The Stress test results are in.

Over the next few days, these pages will be dissected and analyzed for its results, correlation to reality, foibles and methodological errors.

As we noted back on April 24th, the Stress Tests were not very stressful; That pesepctive was a decidely outlier viewpoint back then. Now, it has become more mainstream, as even a WSJ headline this morning declared: U.S. Banks’ Not-So-Stressful Test.

Consider this simple fact:  Treasury and the Fed want these banks to have Tier 1 capital (common and preferred stock) equal to 4% of risk-weighted assets. In other words, 25-to-1 leverage as safe for the future.

Hence, it is not a big stretch to conclude that the entire stress test exercise is a near charade, with foregone conclusions of deleveraging banks to still wildly over-extended positions.

Recall that before the 2004 SEC Bear Stearns exemption for the 5 biggest investment banks, net cap rules limited leverage to 12-to-1 for investment banks.

Is 25-to-1 leverage appropriate for depository banks? Well, maybe before the repeal of Glass Steagal — but with today’s toxic asset laden banks, 25-to-1 seems awfully friendly.

Why the generosity? According to Bloomberg, its to allow the banks to “grow” their way out of the mess through earnings. Instead of being an honest broker of the banks conditions, the Treasury Department is now a shareholder and cheerleader for bank profitability:

“Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s “lost decade” of the 1990s: earn their way out of trouble.

The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money. That compares with the hundreds of billions of dollars seen by outside analysts, including the International Monetary Fund, and takes into account banks’ projected earnings over the next two years.”

What a horrific idea.

Put on your rally caps, Uncle Sam is in da house . . .

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Previously:
Stress Test: Not Very Stressful (April 24th, 2009)

http://www.ritholtz.com/blog/2009/04/stress-test-white-paper/

Stress Test — or Reality Check? (May 1st, 2009)

http://www.ritholtz.com/blog/2009/05/stress-test-or-reality-check/

Sources:
U.S. Banks’ Not-So-Stressful Test
Peter Eavis
WSJ, May 8, 2009

http://online.wsj.com/article/SB124174706382899483.html

Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings
Rich Miller and Matthew Benjamin
Bloomberg, May 8 2009

http://www.bloomberg.com/apps/news?pid=20601087&sid=aff8iC.Mwg1U&

Category: Bailouts, Federal Reserve

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

36 Responses to “Stress Test: 25-to-1 Leverage as a Healthy Bank Target?”

  1. dead hobo says:

    As usual, the vast majority of the business media got it wrong. The WSJ is the only paper, so far, to notice that a $599 billion loss from 19 banks is pretty steep, and the rest of the banking system isn’t included in that number.

    The others just see $75b and who knows what that equates to. Probably nothing. In their simplistic minds, it probably goes “Raise money, Go home. All clear. Game over. Recovery time. Buy stocks.”

    Even at Zero Hedge the posters there don’t get it. I posted something there about losses and noted that ‘deadbeats’ who can’t repay bank loans aren’t going to borrow more, nor will banks want to lend aggressively. Some jujubee dissed me for using the word deadbeat. That’s the total reaction there.

    The total losses should hit $1 trillion, at least, industry wide.

    Given that, banks will not aggressively loan money. People in debt will not seek to borrow more. This means consumption will continue to lag. Ditto employment. Add bankrupt car companies and the fact nobody wants a car out of warranty from a car company that might no longer exist. Thus, even though Uncle Stupid is guaranteeing everything in sight, he can’t guarantee a resale value for a car 1 day out of warranty if said car’s manufacturer no longer exists.

    Oil’s rising price means gas will cost more soon, as will everything made from oil Oops, there goes another wealth transfer to the oil companies and the oil speculators. Not to the stores.

    Why do idiots buy stocks in this economy. Why are so many reporters so incompetent.

