The Breakthrough Institute

Much ink was spilled last week around the release of the banks' stress test, and the reaction was largely negative. In case you missed the debate -- or if you're still looking for clarity -- here are a few key readings:

"Grading the Banks' Stress Test," NYT Room for Debate

"Stress Tests & the Nationalization We Got," Simon Johnson and James Kwak, Baseline Scenario

"Stressing the Positive," Paul Krugman, NYT

"We Can't Subsidize the Banks Forever", Matthew Richardson and Nouriel Roubini, Wall Street Journal

"Background on the Stress Tests," Dean Baker, American Prospect

But very few offered as comprehensive an analysis as Nouriel Roubini at RGE Monitor. For those still trying to make sense of these tests, see his take below (for the full version you need a free account at RGE):

For a number of reasons these results are a significant underestimate of the capital/equity needs of these 19 large US banks. Also this underestimate of the losses and the current "muddle-through" approach to the banking and financial crisis may accelerate the creeping partial nationalization of the US financial system, exacerbate moral hazard distortions, not resolve the too-big-to-fail problem, increase the fiscal costs of this financial crisis, make the credit crunch last longer and lead some near insolvent financial institutions to become zombie banks. Let me explain in ten points why I hold such views:

First, the stress tests are not stressful enough. As discussed in a previous note current levels of unemployment rates are already higher than those assumed in the more adverse scenario; and even assuming that the rate of job losses will slow down over the next few months to a 400-500K monthly range it is highly likely that the US will reach an unemployment rate of 10% by the fall of 2009, a rate of 10.5% by the end of 2009 and a rate above 11% some time in 2010; instead the parameters of the stress tests assumed that the unemployment rate would average 10.3% in the more adverse scenario in 2010, not 2009...

Second, the capital/needs of these banks depend on a race between retained earnings before writedowns/provisioning that will be positive given a high net interest rate margin and the losses deriving from further writedowns. It appears that regulators have overestimated the amount of such retained earnings for 2009-2010. The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks - not just these 19 ones - would be only $300 bn total over the 2009-2010 period. The stress tests - instead - assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators...

Third, banks bargained hard to reduce the regulators estimates of needed additional equity. For example, according to press reports Citigroup was initially assessed to need an additional $30bn of equity; such figure was then reduced to $5 billion after aggressive bargaining by the bank. One can only guess how much higher were the regulators initial estimates of the banks' capital needs and how much lower the published estimates became after the banks lobbied for lower figures...

Fourth, the estimates of additional losses on loans - $445 bn - appear to be relatively reasonable even if they could end up being significantly higher in a weaker macro scenario. But estimates of losses on securities - $154bn - are most likely too low. And the results of the stress scenario do not provide details on how much regulatory forbearance has been provided in the estimate of losses on securities; while current market values of some securities may be lower than long term values given an illiquidity premium many banks still keep many of these securities in the level 2 and 3 buckets and use a mark-to-model, rather than a mark-to-market approach to value these assets...

Fifth, estimates of net retained earnings before writedowns are massively beefed up by the direct and indirect subsidies that the government is providing to the financial system: with the Fed Funds rate and deposit rates now close to 0% and with banks having been able to borrow since last year about $350 bn at close to 0% interest rates given the FDIC guarantee on new borrowings the bank can now earn a fat net interest rate margin that is a direct subsidy to financial institutions... Overall, the US government has committed - between liquidity supports, recapitalization, insurance of bad assets, guarantees - over $13 trillion of resources to the financial system and already provided $3 trillion of such resources to the financial institutions. The financial system is already effectively a ward of the state in spite of the fact that all these direct and indirect subsidies have bailed out both the shareholders and the unsecured creditors of financial institutions.

