What Is All The Stress With The Bank Stress Test?

There has been a lot of buzz lately regarding the US government’s stress test on the banks. This article with the tongue twister title will sum up what is it, what it really means for investors, and how concerned we should be about it.

What Is It?

The test is an analysis of the assets on the books of 19 of the largest U.S. banks implemented by the US Treasury, by applying scenarios that simulate the impact of a deeper recession. So far, the inputs to be applied in the test that were leaked to the media include the following assumptions (but there are likely more):

– Unemployment goes to 10.3%.
– 8.5% loss ratio applied for first lien mortgages over two years.
– 8% loss on commercial and industrial loans.
– 12% loss on commercial real estate loans
– 20% loss on credit card portfolios.

The banks have to show a 3% tangible capital ratio at the end. The test results could force financial institutions that are deemed “at risk” to set aside more, or raise capital, to cover future losses.

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Why Are They Doing It?

The Treasury said it will help identify the institutions that are at the greatest risk of failure if the recession deepens. Administration officials cite the effort as an attempt to avoid nationalizing banks, by targeting aid to the banks that need it most, ensuring they can lend money. Although officials mentioned that most banks are considered well capitalized, the uncertainty surrounding economic conditions is hindering them from attracting private capital, reducing their ability to lend money.

Apart from the government being able to use the results of the test to prepare and plan, we should note that the test is also centered on the credibility of the US officials. Since the government has invested a monumental amount of public tax dollars, there is pressure to put as positive a spin on their actions to rebuild confidence in the financial system and Washington. Secretary Tim Geithner had stated that the banking system has enough capital, so they want to show that as well. If the tests show otherwise, it will appear to the public that they don’t know what they are doing and always assess situations incorrectly.

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Why Is There So Much Stress Surrounding This?

The results of the bank stress tests are not in yet, so everyone is guessing as to what the results will be, and what will happen after that. Its human nature to be stressed out because of uncertainty. And the public is repeatedly reminded by the media, about how uncertain things are. The banks that have been rumored, estimated, and suspected by many analysts that might fail or fall short in the test (and would need to raise capital) have been named to be Citigroup (C), Bank of America (BAC), Bank of New York Mellon (BK), Fifth Third Bancorp (FITB), KeyCorp (KEY), PNC Financial Services (PNC), Regions Financial Corp (RF), SunTrust Banks (STI), and Wells Fargo (WFC).  However, these are just the findings of the analysts’ scenarios, which I usually don’t put much faith in (as they also don’t tell us what inputs or method they used so that we can compare them with our own).

Whether the banks fail or fall short in the tests depends on if the government allows existing reserves to count, and if they allow some level of normalized earnings for the next two years. It is likely that some of the banks will have some level of earnings within the next two years. Some will have a higher level of earnings while others may not have any at all. However because this is a standardized test, they will make no differentiation among the banks. If reserves and earnings are included, then it has been estimated by analysts that only Citigroup and Fifth Third need to raise capital.

The government has also focused on one metric, level of tangible common equity. If banks do not pass their criteria, it is highly possible that they will force banks to raise equity capital, even if the bank does not feel it is in the best interests of the company or shareholders. And if they can’t raise capital, the government may force them to sell more preferred shares (likely at juicy yields of 9%!), that will also be convertible to equity as well.

All this causes fears of banks not being well capitalized to resurface again, which the public interprets as being unstable and close to insolvency (nationalization fears as well). The government has made it clear that it plans to backstop the banks, and Geithner has said the government would be a last resort investor if the banks in question can’t raise capital.

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What Does This Really Mean For Investors?

For investors we by-pass all the circus and take the test and its results for what it is. Its the government’s own scenario analysis, just as we have our own scenario analysis work before we invest. Investors usually perform a range of scenarios with all kinds of criteria and inputs. This would include multiple scenarios consisting of positive, nominal, below average, negative, negative, and worst cases. The government’s test is just another one and it falls somewhere in that range. Investors will need to look at the Treasury’s assumptions when the test results are fully released.

