Quick thoughts on the stress test and CAP

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I am on the road so I haven’t had a chance to fully detail our views or reflect on them relative to the equities. That said, here are quick initial thoughts on the stress test and CAP:

The underlying macro-economic assumptions of the stress test are not terribly “stressed”. They are more probable than unlikely:

* 0.5% GDP growth in 2010, after -3.3% in 2009 is now looking quite realistic

* 10.3% unemployment rates in 2010, after 8.9% in 2009. We have estimated, if government stability plans fail, the rate will rise to 11% in 2010)

* 7% declines in home prices in 2010, 22% in 2009 (They are down 18.8% y/y and 27% since 2006 peak, we have estimated a 2011 trough. Long term trends in home prices suggest that we will revert close to the peak levels of the previous cycle)

As a result, our initial expectation is that this will not be the last stress-test we run nor the last capital plan. This CAP plan will, like the other plans before, not resolve the problems with troubled banks. Instead, it will result in ultimately larger losses, larger Treasury issuance, larger deficits and several more weak and anticompetitive banks.

The terms on this also raise questions. I highlight two, as example.

– “Convertible in whole or from time to time in part at the Conversion Price at the option of the QFI at any time, subject to the approval of the QFI’s primary Federal banking agency.” – The investor doesn’t control the conversion, the issuer does! What kind of convert is that?

– “Notwithstanding the foregoing, if applicable, the dividend rate on the Convertible Preferred shall increase to 20% per annum on the sixth month anniversary of the issue date of the Convertible Preferred if the consent of the QFI stockholders described below has not been received by such date, and shall remain at such level until the date on which such stockholder approval is received.” – Is a contract under duress legal? It sounds like it is essentially saying “if you don’t have enough shares out to allow conversion we will charge you 20% until shareholders approve shares for their own dilution”.

– Nowhere does the plan define whether they will fill the capital hole in entirety or not nor does it define how the stress test will flow through to the banks capital needs.

– There are key capital valuation assumptions that are missing from the plan. How does a black box macro model flow through to the loss estimates? Ironically it seems we are continuing down the path that drove me to label this failed era in financial services – beginning to end – as “when models failed”.

They’ll almost certainly come back in 6 months or so for a third round run of this. In the meantime consider that last years Treasury net issuance of about $350 billion could increase above expectations of about $1.5 trillion to perhaps $2.2 or $2.3 trillion. It is enough to expect China, Japan and others to continue to purchase our debt. Will they quadruple or quintuple their purchases? What would happen if we had an undersubscribed auction? How long could we have a straw buyer bidding? What would happen to inflation expectations?

We have a viable banking system of 8500 banks. The argument that the top banks are the entirety our system of intermediation is not true, especially given the lack of capital market activity they drove through syndication, securitization and offerings. Let’s get on with it. Wipe out the bad banks today before we have to wipe out depleted government equity in those banks tomorrow. Body parts of the dead could provide life to the wounded.