Stress Tests & Tim Geithner’s Bar Mitzvah

May 5. 2009

Thursday is stress test day. Not on a treadmill, but it may just as well be so.

We are now going to add some Geithner-Bernanke-Summers-esque formula of bank strength or weakness assessment to an already long list that includes Tier 1, Tier 2, TCE, and CAMELS and BOPEC. Tier 1 and 2 capital measures are released by banks in their public disclosures. TCE (tangible common equity) can be calculated from public documents.

Two other ratings are kept confidential. They are critical to regulators; and, in an affront to democracy and transparency, we are not permitted to learn them. Banks are not permitted to reveal them and the penalties for doing so may be harsh. Welcome to modern banking in America.

The BOPEC acronym stands for the five key areas of supervisory concern: the condition of the Bank Holding Company’s (BHC) bank subsidiaries, other nonbank subsidiaries, Parent company, Earnings, and Capital adequacy. BOPEC ratings are assigned according to an absolute scale, from the highest rating of one (indicating strong performance) to the lowest rating of five (very poor performance).

CAMELS ratings are assigned to banks within a bank holding company. Since the condition of a BHC is closely related to the condition of its subsidiary banks, the off-site BHC surveillance process includes monitoring recently assigned CAMELS ratings. The CAMELS system is used by the three federal banking supervisors (the Federal Reserve, the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient summary of bank conditions at the time of an exam. The acronym CAMELS refers to the six components of a bank’s condition that are assessed: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and a bank’s Sensitivity to market risk.

For a critical discussion of the coming stress test environment see Dick Bove’s guest commentary on Cumberland’s website: . We thank Dick for giving our readers access to his essay. We agree with him.

We also thank the San Francisco Fed Research Department for their assistance. Readers may wish to consult the 2009 Economic Review. A paper by John Krainer and Jose Lopez excellently sets forth the variability of regulators’ ratings over time. I wonder if Treasury Secretary Geithner read it. I also wonder if it shouldn’t be mandatory reading for anyone hired in any bank regulation capacity. The authors note how the goal of FIDICIA (acronym for Federal Deposit Insurance Corporation Improvement Act) was to (1) “assure the least-cost resolution of insured depository institutions that were sufficiently near insolvency” and (2) “improve bank supervision.”

Dear reader: how would you rate the government on their success? What makes you think any new systemic regulator can do any better? Isn’t it time we finally let some sunlight fall on this mess? Why are we persisting with a sequence of questionable programs? The next ones will be TALF and PPIP. See:

Let’s add a specific note about commercial real estate and bank holdings of commercial mortgages. We think this is the next shoe to drop. In fact, it may become a boot!

Banks and insurance companies hold billions in commercial mortgages. Unlike residential housing loans, these mortgages are not heavily securitized. And they are not marked to market on the bank’s balance sheets. The securitized version is marked under the new FASB rules, but if the loan is held by the bank a different set of rules is applied. The banks reserve for expected actual loan losses over the future 12 months (four quarters) and update those reserves quarterly when they report earnings.

We may soon find out what the stress tests will tell us about this asset class. Or it may be hidden from us, as are the key ratings or BOPEC and CAMELS. If it is hidden, it should be worrisome. Transparency is something that gets lip service in Washington, but somehow doesn’t get implemented into credible policy.

There is a falling price level in the commercial real estate (CRE) market. It is a national problem and it is accelerating to the downside. Furthermore, CRE lacks the political constituency that surrounds residential housing. No Washingtonian would sponsor foreclosure protection for a mall developer. That means market forces will drive the price level for CRE.

Those prices will be influenced by rising vacancy rates, which continue unabated nationally, coupled with the major upheaval occurring in the automobile industry. The latter is important because the franchise agreements that protect individual auto dealers are going to be broken in bankruptcy. That means many dealers will close. Some already have.

Picture CRE with thousands of empty auto dealer facilities lining our highways around the United States. These are splotches of commercial space that will be empty for years. Financing to save them is nearly impossible under the present banking industry status. And the demand for that space is negligible.

All this weighs on CRE. We think the best metaphor for CRE nationally lies in the three-decade-old picture of Houston with its “see-through” buildings of the mid-‘80s energy bust. But that CRE bust was limited in geography to the nation’s oil patch. The present CRE is truly national. Want stress tests to tell you something, Mr. Geithner? Give us the details on this sector and each bank’s exposure to it.

A second disturbing aspect of CRE lies in the existing loans and projects. A client case study is appropriate here. We will call the client Mr. K. He has a project about to be completed. It will convert to permanent financing. His cost is $5.7mm. He has a first-rate tenant for a ten-year triple net lease. In the old days he could easily get credit insurance or enhancement for the lease payments, to give additional security on the mortgage. Those days are gone.

He was set to borrow 75% of his $5.7 million cost. Now the bank wants a new appraisal under more stringent lending rules imposed by regulators. The new appraisal reflects a value estimate for $4.7 million even though the cost is $5.7. The bank will now lend only 65%, not 75%. This is an actual example of the new paradigm in CRE

This paradigm shift anecdote demonstrates how the deleveraging in CRE will act to intensely depress CRE prices. Our client is financially strong and will be able to fund the additional cash and complete the project. But he will be a lot more cautious about any new project and will require a higher return on equity due to these changes. A less well-managed business with weaker credit will be frozen out of the market. That weaker business may fail.

Will there be bargains ahead in CRE? Yes. At what price level? No one knows. We have seen estimates ranging from 15% down to 35% down. CRE, like residential housing, is ultimately dependent on local geography so the national number is just a composite of many local numbers.

We don’t like some of the federal government’s solutions to the financial crisis. Some of them are making things worse. The results have been delayed and dampened by politics because they are centered in the housing sector. That is about to change. CRE will be the first free-market test of an adjustment in the real estate price level; provided that the government doesn’t manipulate that sector with programs like TALF and PPIP. Remember: all government intervention and subsidy Is ultimately at taxpayer expense.

Cumberland remains underweight this CRE sector in its ETF accounts and in its selection of bond sectors.

We want to end with this marvelous quote from Congressman Barney Frank. It seems he has turned on Mr. Geithner and is defending the banks’ right to repay the TARP money, while Geithner is objecting to the repayment. In an interview with the Financial Times (April 25), Frank said: “They made a mistake with Geithner: they put him out there when he wasn’t ready. Geithner sometimes gives the impression that he’s giving a bar mitzvah speech and his voice is going to crack.”

A bar mitzvah speech from the Secretary of the Treasury of the United States of America: now that is stress test!

Many thanks to the San Francisco Fed Research Department, Dick Bove of Rochdale Securities, and to Chris Whalen, our friend and a driving force behind Institutional Risk Analytics, . Chris publishes an independent bank-rating service, which we use. Readers may wish to try it as they follow a particular bank of interest to them.

David R. Kotok, Chairman and Chief Investment Officer, email:


David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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