Stress Test: 25-to-1 Leverage as a Healthy Bank Target?

The Stress test results are in.

Over the next few days, these pages will be dissected and analyzed for its results, correlation to reality, foibles and methodological errors.

As we noted back on April 24th, the Stress Tests were not very stressful; That pesepctive was a decidely outlier viewpoint back then. Now, it has become more mainstream, as even a WSJ headline this morning declared: U.S. Banks’ Not-So-Stressful Test.

Consider this simple fact:  Treasury and the Fed want these banks to have Tier 1 capital (common and preferred stock) equal to 4% of risk-weighted assets. In other words, 25-to-1 leverage as safe for the future.

Hence, it is not a big stretch to conclude that the entire stress test exercise is a near charade, with foregone conclusions of deleveraging banks to still wildly over-extended positions.

Recall that before the 2004 SEC Bear Stearns exemption for the 5 biggest investment banks, net cap rules limited leverage to 12-to-1 for investment banks.

Is 25-to-1 leverage appropriate for depository banks? Well, maybe before the repeal of Glass Steagal — but with today’s toxic asset laden banks, 25-to-1 seems awfully friendly.

Why the generosity? According to Bloomberg, its to allow the banks to “grow” their way out of the mess through earnings. Instead of being an honest broker of the banks conditions, the Treasury Department is now a shareholder and cheerleader for bank profitability:

“Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s “lost decade” of the 1990s: earn their way out of trouble.

The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money. That compares with the hundreds of billions of dollars seen by outside analysts, including the International Monetary Fund, and takes into account banks’ projected earnings over the next two years.”

What a horrific idea.

Put on your rally caps, Uncle Sam is in da house . . .

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Previously:
Stress Test: Not Very Stressful (April 24th, 2009)
http://www.ritholtz.com/blog/2009/04/stress-test-white-paper/

Stress Test — or Reality Check? (May 1st, 2009)
http://www.ritholtz.com/blog/2009/05/stress-test-or-reality-check/

Sources:
U.S. Banks’ Not-So-Stressful Test
Peter Eavis
WSJ, May 8, 2009
http://online.wsj.com/article/SB124174706382899483.html

Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings
Rich Miller and Matthew Benjamin
Bloomberg, May 8 2009
http://www.bloomberg.com/apps/news?pid=20601087&sid=aff8iC.Mwg1U&