  2. call me ahab says:

    from Krugman-

    “while bankers may find the results of the stress test “reassuring,” the rest of us should be very, very afraid.”

    thanks Gheithner, Obama, Summers, et al- you guys are the best- we knew we could count on you for an honest assessment and hard choices- that’s what leaders are for

  3. Moss says:

    Don’t forget the PPIP… That will be the next hand out to the banksters.

  4. Carlomagno says:

    “Put on your rally caps, Uncle Sam is in da house . . .”

    ROFL. And remember – converting the prefs to common will restore the banking sector to solvency. To quote British magician Paul Daniels: “Now, that’s magic!”

  5. flipspiceland says:

    “But I am a Minister. We are the government. We were elected to DO something”!

    “,Ah but no, minister, we were not. We were elected to APPEAR to do something”.

  6. some_guy_in_a_cube says:

    With the results of the stress test a foregone conclusion, the banking-beltway cabal is “declaring success”, and moving on.

    See you at SPX 150.

  7. ben22 says:

    OH barry, come on, not very stressful?

    every single paragraph was something along these lines:

    our assumptions are worse than what happened during the depression. What more do you want?

    lol.

  8. call me ahab says:

    here is he future of the S&P-

    http://en.wikipedia.org/wiki/File:Nikkei_225(1970-).svg

    the Geithner plan is the rehashed Japan plan- see how well it worked- multi decade stagnation- why should the stock market rally? To get your money- until to lose it to the house- when it resets to the reality of deflation

    try this link- please note the chart starts year 1989- what a place to have put your hard earned money for the last 20 years

  9. ZackAttack says:

    Amazing how spot-on the leaks were. Over/under on any prosecutions taking place?

    I’m frankly stunned the leaks didn’t highball the capital requirements estimates so the banksters could claim an upside surprise.

    My view on the stress tests? Panem et circenses. Intended for public consumption; symptomatic of the belief that this is an issue of liquidity and confidence, not one of fundamental solvency.

  10. matt says:

    The banks will be able to earn their way out of this if Uncle Ben is able to create the inflation required to devalue the debt. Given the mainstream economic preference of minimizing the savings rate and maximizing consumption, I fully expect them to figure out how to throw these newly minted American savers under the bus to save the big debtors.

  11. snapshot says:

    So the banks need to “earn” their way out of this. I have no trust in this economy – how about you? Are we somehow supposed to be heartened by the fact the big banks won – and go out and buy a few shares?

    When people who did nothing wrong are losing their jobs and houses the system is broken.

    After reading a post by MEH yesterday on the psychology behind the financial crisis, I’m more inclined to believe people are getting more satisfaction from saving. The trust is gone. For me anyway.

  12. call me ahab says:

    Sanpshot Says:

    “The trust is gone. For me anyway.”

    the sentiment of many of us

  13. DeDude says:

    Who cares about Tier 1 common stock? It could be 1% or 20% as long as I can still get my savings back even after they have taken the next trillion in losses.

  14. SavetheWhales says:

    And by “Earn”, they mean take fom the prudent and give to the failures.

    Instead of leaving some income to prudent savers and punishing the imprudent, ZIRP has destroyed the savings income of Americans. ZIRP recapitalizes banks on the backs of everyone depending on savings account and MM account income.

  15. danm says:

    The banks will be able to earn their way out of this if Uncle Ben is able to create the inflation required to devalue the debt.
    —————-
    If they create inflation, you’ll be getting a LOT of companies defaulting on their debt. Not goo for banks. For the last 2 decades, most companies’ business plans have been based on cheap oil and cheap money.

    If you create inflation, all those 15-30 fixed rate mortgages on the banks’ books will go down in value. Unless of course they’ve managed to fix that margin for 15-30 years… But banks are not insurance companies, their operation aren”t based on 15-30 year modeling. Like I said government is so entrenched, it won’t be able to walk away any time soon.

    The USA is now the USSA.

  16. Stuart says:

    a GREAT write up on the stress tests. Well worth a read.

    http://market-ticker.denninger.net/archives/1025-The-Scam-Of-The-Stress-Test.html

  17. dead hobo says:

    Futures are up. If there is big selling into the morning pop, I think that will be confirmation of the dump phase of the current market pump and dump. We’ll know by a couple hours after the open.

