Final Thoughts Pre-Stress Test Results

In just a few minutes the results of the stress tests will be released. Rumors have been swirling around the market for weeks about what they will show. This has given the whole exercise a certain “Maxwell Smart” feel to it: “Would you believe all of the banks are solvent? No? Well how about Citigroup (C) only needs $5 billion? No?  Would you believe 10 of the tested 19 need more capital?”

It’s sort of like the Fed and the Treasury have been floating trial balloons to see how the market will react to different outcomes. Here is the latest tabulation of the anticipated results for the big 19 (from http://www.calculatedriskblog.com/) based on various press reports (leaks).

As with any leaks or rumors, I have no idea if these figures will prove to be accurate. However, let’s step back a minute and think about the overall testing process. First of all, it is nice to be doing this, but isn’t this part of the normal job description of a bank regulator, to make sure banks have enough capital if the economy turns bad?  This should be an ongoing thing, not a one-time special. I hope that we will have regular stress tests (minimum annually) in the future.

Second, while we have recently seen some encouraging news on the economy, the stress test has not been all that stressful. The baseline scenario is a joke, and the “more adverse” scenario is not worst case, but generally in line with what some of the best forecasters are expecting.

On the other hand, even if we cannot be all that confident of the absolute standing of these institutions after the results are announced, since a consistent valuation methodology has been used, the tests do give a good indication of the relative strength of each.

Third, there has not been enough effort put into this to really feel confident in the results. A total of 180 regulators went into 19 different financial institutions, or less than 10 at each, and were there for about two months. These are not exactly plain vanilla organizations; rather, they are far-flung enterprises filled with extraordinarily complex derivatives and a wide variety of other financial instruments. Hercules cleaning out the Aegean Stables by himself was a lesser task.

Finally, after the tests were done, the banks were actually allowed to negotiate the results. (”Come on, Teach, I really don’t deserve a D on the test. If you give me that, Coach won’t allow me to play in the big game on Friday night!”)

Yes, everybody will “pass,” although some will have to raise more capital. Even there it looks like they will not actually have to come up with fresh cash, but simply move some of their preferred stock into being convertible preferred stock. This sort of looks like simply playing a bunch of accounting games to me (sort of like the “good” first quarter “earnings” that the banks posted). Passing the test is like a six year old getting a participation trophy for playing T-ball — it is not a reward for true accomplishment.

Zacks Investment Research

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