The Bank Stress Tests Are Counter-productive (published in May of 2009 in the SB News Press)

For local investors who own stock, bonds, or preferred stock in the one of the nineteen major banks subjected to the government’s bank stress tests, or for shareholders, depositors or potential borrowers of any of our local banks, there are broad-based implications.  While I understand the government feels the need to know which banks are healthy and which are not, I do not believe that setting arbitrary conditions and then forcing the banks to comply with them, is going to help the financial system or our economy. In fact, these stress tests will likely have the opposite effect.

Your money is safe!

First and foremost, and regardless of the results of the stress tests, the FDIC (Federal Deposit Insurance Corporation) covers deposits in member banks, up to $250,000 through the end of 2009 (at least), and no depositor has ever lost a penny of FDIC-insurance funds.  FDIC insurance covers funds in deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit (CDs). FDIC insurance does not, however, cover other financial products and services that insured banks may offer, such as stocks, bonds, mutual fund shares, life insurance policies, annuities or municipal securities, although most financial institutions that offer these have SIPC or private insurance.  The FDIC also offers participating banks the Temporary Liquidity Guarantee Program, through-which non-interest bearing accounts are fully insured no matter how large the balance through the end of 2009.  (Check with your bank or visit the FDIC website (www.fdic.gov) for more detailed information on FDIC coverage.)

Stress tests

The government, by conducting stress tests on the top nineteen banks, wants to understand what the impact of a prolonged, deep recession (a worst-case scenario), will have on the top banks.  Their concern is that, if the recession deepens and they have not taken action to shore-up these banks beforehand, the entire world financial system could implode, as many of these banks would become insolvent.  While the government’s concerns are warranted, I fail to understand how these completely arbitrary stress tests are going to help us in any way. 

The way these tests work is the government, using their arbitrary assumptions, estimates what the banks’ balance sheets would look like under those economic conditions, and then calculates each bank’s TCE (tangible common equity) ratio.  The TCE ratio is calculated by taking the total number of common shares of the bank, multiplying that number by the price of the stock, and then dividing that result by the total assets of the bank.  The government wants to require banks to have a minimum TCE ratio of three percent.  Any bank determined to have a TCE ratio below three percent, given the government’s assumptions, will need to raise more capital.

The bank stress tests are the latest in a long series of actions taken by the government, which place the financial markets at greater risk.  I disagreed with the government’s decision to relax the mark-to-market rules in an attempt to improve the appearance of healthy balance sheets for the banks.  But, relaxing the mark-to-market rules has taken some pressure off of bank balance sheets, allowing banks to make more loans, which in turn should help the economy recover. The stress tests reverse any perceived improvement to the bank balance sheets by forcing them to either sell assets, or sell more common shares, to raise capital and raise their TCE ratios. 

At least ten of the nineteen banks being tested will need to raise additional capital, with Bank of America needing $34 billion and Wells Fargo needing $13.7 billion.  If banks needing to raise capital choose to sell assets, they will likely choose to sell their better-quality assets.  This means that they will get far less than these assets would bring in a better economy and at a time when the banks can wait for the best price. 

Selling common shares right now is even worse for the banks.  Not only are their share prices historically low right now, but if they sell more shares, they will put pressure on the share price, and will dilute the exiting common shareholders, reducing their ownership stake in the company.  As the share price falls, the calculation of the TCE ratio is impacted (remember that the TCE ratio requires the number of common shares outstanding to be multiplied by the current share price).  So if the share price falls, the TCE ratio falls. 

Selling more shares could cause a downward spiral of balance sheet values for the banks, and could put the entire financial system into freefall.  Worse yet, we could see runs on these banks, and possibly on the entire banking system.  When Lehman Brothers failed last September, there was a run on banks and even on money market accounts.  This is why treasuries and gold are at such elevated prices right now—trillions of dollars exited stocks, banks, and money market accounts, and was dumped into treasuries and gold.  If depositors in banks that fail the stress tests panic, believing that their money is at risk, they may line-up to withdraw their funds.  The more money that goes out the door, the more pressure on the banks’ balance sheets, fueling even more distress.

Banks that have failed the test have six months to bring their TCE ratios up to the three percent minimum.  The Treasury is offering a backstop option for banks that cannot raise capital on their own, which involves the Treasury (you and me) investing in the bank in return for convertible preferred shares (convertible into common stock) with a very expensive, 9 percent dividend.  These dividends will further drain the banks’ cash balances, further weakening their TCE ratios. 

While the government has said they have no plans to test any other banks, it is highly likely that depositors and investors who own securities in banks that have yet to be tested, will either demand tests, or will simply pull their money, with potentially devastating results.

The government used the $700 billion TARP (troubled asset relief program) to give banks excess cash so they could make more loans.  Now, by conducting these stress tests, the government is reversing all of the positive effects of the TARP, which will result in banks that cannot make as many loans because they are forced to maintain TCE ratios of at least three percent.  If the purpose of the government’s efforts is to prevent a deepening of the recession and to stimulate the economy, I do not see how the stress tests help to accomplish their objectives.

At the end of the day, I fail to understand how these completely arbitrary stress tests, which are based on assumptions that were pulled out of some economist’s hat (who doesn’t wear a hat), are going to help us in any way.  These tests are certainly not helping the banks make more loans, which is the only way we are going to get out of the financial mess we are in, and they are going to offset any positive impact we have gained through the TARP, or the relaxing of the mark-to-market rules.  I believe the economy is improving, and although we need to monitor the banks’ balance sheets, I do not believe we should set arbitrary standards for the banks, especially when those standards restrict lending and put the entire world financial system and economy at risk.