How the banks cheated to ace the stress tests
Update: Treasury Sec. Geithner wrote an op-ed on this here.
The Wall Street Journal reports today that banks undergoing the federal ‘stress tests’ (if you could call it that) had successfully lobbied the Fed to nerf the tests. In particular, the banks objected vociferously when preliminary results had shown that they faced daunting capital deficits, which were magically toned down under pressure from the banks:
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed’s exaggerated capital holes. A senior executive at one bank fumed that the Fed’s initial estimate was “mind-numbingly” large. Bank of America was “shocked” when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.
At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks’ ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.
This is shockingly outrageous. Imagine if students at a college had used similarly reprehensible tactics to forcefully and successfully pressure their professors to give them better grades at a make-up examination re-test. Yet when the same situation plays out analogously at Wall Street, this time involving the purse strings of the American taxpayers, this egregious behaviour goes unpunished. In particular Bank of America, Wells Fargo and Citigroup lobbied successfully to have their identified capital shortfall reduced because their executives could somehow forsee that pending or future transactions could easily make up for much of the deficit:
Bank of America’s final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.
Wells Fargo’s capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.
Citigroup’s capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.
That’s not all that transpired. The Fed actually used a less punishing metric by which to gauge the financial health of the banks. They switched from measuring the tangible common equity as originally agreed to evaluating tier 1 common capital ratio. The consequence? More than US$68 bn of identified capital shortfalls for all 19 banks in total magically disappears. I didn’t know Geithner was an illusionist:
On Friday, some analysts questioned the yardstick, known as Tier 1 common capital, that regulators chose to assess capital levels. Many experts had assumed the Fed would use a better-known metric called tangible common equity.
According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks’ cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.
Still, as has been noted earlier, since all financial crisis are fundamentally psychological in nature, spinning and tweaking the results (and the tests themselves) has the effect of maintaining the recent bullish rally on Wall Street and has helped the same banks raise capital to make up for their identified (albeit magically reduced) shortfall:
Banks pressed ahead on Friday with plans to fill their capital holes by tapping public markets. Wells Fargo raised $7.5 billion in stock through a public offering. The bank originally planned to raise $6 billion, but expanded the offering, which was valued at $22 a share, due to robust demand. Shares of Wells Fargo rallied $3.42, or 14% to $28.18.
Morgan Stanley, which is facing a $1.8 billion capital hole, raised $4 billion by selling stock. Shares of Morgan rose $1.06, or 4%, to $28.20.
In other words, don’t count on the recent green shoots on Wall Street to persist.