Zombie Dance Party: Q2 Update and Stress Test Preliminaries

Earlier today we announced the preliminary Q2 stress test results for all US banks.  Gretchen Morgenson gave us great ink yesterday in the NY Times:  “What the Stress Didn’t Predict.”

The preliminaries are of interest because they exclude the large banks and thus give you a regional/community bank view. In Q2 2009 the preliminary bank safety and soundness ratings calculated by the IRA Bank Monitor using the data from the FDIC indicate a dramatic climb in the stress in the US banking industry, up 23% to 6.87 in Q2 2009 (1995=1) vs. the preliminary Stress Index value of 5.57 in Q1 2009.   The rate of change in the preliminary Bank Stress Index was lower than in the previous quarter, but the absolute stress test score is at record levels.  The final industry aggregate average Bank Stress Index calculated by IRA was 1.8 at the end of Q4 2008 and 2.36 as of Q1 2009, illustrating the degree of subsidies flowing into the larger banks, as discussed below.

IRA’s unique automated system enables us to gather and process CALL reports in real time, as they become available on the FDIC CDR web facility.  This facility cuts several weeks off the wait time for the public to access FDIC data, but some of the largest banks are still not released until the FDIC releases its own analysis of the quarterly data, roughly 60 days after the quarter close.  Since the largest banks and/or the FDIC deliberately hold back the release of certain bank CALL reports until just prior to the press conference, the sample of CALL reports available via the FDIC CDR facility just prior to the FDIC press conference allows us to view the rest of the US banking industry “ex-big bank.”

Q2 2009 “Ex-Big Bank”:  Less Worse Than Previous Quarter, But Still Climbing

Prior to the FDIC press conference in Q1 2009, IRA for the first time calculated a preliminary Banking Stress Index rating for the industry using the bank CALL reports that were available on the FDIC web site about 50 days after the quarter close.   This preliminary Bank Stress Index rating included over 7,000 institutions, but excluded the largest banks and therefore provided a perspective on the rest of the industry.

Based on this methodology, in Q1 2009 our preliminary snapshot of this “ex-big bank” subset of the US banking industry shown via the Bank Stress Index jumped over 100% to a whopping 5.57 or half an order or magnitude above the 1995 benchmark year which is = 1.  In Q2, using the same methodology with almost 7,000 institutions, the stress rating calculated by IRA was 6.87 vs. the 1995 benchmark year of 1, a smaller rate of increase but still a dramatic deterioration in banking industry performance compared even with the preliminary result in Q1 2009.

In Q1 2009, when IRA calculated the final Stress Index Results for the US banking industry, the average stress test score was just 2.36, reflecting the enormous public sector subsidies that are flowing through the largest US banks.  Whereas in past years the large banks have tended to skew the stress test scores of the industry higher, indicating greater stress, in Q1 and very likely in Q2 2009, when we calculate the final Bank Stress Index score for the entire industry in about a week, the results likely will be well below the 6.87 preliminary score that we are releasing today.

Q2 2009 Preliminary IRA Bank Stress Rating Grade Distribution

(*Based on preliminary data; ** Based on final data)

Source:  FDIC/IRA Bank Monitor

Based on our preliminary review of the individual bank reports, the apparent reasons for this large increase in stress are the number of banks that delivered deteriorating performance in terms of realized losses or charge-offs and/or bank efficiency.[1]

We see indicators of a continued migration of banks from the A+ range where stress fall below the index benchmark year of 1.0, into the A range, indicating more banks are now feeling the effects of economic conditions regardless of the business practice models they’ve had in place.

In prior quarters, banks wound up getting “F” grades because they were barely making money; that is, they had small but positive net incomes that produced ROE’s sufficiently below industry averages to indicate elevated business operating stress.  A lot of these institutions were suffering due to mark-to-market accounting, goodwill write-downs and other ROE issues.

The trend in the US banking industry appears to be shifting to realized losses and degraded operating performance as measured by efficiency.   The distribution of ratings from Q1 2006 through Q1 2009 is shown in the table below.

IRA Historical Bank Stress Index Distributions

Based Final FDIC Master Files

Source:  FDIC/IRA Bank Monitor

Charge-offs and degradation of bank efficiency seem to be the leading factors in higher Bank Stress Index scores.  Notice, for example, that the number of banks rated “F” in Q1 actually fell vs. year-end 2008, but based on preliminary Q2 results, the number of banks rated “F” by the IRA Bank Monitor is already above the Q1 levels based upon the final data from the FDIC.

Or as we said to Larry Kudlow today on CNBC with Dick Bove, there is no connection between the equity market valuations of financials and the fundamentals.

— Chris

[1] The standard FDIC definition of the efficiency ratio equals operating expenses divided by the sum of noninterest income and net interest income.