Government’s Evaluation Of Banks’ Loan Portfolios: SCAP Is Crap

I was reading through some of the governments - supposed - evaluation of the banks and their loan portfolios. I’m sure that this exercise is well intentioned - with the hopes of suckering additional private investors to pony up equity in these zombie banks. This type of analysis is not a predictor of what can or might happen in the real world. It’s not that simple.

It sounds like the FED took all the information from the banks - which they were required to provide - and ran it though some big financial models, complete with probability analysis, all based on assumptions eminating from historical data. As we all now know ….”Past performance is no guarantee of future perfomance” - Nassim Taleb has made all of us acutely aware of this - via his book The Black Swan - which looks at ways that investors are lured into believing probability distributions. Some events fall way outside of the normal distribution. I think that this crisis falls way outside the normal distribution.

It’s a fallacy to model solutions or expectations to this problem based on historical norms. This is a one in a lifetime event. Anyone relying on SCAP, as a basis for investing their hard earned equity into bank stocks, must pause and consider what Taleb has taught us. SCAP is one theoretical example, but in my opinion, should be lightly weighted. Ultimately SCAP solves nothing. It suggests that it’s a means to evaluate the equity that banks have and if they fall short, then they’ll need to raise more equity……DUHHHH……Isn’t this always the case ?

The banks are banks until they aren’t banks. DUHHHH. SCAP offers no solutions to the situations that might arise, other than to suggest that the taxpayers will bail them out. Nothing new there.

Another potential problem that I see in the analysis, is that what happens when the economic situation deteriorates beyond the “ADVERSE” scenario - now investors will surely run for the hills. By offering a “worst case scenario”, it has put much more weight on the unemployment and GDP reports - As these reports come out, there is now a benchmark by which we will measure the “solvency” of the banking system.

Here’s a couple of comments from my read through of the Fed Statement:

This rigorous government test is conducted with loan loss estimates provided by the firms. Can these banks, truly be expected to be honest with their estimates of loan losses and revenue projections going forward. I say no. The worse that they are made to look by submitting honest estimates to the US Government, then the less likely it is that they will receive capital or private equity, when the need arises.

This paper describes the SCAP process conducted by the federal bank regulatory agencies (the agencies) from Feb. 25, 2009 through late April of 2009. 1 All domestic BHCs with year‐end 2008 assets exceeding $100 billion were required to participate in the SCAP as part of the ongoing supervisory process. These 19 firms collectively hold two‐thirds of the assets and more than one‐half of the loans in the U.S. banking system, and support a very significant portion of the credit intermediation done by the banking sector. The firms were asked to project their credit losses and revenues for the two years 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011, under two alternative economic scenarios. The baseline scenario reflected the consensus expectation in February 2009 among professional forecasters on the depth and duration of the recession, while the more adverse scenario was designed to characterize a recession that is longer and more severe than the consensus expectation. The firms were also asked to provide supporting documentation for their projected losses and resources, including information on projected income and expenses by major category, domestic and international portfolio characteristics, forecast methods, and important assumptions.

Loans being evaluated are not evaluated on a mark to market basis - pure fiction !

The SCAP was designed under the assumption that the institutions continue to operate under the regulatory and accounting frameworks existing as of December 31, 2008 and considering the effect of significant changes that have or are expected to occur during the next two years.2 Loans held in portfolio subject to accrual accounting are carried at amortized cost, net of an allowance for loan losses. The use of accrual accounting for these assets is based on BHCs’ intent and ability to hold these loans to maturity, which reflects, in part, a combination of more stable deposit funding and information advantages about the quality of the loans they underwrite. The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices, which may be driven by market liquidity considerations, if those factors do not affect the ultimate likelihood of repayment. The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis. As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.

The SCAP assumptions made above, project two scenarios a baseline case and a more adverse case. I believe that the adverse case is more likely than the baseline case. A footnote suggested that the baseline case and the more adverse projections were provided by private forecasters that used assumptions - and probabilities dating back as far as 1970. Wouldn’t it be more rational to have used depression era probabilities ? They suggested that there is a 90% chance that the unemployment rate will not rise above 8.9% or 10.3% in 2009/2010 respectively.

The “more adverse” scenario was constructed from the historical track record of private forecasters as well as their current assessments of uncertainty. In particular, based on the historical accuracy of Blue Chip forecasts made since the late 1970s, the likelihood that the average unemployment rate in 2010 could be at least as high as in the alternative more adverse scenario is roughly 10 percent. In addition, the subjective probability assessments provided by participants in the January Consensus Forecasts survey and the February Survey of Professional Forecasters imply a roughly 15 percent chance that real GDP growth could be at least as low, and unemployment at least as high, as assumed in the more adverse scenario.

The huge caveat……lawyers I’m sure. - Essentially, the suggestion is that the analysis might have no true bearing on what will actually happen. I really don’t think that the asessment is worth the paper that it’s printed on.

Assessing Capital Needs in an Uncertain World, Projecting estimated losses and revenues for BHCs is an inherently uncertain exercise, and this difficulty has been amplified in the current period of increased macroeconomic uncertainty. The future path of GDP growth, unemployment, and home prices, for example, are unknown, with a wide range of plausible outcomes. Indeed, this increased uncertainty was a key motivation for the SCAP, as policymakers are interested in restoring confidence that BHCs have sufficient resources to continue to lend to creditworthy borrowers across a wide range of macroeconomic outcomes. Forward‐looking assessments across a range of possible outcomes including more adverse environments, commonly referred to as “stress tests,” are regularly used by both institutions and supervisors and are regularly integrated in traditional risk‐management practices. This approach provides additional information to firms and supervisors about the vulnerability of a BHC by examining how it might fare under different economic scenarios.

This type of analysis, however, is itself subject to considerable uncertainty, including uncertainty about the range of potential macroeconomic outcomes to consider, the relationship between BHC results and macroeconomic scenarios, the degree to which historical relationships will continue to be relevant in a more stressed environment, and the potential changes to consumer behavior in response to both macroeconomic and institutional changes.

Nevertheless, this type of exercise can be extremely useful in helping supervisors and analysts broadly understand a BHC’s risk, especially in periods of high uncertainty. Moreover, a stress test provides a systematic, disciplined framework for gauging the magnitude of capital buffers that might be needed by different firms to absorb losses under plausible “what if” scenarios.

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Comment by johnson

2009-09-11 09:29:16

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