From certain quarters, reaction to the stress test results is utterly predictable
tâs no secret I believe the governmentâs just-completed stress test of the big banks was beside the point, and only served to hurt bank investors, and complicate a financial mess that is complicated enough already, thanks very much.
First, the tests themselves were just a crude re-run of the more tailored tests regulators already routinely run in the course of overseeing the industryâso they didnât tell regulators anything that they didnât already know. Worse, they were rigged. The government knew that for the âtestsâ to be âcredibleâ theyâd have to show that multiple institutions needed new capitalâwhether or not those institutions really did. Thus shareholders have been brutally diluted, all for the benefit of the political theatre cooked up by the president and his advisers.Ă
Even more unfair, the countryâs other, 8,000 or so smaller, un-stress-tested banks havenât had to go through this particular wringer, and their shareholders havenât been forced to swallow a slug of dilution.
Iâm at a loss to understand why the government is so intent on abusing bank shareholders based on a set of bearish economic assumptions that, by the governmentâs own admission, are far-fetched. It adds up to a ham-handed intrusion by the government into the private markets by a president who simply wants to show he is attacking the âproblem.âĂ
The likely result of all this? Just as in the last recession, the big banks will emerge overcapitalized, over-reserved, while their shareholders have been unnecessarily diluted.Ă Itâs a disgrace.
But as unhappy as I am about the stress test, Iâm even more shocked by all the commentators who dismiss the test results because they believe it wasnât stressful enough. Some of these people simply believe the U.S. economy is headed into a death spiral; no how matter how bearish a given forecast is, theyâll tell you itâs not bearish enough. Others have lately built a nice business for themselves by being relentlessly, flamboyantly negative. Still others simply donât know what theyâre talking about.Ă Letâs look at a few of these people have had to say lately:Ă
Meredith Whitney
Meredith Whitney, the It Girl of the global financial collapse, was predictably dismissive of the test results. In particular, she seems skeptical that even with their piles of new capital, banks will have an easy time getting through the recession. âThe revenue environment is very different,â she told the New York Times on Saturday, then added that she believes that, given the slowdown, banks are not going to make much money from credit cards or originating mortgages.Ă
Whitney seems to be willfully denying reality. First, with respect to credit cards: Duh!Ă The testâs stress case loss assumption for cards was 20% over the coming two years, or roughly twice the loss rate of the past two years. (And the past two years, donât forget, havenât exactly been a picnic.) So, yes, the outlook for card lending is dim. It happens every recession.
But as to mortgages, what can she be thinking? Mortgage rates are at historic lows, and lending activity is surging. Inside Mortgage Finance recently reported that, in the first quarter, the mortgage banking industry generated record profits of more than $9 billion. Results figure to be even stronger in the second quarter. There are a lot of problems areas in the lending business these days. Mortgage lending is not one of them.Ă
Nor is the mortgage strength apt to be temporary. If the economy becomes as weak as the stress-case economic projections suggest, mortgage rates will stay low and perhaps go lower and kick off a new wave of soaring profitability.
Perhaps she was misquoted.Ă
Keefe Bruyette and Woods
In some ways, I have a soft spot for KBW, if for no other reason than the firm has managed to keep pursuing a business model, the bundling investment-banking services with equity research, that one would think went out during the Spitzer era. Not at KBW. Just as in the old days, the firm keeps conning its clients into paying for investment advice that is hopelessly conflicted.Ă
For KBW, the stress test was a potential gold mine. Two weeks before the release of the results, the firm reportedly advised its clients (of which we are not one, please be assured) that the banking industry will need $1 trillion in new equity.Ă Then after the Fed announced that the 19 banks (which account for two-thirds of industrywide loans, recall, and half of deposits) needed to raise only $75 billion, KBW didnât miss a beat, and issued a report that said:
In general, the assumed loss content was inline with KBW estimated range . . . The capital requirement in the SCAP were somewhat lower than KBW estimates.
âSomewhat lowerâ? KBW was looking for $1 trillion! So how does it reconcile the fact the banks that account for two-thirds the industryâs loans and half its deposits have to raise just 7.5% the estimated capital it thought the industry needed? By wishing out loud:
We do not think this is the defining capital raising in this severe economic cycle.Ă The capital levels required by the government in a Stress Test scenario are enough to allow most banks to survive, but not for the industry to thrive.Ă As a result, we expect continued significant capital raising in the industry, including capital increases at smaller banks for both defensive and offensive reasons. [Emph. added]
What a self-serving crock!Ă KBW has somehow gotten it into its collective head that regulators will boost the Tier 1 common minimum to 7.5% from 4% by the end of the cycle. Why it believes this, it doesnât say. What evidence it has, it doesnât share.
