After many delays and rumors, we finally got the results of the government’s bank assessment tests late last week. The results were a little anti-climactic: 10 of the 19 banks will be required to raise $75 billion to cushion against up to $599 billion in additional losses over the next two years. Bank of America, at $34 billion, and Wells Fargo, at $13.7 billion, will need to raise the largest sums. Citigroup, because it’s getting credit for prior plans to convert its preferred equity into common shares, will only have to raise $5.5 billion.
The bigger story, though you wouldn’t know from the enthusiastic reaction from Wall Street, was the way the tests were conducted.
You already know that the test methodology revealed that the banks themselves ran the scenario analysis on their balance sheets. Federal regulators submitted loan loss estimates for various loan types and supervised the process. Now we’re getting reports that bank executives were still unsatisfied with the level of scrutiny they received.
According to the Wall Street Journal, Federal Reserve officials "significantly scaled back the size of the capital hole facing some of the national’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining." Bank of America executives were allegedly shocked at an original capital deficiency of over $50 billion while Citigroup originally faced a sum of roughly $35 billion. About half of the banks pushed back, arguing that the Fed wasn’t fully accounting for earnings growth as revenue expands and costs are cut.
As far as the difficulty of the tests, Treasury Secretary Tim Geithner likes to point out that the 9.1% total loan loss estimate, part of the ”adverse" economic scenario, is worse than the peak losses seen during the Great Depression. While this makes for great headlines and lends some credibility to the tests, the underlying loan loss rate on first-lien mortgages (8.8%) may not be adequate. According to the latest data on delinquencies from the Mortgage Bankers Association, the percent of loans that are either in foreclosure or are at least one payment past due is nearly 12%. This is up from 10% at the end of September, and 8% at the end of 2007.
Moreover, on Friday, government-controlled mortgage giant Fannie Mae said it is experiencing increased delinquencies and default rates on its entire loan book, "including loans with lower risk characteristics" as troubles spread well outside subprime loans to the Alt-A and Prime credit tiers.
What’s scary is that these borrowers…
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What’s scary is that these borrowers are mostly responsible types that are probably eligible for assistance through the Obama Administration’s mortgage modification plan. Some are being affected by job loss. But my hunch is that more than a few — given the contemporary attitude of viewing a home as a short-term investment to "flip" instead of a long-term source of shelter — are just walking away from a bad decision.
Real estate researchers at Zillow.com just calculated that 22% of all American homeowners owe more than their house is worth. With the big increase in foreclosure sales weighing on prices, this percentage will only grow this year. Add increased job losses, and you have a recipe for more mortgage defaults across the credit quality spectrum.
And of course, unless default rates start improving, which requires progress on the employment front, the stress test results will start being seen for what they are: A political PR stunt. Don’t get me wrong, I think Geithner made the right move as we certainly need to know the capitalization hole. As we’ve already seen in the rally out of the March lows, in an economy, confidence is contagious: Optimism over the profitability and solvency of banks encourages investment, creates big percentage moves in beaten down bank stocks, boosts broad market averages, helps the banks recapitalize, and boosts household net worth which encourages retail spending.
The trouble is, the credibility of the stress tests and the Obama Administration are now intertwined. If the former is shown to be a farce, and the market takes another swoon, the latter will have a tough time being believed by Wall Street. Let’s hope that doesn’t happen.
The Bottom Line
The bottom line is that the stress tests were like a teacher asking kids to create a test, then take it and grade themselves. The teacher, in this case the Fed and Treasury, then came along and just checked the math. It’s an exercise that needed to be done, but it really solves nothing for the most troubled banks.
While the Fed said U.S. banks need $75 billion in new capital as reserves, the IMF has estimated they banks worldwide need more than $800 billion and more pessimistic researchers, like Nouriel Roubini, believe the final number will be well over $1 trillion. That’s a huge spread, which only goes to show how varying assumptions about future growth, unemployment and losses affect the models.
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This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.