  18. edhopper says:

    Does anybody else have deja vu to 2007 when the the market seemed oblivious to the awful economic fundamentals that existed and rose to ridiculous levels?
    I can’t help but think, this cannot end well.

  19. [...] Big Picture: Barry Ritholz says the 25-to-1 leverage ratio now being imposed on banks is too [...]

  20. Mannwich says:

    When it all falls apart again, the oldie but goodie line will be trotted out: “nobody could have foreseen”.

  21. tyaresun says:

    Consumer credit falls by a record $11B. How the hell are the banks supposed to earn their way out?

    http://money.cnn.com/2009/05/07/news/economy/consumer_credit.reut/index.htm?postversion=2009050715

  22. zot23 says:

    Master Yoda to Padwan Geithner: And that is why you fail…

    Seriously, I have a question for the good folks here. So where was a good place to park your money in Japan during the lost decade? Gold? Since we seem hell bent for leather to have the same situation, I would like to know how to position myself now for the long haul. I’ve never invested long term into this sort of shit-wall, would like to know how to keep it down to about knee-height.

  23. bman says:

    Earn their way out of my ass. I wrote a check to my assistant on my business account a couple weeks ago the check was drawn on one of the regional banks that is reported to need more capital. My assistant, just wanted cash so I said take it to the bank I wrote it on and cash it. They told her they had an eight dollar fee to cash a check if you don’t have an account with them, even though the check was written on their funds. This business account was advertised to me as no fee checking. ok so they’re not charging me the fee, but they’re ripping off my employee. They tried to pretend like it was just business as usual, they charge everone that fee blah blah blah. Needless to say I am shopping for a new business bank account. I hope that bank is one of the ones to go insolvant.

  24. DeDude says:

    So they are going to earn their way out of this the good old way. Revolving credit debt is about 1 trillion. Lets say they can keep a spreed of 10% on that for a profit of about 100 billion per year. Non-revolving is 1.5 trillion and with a spread of 5% they would make 75 billion per year. So that is 175 billion per year of profit to dig out of this hole. Even if the hole by some magic didn’t get any bigger, it would be many years before they recover the trillions of losses they already have suffered. Have fun bying bank stocks, just don’t forget those stop loss orders.

    And as bman says, people are revolting about all the fees and BS so that is not going to last long. Sears is trying some “even when you pay your balance in full there is a “residual” that you must pay interest on” BS with my credit card, so they just lost another costumer on that. I say short Sears, they are going to lose their reputation faster than a stone can fall if they are into that kind of scam.

  25. Peter Pan says:

    I watched ABC national news last night where the top story was about the stress tests on the banks. Lead anchor Charlie Gibson described the tests as “exhaustive”. I assumed he was refering to smelly methane gas released out of Tim Geithner’s rear end and had a good laugh over his humourous descriptor.

    So the news is good and the government doesn’t need to continue on with the PPIP. Right ?

  26. JesseLivermore says:

    http://www.wiserthanthecrowd.com/2009/05/tinkerbell-stress-tests.html

    Geithner’s plan is what I call the Tinkerbell strategy: if we all clap our hands and believe in fairies, the banks will be solvent and the recession will go away. To some extent, this is really true. The root word of credit is credere, Latin for “to believe.” No banking system can work if no one trusts anyone else. Trust is a necessary but not sufficient component of the system. But how does the promotion of these transparently phony stress tests promote trust?

    A bubble occurs when individual speculators stop caring about the fundamental value of an asset, and start concerning themselves only with what other speculators will pay for it. In the early stages of a bubble, it makes rational sense to overpay for the asset, with the strategy of re-selling to a “greater fool” at an even more inflated price. When it becomes apparent to all involved that the trading value of the asset is utterly unsupported by the fundamentals, the supply of fools runs out, and the trading price collapses back to the fundamental price.

