STRESS OF STRESS-TESTS

According to Turner Radio Network on Monday, the results of the banking "Stress Tests" demanded by Tim Geithner, US Treasury Secretary, of the top 19 US banks, which include HSBC and RBS Citizens and other foreign banmks' US subsidiaries, have been unofficially leaked to the media and thereby to the public. And, in short, the results are supposedly disastrous. The stress-tests results were not due for some months yet and therefore some doubt may be exercised as to the completeness or truth of this story.
As you know, (see my various essays on the subject at www.mcdowellobamanomics.blogspot.com) the stress tests were conducted to determine how the top 19 banks in the USA could withstand future economic hardship in terms of loss of capital, by which is meant loss provisions as a % of the bank's core Tier 1 and total reserve capital (also called 'Economic Capital') which are the unencumbered 'own-capital' liquid reserves of the banks to absorb loan losses. Regulators at the Treasury, FDIC and The Federal Reserve were reported earlier this month to be haggling over how and when to release these results, which did not have to be released until September at the latest. The economic drivers proposed by FDIC for these tests were in my opinion relatively mild, but realistic. The story is being treated as 'shock-horror' but coincides with positive multi-$billion profit results of Citi, JPM and Wells Fargo, and others, reporting record quarterly net earnings ('internal capital generation'). In response, the market in financial stocks extended gains. The problem of the stress-test results seemed temporarily solved until the Turner Radio Network obtained the leaked stress test results.
The bullet-point summary of the findings is that of the top nineteen banks in the nation, sixteen (are already technically insolvent, meaning that defaults requiring loan loss provision exceed capital reserves. This is however before watchlist impaired loans of half a $trillion have been sold at heavy discounts to hedge funds and others via the Fed's equivalent of the Bank of England's £575bn Asset Protection Scheme (also see www.mcdowellobamanomics.blogspot.com for details). The leaking of the results, if they are the true results, may serve to dissuade banks from seeking to engage as buyers as well as sellers of distressed assets, and may also serve short-sellers, in both cases the gainers being the hedge funds?
Of the 16 banks that are already technically insolvent (when note should be taken that insolvency is an ambiguous concept with at least six variants of how this may be measured), not even one bank can withstand any disruption of cash flow or any further deterioration in non-paying loans. This is no surprise to readers of my blog essays, as I have long forecast that bank capital will be wiped out twice before the crisis is over.
If any two of the 16 insolvent banks go under, however, they will totally wipe out all remaining FDIC insurance funding. Of the top 19 banks in the US, the top five are apparantly so under-capitalised that there's serious doubt, according to some doom-merchants about their ability to continue as ongoing businesses. But this is predicated on the dubious assumption that five large U.S. banks have uncovered credit exposure related to their derivatives trading that exceeds their capital e.g. Bank of America's total credit exposure to derivatives at 179% of its risk-based capital, Citibank 278%, JPMorgan Chase 382%, HSBC 550%, and Goldman Sachs a whopping 1,056%. That's the big players. In addition, 1,800 regional banks are reportedly currently at risk of failure.
Thisis apparently a sneak preview summary of a "leaked" report of the stress tests. But I personally believe that these findings are wholly innaccurate, for reasons that range from exaggerating the derivatives market exposures, inadequate stress-test models, and misunderstanding the reality of liquidity risks and insolvency measures. The news is guaranteed however to create panic that the entire US Banking system runs the risk of total collapse, while Gold will soar, the dollar weaken and stock markets will fall aggressively lower.
No matter if these results are true or not, the damage and any damage-limitation measures are now urgent concerns. All the big banks are putting out very positive results, like the first-quarter profit for Bank of America Corp, which more than doubled. But a surge in troubled loans caveated the bank's earnings report. Chief Executive Kenneth Lewis nevertheless said on a conference call that "we absolutely don't think we need additional capital," which is not an ambiguous statement. Just one quarter after losing nearly $2bn, BoA reports a profit of $4.2bn last quarter, seven times greater than expected. But shares of BOA opened down 10%. Why? Because BoA had rallied high enough already, and a cursory look at BoA’s earnings shows over $4bn in profits came from selling a stake in China Construction Bank and “debt adjustments” on Merrill Lynch’s balance sheet.
Citigroup reported $4.69bn profit in fixed income trading last quarter, which allowed it to eke out a $1.6bn bank-wide profit. Citigroup's other major operating segments reported fallen revenues for the quarter. Its global credit card revenue fell 10%, consumer banking down 18%, Global Wealth Management down 20%. Fixed income trading revenues were boosted by a net $2.5bn positive CVA on derivative positions, excluding monolines, due to the widening of Citi's CDS spread. A CVA is a ‘credit value adjustment’, the credit risk premium of a derivative contract i.e. Citi ‘made’ $2.5bn on derivatives positions designed to profit when its own credit default swaps spreads widen i.e. worsened - and not the only bank to do this. You may view this as clever and prudent or just another aspect of the looking glass topsey turvey world of high finance; Citi profited because it bet the cost of insuring against its own liquidity risk would rise, the closer it gets to insolvency, the more money it will ‘make’ on its derivatives.
Despite all the hemming and hawing at congressional hearings and the issue of whether to convert TARP preference share holdings into banks common equity (nationalisation), according to a WSJ study, new loan origination from US banks (the top 21 TARP recipients) fell 4.7% since the last credit crunch crisis period (a crisis for banks wholesale funding) began in September/October '08 from $226bn then to $174bn in February. Personally, I think this is a good result in the circumstances.