Regardless, the firm is making an irresponsible assertion.Ă If U.S. banks were forced to hold Tier 1 common at 7.5% of risk-weighted assets, theyâd be at an extreme competitive disadvantage to non-U.S. banks. And if (as KBW perhaps implies) Basel capital standards for all banks worldwide were be raised to 7.5% over the next couple of years, loan yields would have to be raised so high as to choke off any economic recovery. It is simply not going to happen.Ă
Personally, I donât think KBW really believes regulators are about to raise the Tier 1 common minimum to 7.5%. But I do believe that KBW likes the idea of banks having lots and lots of new equity, and also like the idea of KBW helping them raise it. And the firm is certainly not above using its research arm into scaring its bank clients into hiring KBW to do an offering, whether they need the new capital or not.
Mike Mayo
Mike Mayo speaks for many when he says that he believes that the testâs stress-case economic assumptions were not stressful enough. Hereâs what he wrote to his clients on May 8:
If unemployment reaches the level targeted by CLSA economists vs. the Stress Case scenario of the government (12% vs. 10.3%), the government could change its view and require addition action. . . [Emph. added]
Well, Mike, yes. And guess what? If even the CLSA economist is too optimistic and unemployment goes even higher than he expects, bank losses would top even CLSAâs estimates. So what unemployment assumption would make you happy? If your economist has a patent on a crystal ball, I havenât heard about it. What makes his forecast any more likely than the others? Remember, the testâs results werenât based on the most likelyeconomic forecast, nor were they based on the most negative forecast anyone could come up with. Itâs a stress test, not an apocalypse test!
Using highly severe, highly unlikely economic assumptions makes no sense if the Treasury is going to require capital actions be taken today based on those wild assumptions.Ă
Mayo also complains about the stress test because the âcomposition of permitted capital to include several items that investors may exclude, such as unrealized losses on AFS securities, deferred taxes, and overfunded pensions.â
Mayo, of all people, should know what nonsense this is, since he used to work for a regulator. Banksâ capital standards have been established for years. It doesnât matter what Mayoâs hedge fund pals (who seem to be uniformly short the banks) now suddenly want to include or exclude!Ă Collectively, those people (including the firm I run) influence the trading volume and price of bank stocks every day.Ă But Mayo shouldnât criticize the regulators for not changing their definitions of capital and capital requirements to conform with the ever-changing whims of investors.Ă
Gretchen Morgenson
In yesterdayâs New York Times, columnist Gretchen Morgenson argues that the tests couldnât have been stressful enough, since bank loan losses havenât peaked. Which they havenât: practically no one expects the industry loss rate to peak before this yearâs fourth quarter or sometime in 2010.Ă
To Morgenson, that means the stress case wasnât tough enough because the cost of dealing with bad loans and assets will rise in the future. Of course, the banks and the regulators are aware of that fact, and built it into their forecast when they constructed the test.
More perplexing, Morgenson flags only one stress-case assumption as being too low: the 8.8% two-year average loss on first mortgages. Her source, Janet Tavakoli, says a more reasonable stress number would be 10%. âGiven what has happened with the economy and unemployment,â Tavakoli tells Morgenson, â[the administration] is in massive denial.âĂ
Massive denial? When Tavakoli only apparently quibbles with a single stress assumption? Morgenson often seems to arrive at her conclusion before she does any reporting. This time, she has outdone herself. Sheâs arrived at a conclusion that appears to be at odds with the evidence she herself presents.
Unwinding the Financial Stock Sink Hole
Iâve compared the undervaluation of financial stocks now to the overvaluation of technology stocks at the peak of the Internet bubble in 2000. There are a ton of similarities between the two, not the least of which are the over-the-top forecasts regularly churned out during both periods that investors were only too willing to believe.
During the tech bubble, the bulls concocted outrageously optimistic growth forecasts; now, the bears on the financial stocks have been coming up with outrageous loss forecasts.Ă The stress test results were too negative, in my opinion. Even so, they produced estimated stress losses that were well below forecasts of the super-bears. And yet the super-bears are unmoved.Ă
Despite the encouraging economic news over the last six weeks, the better-than-expected first quarter earnings reports, and the stress test results, many banks analysts and investors remain extremely bearish. Thatâs good. The unwinding of excessive pessimism has only begun, but it has begun.
What do you think? Let me know !