Sixth, in estimating equity needs of these 19 banks the regulators correctly used a measure of capital - Tangible Common Equity or TCE - that is narrower than Tier 1. Tier 1 capital includes many forms of capital - on top of tangible common equity - that are of poor quality as a buffer against losses or outright fishy: preferred equity and in particular intangible assets and goodwill. While Tier 1 capital of US banks was - at the end of 2008 - about $1,550 common tangible equity was only about $560 bn. The regulators estimated equity needs of the 19 banks based on a TCE ratio of 4% (as a percent of tangible assets). However, even 4% implies a leverage ratio for these banks of 25. The IMF instead - properly - considered a scenario where the TCE ratio is increased to 6% that is equivalent to a leverage ratio of 17 that represent the average leverage ratio for all US banks in the mid-1990s before leveraged shot up in the latest credit bubble...

Seventh, considering even only the need for a higher TCE ratio for too-big-to-fail banks - let alone the implications of other factor discussed above that would have increased the estimates of capital needs for US banks - all 19 banks would have required higher TCE. Giving a clean bill of financial health to half a dozen too-big-to-fail banks - including JP Morgan Chase and Goldman Sachs - that have survived this financial crisis only because of the massive direct and indirect subsidies received from the US government is a public disservice in two ways: first, it does not recognize that these banks survived the crisis only because of the government subsidies (liquidity, insurance, guarantees, recapitalization); second, it ignores the fundamental fact that too-big-to-fail banks should have much more tangible common equity than the one that they currently hold. It is reckless behavior by regulators to ignore the too-big-to-fail distortion that derives from excessively low capital ratios and not to start demanding from such systemically important banks additional capital to control for this negative externality...

Eighth, the figures published by the US regulators are estimates of losses and capital/equity needs of the top 19 banks (those with assets above $100bn). Smaller US banks will have similar losses and capital needs. Based on the results of the stress tests some bank analysts have estimated that 60% of top 100 US banks (beyond the 19 ones in the stress tests) will need more capital/equity. Note that while large US banks (those with more than $4 billion in assets) have about 49% of their total assets into real estate assets the percentage of real estate assets for small US bank (those with assets below $4 bn) is about 63%. Thus, the losses for such smaller banks may end up being larger (as a % of their total assets) than the ones of large banks...

Roubini continues, then concludes with a call for an alternative approach:

There were three possible alternative approaches that made more sense. One option would be a temporary nationalization of such near insolvent large banks: take them over, wipe out common and preferred shareholders, have unsecured creditors take some of the losses (haircuts on their claims and/or conversion of their claims into equity), separate good and bad assets and sell a clean-up bank - possible after breaking it up to create smaller pieces that are not too big to fail - as fast as possible to the private sector. This was the strategy followed for Indy Mac that was taken over last summer by the FDIC and sold back to a group of private investors in about six months. Such temporary nationalization option is feasible and orderly even for systemically important banks as long as Congress is willing to pass soon the new insolvency regime for large financial institutions.

A second option would be the approach favored by a number of economists of separating each troubled bank into a good bank and a bad bank and placing bad assets and unsecured claims into the bad bank while providing significant equity into the good bank to the unsecured creditors that would have losses on their bad bank claims. This solution combines separating good and bad assets and converting unsecured claims into equity and it minimizes the fiscal costs of a distressed bank resolution.

A third option would be to induce unsecured creditors - under the threat of a receivership that becomes credible once a special insolvency regime for too-big-to -fail banks is implemented - to convert their claims into equity. Then, the bad assets of the bank can be taken off the balance sheet of the bank via the PPIP program or a number of other alternative ways to separate good and toxic assets.

Each one of these three proposed solutions implies that unsecured creditors of banks take some losses and convert their claims into equity. Instead, the paradoxical result of the current US approach is that - in order to avoid a temporary nationalization of insolvent banks and in order to prevent unsecured creditors of banks from taking any losses - the result is a creeping and increasing partial nationalization of the financial system: the government will have to inject more preferred shares into troubled banks and convert more of its preferred shares into common equity. So, even without a temporary government takeover of the insolvent banks, we will end up with a longer-term partial government ownership of many large banks. To avoid this creeping partial nationalization inducing the banks creditors to convert their claims into equity would be a more sensible solution that minimizes the fiscal costs of the crisis, reduces the moral hazard of government bailouts and keeps more of the banking system into private hands.