The Fed Figures Out A Way To Use Stress Test Results To Screw Bank Shareholders One More Time

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May 29, 2009
The Obama administration’s war on bank shareholders continues. This morning, the Wall Street Journal reports that the Fed, in putting the finishing touches on the administration of its misbegotten stress test on 19 big banks, now says that, no, banks that need to raise new capital can’t use their own estimates of the first three quarters’ worth of pre-tax, pre-provision net revenue to fill their holes. They have to basically use the Fed’s own, much more conservative PPNR estimates, instead.Â

Oh, brother. If what the Journal is reporting is true, the Fed has succeeded in making a truly asinine, costly regulatory process even more asinine and costly than it was before. Which is saying something.

First of all, if history is any guide, regulators’ loss assumptions for the next two years will end up being way too high and its estimated PPNR for the banks way too low. Yet despite these overly conservative assumptions, regulators are still requiring that banks build capital to levels that are materially in excess of what the Fed says it believes constitute “well-capitalized.” Don’t ask me why the government keeps insisting on moving goalposts. The stress test is best understood if you simply assume that everything the government does is irrational, or soon will be. The whole idea behind the stress test, and banks’ post-test action plans, has never made sense. This latest change, if true, makes the process crazier than ever.Â

When the Fed announced the tests’ results on May 7, you may recall, ten of the 19 banks were deemed to be short of Tier 1 common equity ( don’t get me started on that!). The Fed then gave those ten institutions until June 8 to develop a plan to “fix” their shortfalls. They have until November to implement their plans.

At the time, managements were told they could count as prospective new capital their own forecasts for PPNR for the first three quarters of the year, rather than assuming the Fed’s own, more conservative forecast. That made total sense. The first quarter is already done, and the second quarter almost done. Results for the third-quarter, which begins in five weeks, are highly visible.Â

So the companies have a pretty good idea how business is going. Yet in many instances, the differences between the companies’ assumptions and the Fed’s PPNR assumptions aren’t small. In the first quarter alone, for instance, the Fed’s forecast was $2 billion, or 25%, less than Wells Fargo’s estimate!

Now, though, says the Journal , as banks make up their capital plans, the Fed will only allow them to use better-than-Fed-estimate PPNR to make up just 5% of their capital shortfalls.Ă‚

Which means that a number of banks might have to unnecessarily dilute their shareholders by even more than they’ve had to unnecessarily dilute them already. Wells Fargo, for instance, would be limited to using just $685 million if above-Fed PPNR in its plan. Which is nuts, especially considering that in the first quarter alone, the company’s PPNR $2 billion higher than the Fed had estimated!

If the Journal’ s report is true, and Wells Fargo has to issue even more common equity than it already has in order to fill its “hole,” shareholders would be diluted by another 4%, at current prices. It would be more totally useless dilution!Â

Here’s my prediction. By the end of 2010, the consensus view of the investment community will be that the 19 stress-tested banks are overcapitalized and carry excessive loan loss reserves. This will be a direct result of President Obama’s faulty premise that the banks aren’t lending enough, and that the way to get them to start lending is to force them to raise new capital as a buffer against feared losses. Phooey. The academics and economists who put this notion in the President’s head simply weren’t looking at the data. The unhappy result: value destruction for bank shareholders on a grand scale.

What do you think? Let me know !

Thomas Brown

www.bankstocks.com