Thomas Brown
www.bankstocks.com
tâs no secret I believe the governmentâs just-completed stress test of the big banks was beside the point, and only served to hurt bank investors, and complicate a financial mess that is complicated enough already, thanks very much.
First, the tests themselves were just a crude re-run of the more tailored tests regulators already routinely run in the course of overseeing the industryâso they didnât tell regulators anything that they didnât already know. Worse, they were rigged. The government knew that for the âtestsâ to be âcredibleâ theyâd have to show that multiple institutions needed new capitalâwhether or not those institutions really did. Thus shareholders have been brutally diluted, all for the benefit of the political theatre cooked up by the president and his advisers.Ă
Even more unfair, the countryâs other, 8,000 or so smaller, un-stress-tested banks havenât had to go through this particular wringer, and their shareholders havenât been forced to swallow a slug of dilution.
Iâm at a loss to understand why the government is so intent on abusing bank shareholders based on a set of bearish economic assumptions that, by the governmentâs own admission, are far-fetched. It adds up to a ham-handed intrusion by the government into the private markets by a president who simply wants to show he is attacking the âproblem.âĂ
The likely result of all this? Just as in the last recession, the big banks will emerge overcapitalized, over-reserved, while their shareholders have been unnecessarily diluted.Ă Itâs a disgrace.
But as unhappy as I am about the stress test, Iâm even more shocked by all the commentators who dismiss the test results because they believe it wasnât stressful enough. Some of these people simply believe the U.S. economy is headed into a death spiral; no how matter how bearish a given forecast is, theyâll tell you itâs not bearish enough. Others have lately built a nice business for themselves by being relentlessly, flamboyantly negative. Still others simply donât know what theyâre talking about.Ă Letâs look at a few of these people have had to say lately:Ă
Meredith Whitney
Meredith Whitney, the It Girl of the global financial collapse, was predictably dismissive of the test results. In particular, she seems skeptical that even with their piles of new capital, banks will have an easy time getting through the recession. âThe revenue environment is very different,â she told the New York Times on Saturday, then added that she believes that, given the slowdown, banks are not going to make much money from credit cards or originating mortgages.Ă
Whitney seems to be willfully denying reality. First, with respect to credit cards: Duh!Ă The testâs stress case loss assumption for cards was 20% over the coming two years, or roughly twice the loss rate of the past two years. (And the past two years, donât forget, havenât exactly been a picnic.) So, yes, the outlook for card lending is dim. It happens every recession.
But as to mortgages, what can she be thinking? Mortgage rates are at historic lows, and lending activity is surging. Inside Mortgage Finance recently reported that, in the first quarter, the mortgage banking industry generated record profits of more than $9 billion. Results figure to be even stronger in the second quarter. There are a lot of problems areas in the lending business these days. Mortgage lending is not one of them.Ă
Nor is the mortgage strength apt to be temporary. If the economy becomes as weak as the stress-case economic projections suggest, mortgage rates will stay low and perhaps go lower and kick off a new wave of soaring profitability.
Perhaps she was misquoted.Ă
Keefe Bruyette and Woods
In some ways, I have a soft spot for KBW, if for no other reason than the firm has managed to keep pursuing a business model, the bundling investment-banking services with equity research, that one would think went out during the Spitzer era. Not at KBW. Just as in the old days, the firm keeps conning its clients into paying for investment advice that is hopelessly conflicted.Ă
For KBW, the stress test was a potential gold mine. Two weeks before the release of the results, the firm reportedly advised its clients (of which we are not one, please be assured) that the banking industry will need $1 trillion in new equity.Ă Then after the Fed announced that the 19 banks (which account for two-thirds of industrywide loans, recall, and half of deposits) needed to raise only $75 billion, KBW didnât miss a beat, and issued a report that said:
In general, the assumed loss content was inline with KBW estimated range . . . The capital requirement in the SCAP were somewhat lower than KBW estimates.
âSomewhat lowerâ? KBW was looking for $1 trillion! So how does it reconcile the fact the banks that account for two-thirds the industryâs loans and half its deposits have to raise just 7.5% the estimated capital it thought the industry needed? By wishing out loud:
We do not think this is the defining capital raising in this severe economic cycle.Ă The capital levels required by the government in a Stress Test scenario are enough to allow most banks to survive, but not for the industry to thrive.Ă As a result, we expect continued significant capital raising in the industry, including capital increases at smaller banks for both defensive and offensive reasons. [Emph. added]
What a self-serving crock!Ă KBW has somehow gotten it into its collective head that regulators will boost the Tier 1 common minimum to 7.5% from 4% by the end of the cycle. Why it believes this, it doesnât say. What evidence it has, it doesnât share.