    Geithner is attempting something which has never been done before. He is trying to re-inflate the banking bubble. With the full faith and credit of the US government behind him, he’s trying to convince the fools to dive back into the market. Armed with a sufficient number of fools, even the smart, rational players will get involved again. In theory, the process of the initial bubble will repeat itself. Even the smart money will buy in, intending to re-sell to the fools.

    It won’t work that way. Bubbles are based on a confluence of psychological factors. In particular, they rely on participants genuinely believing that the assets involved are special. During the run-up to the real estate crisis, we heard over and over how house prices had never fallen nationwide. How “they aren’t making any more land.” How financial innovation and derivatives had distributed risk to those best able to bear it, making the system robust and more stable than ever before. No one is going to fall for these lines again. Everyone will be watching everyone else, waiting for the first sign of panic, knowing that they need to be the first ones out the door when it starts. It’s a recipe for a quick boom and an even quicker bust.

  27. danm says:

    So where was a good place to park your money in Japan during the lost decade?
    ———————
    Post office.

    Growth is overrated.

    When you work hard and get a bonus you can decide to divy up the money between the exisitng members of your clan or decide to add a little one. In the first case everyione is a little richer, in the second case, everyone is a little poorer.

    That’s exactly what we’ve been doing in the western world. Everyone is obsessed with GDP growth and population growth, never questionaing it it madkes sense.

    You can have a flat GDP amid a declining population, yet everybody gets richer.

    Every time I’ve been out West, I’ve witnessed the Japanses’s incredible buying power on the ski hills. Let me tell you, it does not look as if they’ve suffered much in the last decade. Maybe the next one will be different but that’s another issue.

  28. [...] – basically considering 25-to-1 leverage as safe – seems too generous, FusionIQ CEO Barry Ritholtz says. He recalls that in 2004, rules limited leverage to 12-to-1 for investment [...]

  29. hawleyl says:

    Please forgive my naiveness, but the only thing I vaguely remember from my college economics class 50 years ago was the cute girl I sat next to. So how does this 25-1 leverage work?

    1. If a bank has $4 do they just write someone a check for $100 to buy some asset (stock, bond, SIV, etc.); or do they actually borrow $96 from a greater fool? If they do just write a check for $100, this would seem to be stretching the meaning of credit (previously shown to be derived from the Latin for “trust me”).

    2. If the value of their asset initially worth $100 declines to $96 is the bank wiped out?

  30. jritzema says:

    25 to 1 is a little off as the target for Tier 1 is 6%, so that would be 16.7 to 1. Then if you consider that a significant chunk of liabilities are FDIC insured deposits, even the 16.7 to 1 is high.

    I would agree with you that leverage is too high for banks that have a lot more volatility in assets (Citi, BofA, etc.) but the regionals that didn’t go crazy with subprime/construction loans should be allowed more leverage than the investment banks masquerading as depository institutions. The amount of leverage should have an inverse relationship with the risk on the asset side. Companies that load up on crappy assets should have low leverage.

    It is suprising to me that anyone would assess companies that largely do unsecured lending (AmEx & Capital One) as needing no more capital.

  31. [...] is not my expertise, but I’ve got to agree with Barry Ritholtz, that working on a 25:1 leverage ratio suggests these are not stress tests are all. Moreover, [...]

  32. Pat G. says:

    Come on BR.. cut them some slack. Afterall, 25 x 1 is better then 40 to 50 x 1 like it was. See.. all our money did help make a difference. LOL

  33. [...] via Stress Test: 25-to-1 Leverage as a Healthy Bank Target? | The Big Picture. [...]

  34. [...] Barry Ritholtz (Big Picture): Stress Test: 25-to-1 Leverage as a Healthy Bank Target? [...]

  35. [...] The stress tests could have been more stressful, in part because banks pleaded for lenience.  (WSJ.com, WashingtonPost.com, naked capitalism, Big Picture) [...]