Stress Test Zombies: Not Too Big To Fail? Tough Tootsies Little Banks!

Further to our post yesterday about the Stress Test Zombies (“19th Nervous Breakdown: TBTF Stress Test Banks”), below is our latest comment about bank stress tests and other such nonsense.  It is not that we do not wish to be helpful, you understand, but if our public officials are not going to say and do things that are credible, we have a duty to say so.  Am I right?

Anyway, one thing I did not put in the post but which definitely deserves some time on the BP is the shenanigans by certain members of Congress around the bank bailout boondoggle.  Like Rep Maxine Waters (D-CA) and her buddies at OneUnited Bank. A mess.  The bank had -7% TCE at year-end 2008.

Click here to see the Q4 2008 profile for OneUnitedBank, which we rated “F.” Now just imagine the entire Congress conducting the bailout of the large banks with the same diligence and clarity of purpose displayed by Ms Waters with respect to OneUnited Bank.  Now you know why we sound a little testy when we write about the zombie dance party in Washington.   Enjoy.

The Institutional Risk Analyst

March 13, 2009

Last week, we learned from Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner that Washington lacks the guts to fix the problems eating away at the US financial system, at least so far. So large are the derivative-fueled losses and so majestic the collective incompetence of the Congress, regulators and the Sell Side dealers on Wall Street in enabling these losses, that the judgment of the single party state called Washington is to simply hide the problem under an ever-widening public TARP.

Now, in most parts of the country, a TARP is used to cover unneeded things, usually a pile of stuff nobody wants, far in the back yard. This is essentially the plan articulated by Bernanke and Geithner: Buy the bad assets, invest more capital in the zombie banks, and hope asset prices eventually recover. This is not a plan to do anything but buy time and extend losses. The scary part is that nobody else in the Obama White House seems to know enough about finance to argue the point.

As we told the subscribers to IRA’s Advisory Service, the Fed and Treasury have created a rule without reason, a ridiculous standard that only ensures the unsoundness and instability of the US financial system. Apparently, banks that fail the Supervisory Capital Assessment Program stress test will not be broken up as required by law, but instead given more capital at taxpayer expense. This is the solution to the financial crisis embraced by President Barack Obama. There is no market discipline, no bad results for the bond holders who stupidly funded these giant derivatives-driven, risk-creation machines.

Below is our best guess as to the identity of the 19 or so banks that are part of the stress test process. We hear in the community that these 19 domestic financials are the de facto “Too Big Too Fail” banks, which of course means that all other banks are not part of the group. We should probably add American International Group (NYSE:AIG) and the Depository Trust and Clearing Corp, which owns a Fed member bank, to the TBTF list.

Notice that there are no foreign-owned banks as part of the stress test group. Note too that there are several banks on the list that are rated “F” by the IRA Bank Monitor as of year-end 2008. These negative ratings are driven both by negative ROEs as well as above-average realized credit losses.

We see two issues facing Bernanke, Geithner and the Obama Administration when it comes to the cowardly “feed the zombies” approach articulated last week. First, it is not sustainable financially and must eventually be changed because of funding constraints. And two, the policy of subsidizing the bond holders of the largest banks is unworkable politically and must eventually also be changed to conform with domestic political reality. That’s right, at some point the Obama Administration may need to choose between our foreign creditors and American voters.

The Bernanke/Geithner approach to not dealing with the financial crisis amounts to a hideous public subsidy of the global transactional class, a transfer of wealth from American taxpayers to the institutional investors who hold the bonds and derivative obligations tied to the zombie banks, AIG and the GSEs. All of these companies will require continuing cash subsidies if they are not resolved in bankruptcy.

Remember that the maximum probably loss (“MPL”) shown in The IRA Bank Monitor for the top US banks with assets above $10 billion, also known as Economic Capital, is a cash number representing the amount of incremental capital the banks may require to absorb the losses from a 3-4 standard deviation economic slump, such as the one we have today. If you include the subsidy required for the GSEs and AIG, the US Treasury could face a collective funding requirement of $4 trillion through the cycle. Do Ben Bernanke and Tim Geithner really believe that they can sell such a program to the Congress? To put it in perspective, the $250 billion in the Obama Budget for additional TARP funds will not quite cover Citigroup (NYSE:C).

Bottom line: The policy decision articulated this week by Bernanke and Geithner represents the largest transfer of wealth in American history, yet no legislation and been passed and no meaningful debate has occurred. The biggest danger facing the markets is that Ben and Tim still do not seem to have a clue what to do about the big banks — other than to write more checks against the public trust. The conflict over this decision to pass the cost to the taxpayer, between the Fed, Treasury and the Congress, on the one hand, and the Wall Street dealer banks is staggering, yet nothing is said in the Big Media.

The Fed and Treasury claim that situations like C and AIG cannot be addressed idiosyncratically, to paraphrase our friend David Kotok, but the reality is more complex. Fact is, the Sell Side dealers have leveraged the real economy via OTC derivatives to such a degree that bailing out toxic waste sites like AIG, several large Euroland banks and the world of structured finance could cost trillions of dollars. That is the true cost of the crisis. The only issue is whether we recognize it directly, via a public resolution, or hide the costs via public subsidies and future inflation.

If we wish to preserve some semblance of market discipline in the US, an alternative strategy must be found. Until somebody, somehow gets to President Obama and effectively refutes the self-serving argument of the Fed and Treasury that we can’t resolve C or AIG, the cost of the zombie dance party can only grow. The way you end the need for public subsidy is by resolving these firms via a restructuring and forcing the bond and equity holders of the bank’s public parent company to absorb the cost of marking assets to market. If we establish a hard rule regarding solvency and break up rather than recapitalize zombie firms, then we have started to apply a real solution.

Mark to Market Accounting

To answer your many questions about our view on mark-to-market accounting, the damage – or adjustment – is done. We opposed the way the return to FVA was handled because it was too much driven by accounting and not enough other issues around business reporting. We need to be cognizant of not just accounting goals and rules, but also business reporting, investor relations, legal and business issues in order to assess this question.

We like the idea of more disclosure. We just think that swings in short-term prices observed by M2M need be confirmed by time, then you begin to convince us that the observed average price over a period of time equals value and should affect assets or income.

We submitted individual comments on same to The Financial Crisis Advisory Group (FCAG) of the IASB and FASB. Members of the financial community who care about M2M should attend the open meetings hosted by FASB and submit comments to the FCAG as well.

When we stated on Bloomberg TV a while back that M2M was an attempt by the accounting industry to deal with the growing opacity and deliberate inefficiency of the OTC world, our friend David Reilly ran downstairs and declared our conversion to the forces of good “on the road to Jerusalem.” Fair enough. Our recommendation is that we continue to report M2M price swings, but be more reasonable when it comes to writing down performing assets vs. income and charging-off credit exposures that are paying as contracted. The inclusion of something that resembles an impairment test may be part of the eventual solution.

Questions? Comments? info@institutionalriskanalytics.com

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