Stress Test Positives & Negatives

Perhaps the greatest achievement of the stress tests is that the uncertainty surrounding them is now over. The banks need a total of $74.6 billion of additional capital; they are expected to submit their plans by June 8 and raise it by November.

And they are already coming out with the plans either to tap the public markets, like Wells Fargo (WFC) and Morgan Stanley (MS), or to convert preferred shares into common equity or sell assets/business line, like Citigroup (C). However, the few weakest ones may still need a government bailout.

On the other hand, the winners like Goldman Sachs (GS) and JP Morgan (JPM) are announcing plans to return TARP capital and free themselves from the government’s clutches.

Since uniform methodology was applied to all banks, the tests are probably precise on relative assessment, and so we can separate out the healthier ones from the weaker ones. At the same time this “a one-size-fits-all’ methodology underestimates the risks of some of the complex instruments on the banks’ books.

We have been complaining about the tests not being “stressful enough” and the “more adverse scenario” appearing to be the “more probable scenario,” but given the recent glimmers of hope in the economy, there is a chance that the “worst case scenario” may not be too terrible.

What concerns us more is that revenue projections were based on the first quarter results, which were unusually strong and unsustainable, as we mentioned in this earlier blog. Also the fact that the banks were able to negotiate their results with the regulators undermines their credibility further.

Some of the estimated loss rates in the “more adverse scenario” look too optimistic, for example, the 8.5% loss rate for commercial-real-estate. No wonder, the government came up with a loss estimate of $600 billion at these 19 banks, comprising two-thirds of the US banking assets, which is significantly lower than some other estimates of approximately $2.5 trillion for the entire US banking system.

Finally does shifting of capital from “preferred” to “common” really improve the solvency of the banking system?

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