will do everything in its power to maintain low short term interest rates, punishing savers and encouraging more to attempt to invest in stocks, commodities or derivatives to combat the risk of inflation produced by printing trillions of dollars

What are investors, bankers and consumers / taxpayers to conclude from this list of self-defeating policy goals? First, these banks ARE still in trouble and WILL need more capital to survive. Second, by failing to force divestitures and downsizing of the trouble firms as part of the risk remediation, the government is allowing them to remain "too big to fail" which means the government WILL have to bail them out when the time comes. Third, by leaving these banks TBTF, the government is encouraging private investors to keep their capital out of the banks so the government can cover the losses until a point of equilibrium is reached. Finally, these philosophically incoherent goals are likely to produce economic statistics and performance like few have experienced or can predict. The level of risk facing every type of investor has never been higher and has room to grow.