The main problem with the stress test is that it is interpreted as being the most valid test of financial condition for the banks, when it clearly isn’t. Its almost certain that the government’s results will not mention what kind of margin of error they may have in their findings either. People will have no way of knowing how accurate their testing may be.  Even if they did give a gauge of what they think their accuracy is, we cannot assume they are giving a non-biased assessment.  Given the complex nature of the many of the assets such as the mortgage-backed assets that their models are analyzing, it would be difficult that any standard model is able to forecast and identify potential problems accurately. Even the banks’ own models were different and unable to accurately forecast, which is why so many of them got the carpet pulled out from under their feet in the first place. Its also easy to see that it would be difficult to accurately gauge the level of risk there contained within in a bank’s loans portfolio. Investors need to assess the methodology they used and see if it is of real concern or not to each specific bank. Standardized testing doesn’t always give a true or accurate assessment of the situation, especially when all the banks did things differently and had their own ways of operating.

The officials have also been focused on the levels of tangible common equity and Tier 1 capital ratios. As mentioned it is possible that banks will be forced to raise equity capital. This is not favorable for the investor as the current environment for raising capital in the markets is difficult. Investors are not willing to pay much for equity in this type of economic situation. The low trading prices means they can only offer at most the current unfavorable market price. In addition it will cause dilution for the current shareholders. Dilution means that the shares are worth less, because the profit pie is split among even more people. This also has other negative implications on the bank as well.

Circulated widely has been Buffett’s interview and comments on Wells Fargo and banking in general. He highlights this issue quite clearly in the interview.

“I don’t think it’ll hamper their earnings. But if you make them sell a lot of common equity it would kill the common shareholder. It wouldn’t increase the earning power in the future, and it would increase the shares outstanding. Wells, if they want another $10 billion in common equity or something like that in Wells, they’ll have it in a very short period of time at this dividend rate. [In March, Wells cut its dividend by 85%.] Wells will be piling up the equity while they’re paying nominal dividends. They could afford to pay the old dividend. But since they won’t be paying the old dividend, that’s $4 billion a year or something that they’ll be adding to equity.”

Although the Treasury has decided to focus on one metric in particular, investors need to decide what metric(s) to focus on for themselves, just as Warren Buffett does and constantly reminds us. To focus on tangible common equity, might be suitable for the government’s purposes, but not necessarily for ours. We keep our own separate and distinct scorecard. Investors need to remind themselves to be business minded. Stocks are an ownership share in a business. Whenever an investor thinks about a business, we focus on how it makes money, among other things. Buffet also comments on that.

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.“. Basically, if you were to open your own bank, that’s the core of how you would make your profit.

He continues to point out how people in general are confused by the money from TARP and how it is used by the banks (using Wells Fargo as the example).

And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently. As we can see different banks do things different, so this standardized testing can’t be the “be all” analysis for financial condition. it is just scenario analysis.

Buffett also highlights another metric in particular for evaluating a bank.

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.“.

Again this is one metric, to be used in combination with other metrics.

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At the end of the day, we should take the government’s scenario results into account, and factor it into our investment analysis. But we shouldn’t allow their assessment to make the investment decisions for us. We have to depend on our own homework, and make sound decisions based on our own findings. When it comes down to it, the government isn’t looking out for the individual investor, they are looking out for themselves.  Ditto for the analysts (their findings are put in the news, which promotes their own name).

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Below is the link to the interview with Warren Buffet regarding Wells Fargo and the banking industry. I encourage all my readers to add whatever new information learned from Buffett to your mountain of knowledge:

http://money.cnn.com/2009/04/19/news/companies/lashinsky_buffett.fortune/index.htm

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Feel free to post questions, comments, or topic suggestions.

Thanks & Happy Investing!

The Investment Blogger © 2009

Author: The Investment Blogger

I’m a private investor, who developed the “function-centric investing” paradigm. I am an investor who blogs a little here and there, rather than a blogger who invests a little here and there. I'm passionate about investing and sharing investment knowledge!

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