Regardless, the firm is making an irresponsible assertion.Ă If U.S. banks were forced to hold Tier 1 common at 7.5% of risk-weighted assets, theyâd be at an extreme competitive disadvantage to non-U.S. banks. And if (as KBW perhaps implies) Basel capital standards for all banks worldwide were be raised to 7.5% over the next couple of years, loan yields would have to be raised so high as to choke off any economic recovery. It is simply not going to happen.Ă
Personally, I donât think KBW really believes regulators are about to raise the Tier 1 common minimum to 7.5%. But I do believe that KBW likes the idea of banks having lots and lots of new equity, and also like the idea of KBW helping them raise it. And the firm is certainly not above using its research arm into scaring its bank clients into hiring KBW to do an offering, whether they need the new capital or not.
Mike Mayo
Mike Mayo speaks for many when he says that he believes that the testâs stress-case economic assumptions were not stressful enough. Hereâs what he wrote to his clients on May 8:
If unemployment reaches the level targeted by CLSA economists vs. the Stress Case scenario of the government (12% vs. 10.3%), the government could change its view and require addition action. . . [Emph. added]
Well, Mike, yes. And guess what? If even the CLSA economist is too optimistic and unemployment goes even higher than he expects, bank losses would top even CLSAâs estimates. So what unemployment assumption would make you happy? If your economist has a patent on a crystal ball, I havenât heard about it. What makes his forecast any more likely than the others? Remember, the testâs results werenât based on the most likelyeconomic forecast, nor were they based on the most negative forecast anyone could come up with. Itâs a stress test, not an apocalypse test!
Using highly severe, highly unlikely economic assumptions makes no sense if the Treasury is going to require capital actions be taken today based on those wild assumptions.Ă
Mayo also complains about the stress test because the âcomposition of permitted capital to include several items that investors may exclude, such as unrealized losses on AFS securities, deferred taxes, and overfunded pensions.â
Mayo, of all people, should know what nonsense this is, since he used to work for a regulator. Banksâ capital standards have been established for years. It doesnât matter what Mayoâs hedge fund pals (who seem to be uniformly short the banks) now suddenly want to include or exclude!Ă Collectively, those people (including the firm I run) influence the trading volume and price of bank stocks every day.Ă But Mayo shouldnât criticize the regulators for not changing their definitions of capital and capital requirements to conform with the ever-changing whims of investors.Ă
Gretchen Morgenson
In yesterdayâs New York Times, columnist Gretchen Morgenson argues that the tests couldnât have been stressful enough, since bank loan losses havenât peaked. Which they havenât: practically no one expects the industry loss rate to peak before this yearâs fourth quarter or sometime in 2010.Ă
To Morgenson, that means the stress case wasnât tough enough because the cost of dealing with bad loans and assets will rise in the future. Of course, the banks and the regulators are aware of that fact, and built it into their forecast when they constructed the test.
More perplexing, Morgenson flags only one stress-case assumption as being too low: the 8.8% two-year average loss on first mortgages. Her source, Janet Tavakoli, says a more reasonable stress number would be 10%. âGiven what has happened with the economy and unemployment,â Tavakoli tells Morgenson, â[the administration] is in massive denial.âĂ
Massive denial? When Tavakoli only apparently quibbles with a single stress assumption? Morgenson often seems to arrive at her conclusion before she does any reporting. This time, she has outdone herself. Sheâs arrived at a conclusion that appears to be at odds with the evidence she herself presents.
Unwinding the Financial Stock Sink Hole
Iâve compared the undervaluation of financial stocks now to the overvaluation of technology stocks at the peak of the Internet bubble in 2000. There are a ton of similarities between the two, not the least of which are the over-the-top forecasts regularly churned out during both periods that investors were only too willing to believe.
During the tech bubble, the bulls concocted outrageously optimistic growth forecasts; now, the bears on the financial stocks have been coming up with outrageous loss forecasts.Ă The stress test results were too negative, in my opinion. Even so, they produced estimated stress losses that were well below forecasts of the super-bears. And yet the super-bears are unmoved.Ă
Despite the encouraging economic news over the last six weeks, the better-than-expected first quarter earnings reports, and the stress test results, many banks analysts and investors remain extremely bearish. Thatâs good. The unwinding of excessive pessimism has only begun, but it has begun.
What do you think? Let me know !
Thomas Brown
www.bankstocks.com
