"Steeled for stress
By Krishna Guha
Published: April 19 2009 20:05 | Last updated: April 19 2009 20:05
Pictured above: the Universal testing machine, then the world’s biggest, snaps a steel bar in 1955. Now, US financial groups are undergoing checks – but are those of similar rigour?
For US banks, it is shaping up as something akin to a giant system-wide rights issue. Acting as underwriter and facilitator: the administration of President Barack Obama.
As early as this week, US regulators will start discussing with bank executives the outcome of “stress tests” they have carried out in an attempt to determine how much capital each of the top 19 banks would need comfortably to survive a deeper-than-expected recession. The tests have involved exhaustive analysis of bank assets over many weeks, during which investors and creditors have been left dangling in uncertainty.
The fate of the whole Washington plan will go a long way towards determining whether – as Tim Geithner, Treasury secretary, and other top officials believe – the banks can be restored to health without first being taken under control through nationalisation or bankruptcy.
What is therefore the likely upshot? People involved in the process say the mission has generated a wealth of information, collected on a standardised basis that allows one bank to be compared to another better than before. But in each case, the bottom line will be a number: the amount of additional equity that regulators want each bank to raise in order to meet the stress-test standard.
Implicit in this number will be the answer to both a total capital test and a quality of capital test – the authorities want banks both to be well-capitalised and to have most of their core capital in the form of common equity rather than other instruments. Banks will be given six months to raise the equity they need from private investors – or they will have to accept government securities that convert into equity as needed to replenish losses but also give the government partial ownership of the bank.
Meanwhile, the authorities will roll out public-private partnerships to buy from banks their toxic securities and loans – now neatly rebranded as “legacy assets”. The controversial partnerships (see below) will bring new liquidity to the market for toxic assets, raising their price to levels more commensurate with their cash-flow value – or beyond, if critics are right.
Policymakers envisage banks using these marketplaces to clean up their balance sheets – some voluntarily, to attract private capital and avoid government equity, and some as a condition of government-backed restructuring. At the same time, they are relying on banks’ ability to generate large profits in markets with high spreads and limited competition to help offset losses on bubble-era assets. The concept is of a process rather than an event, with different elements working to facilitate bank restructuring and recapitalisation. That reflects policymakers’ belief that there is no silver bullet.
Top officials see the plan as a distinctive solution that draws on lessons from past crises in Sweden and Japan as well as from the collapses some 20 years ago among US savings and loans associations. But it differs from those approaches because of the complexity of the modern financial system – and the decision to intervene earlier in the crisis, they maintain. “There is no precedent for it,” says a senior administration official.
He says that in past crises, policymakers waited for at least three or four years before intervening, by which time it was clear that non-performing loans had wiped out bank capital. Deciding what to do in such situations, he adds, is “a simple problem relative to what we are doing” – which is to try to restore the financial system to health at a stage at which it is not bankrupt and might never be.
The senior official says the capital need in the US is “modest relative to past historical experience” and compares favourably to other countries as a proportion of gross domestic product. Still, he admits, it does exist. “There is a gap in some parts of the system and we believe it is better for that gap to be filled earlier rather than wait to see if the bad outcome materialises,” he says. The stress tests will, in theory, both measure the size of the hole and locate where it lies.
Analysts highlight a number of specific concerns about the plan. The moment of disclosure of bank capital needs is fraught with danger for weaker banks; the government – which by its own accounting has only $135bn (€103bn, £91bn) in bail-out funds left – may not be able to fill the true gap if private capital is not forthcoming; and the private sector is fearful of engaging with the government amid a populist backlash against Wall Street.
Policymakers acknowledge that the plan breaks from the “convoy” system of recapitalisation put in place last October by Hank Paulson, Mr Geithner’s predecessor under George W. Bush, at the height of the panic. They say it is better to clear the cloud of uncertainty and allow stronger banks to raise capital from the market than to leave all of them unable to do so. “The market is differentiating more now anyway,” says the senior official. “What we want is for the differentiation to be based on knowledge rather than some big uncertainty.”
He says banks that demonstrate abundant capital and an ability to raise fresh equity should, in principle, be able to repay existing government preferred shares – a prospect that worries weaker competitors. But the assessment would be based on “what is good for the system”.
The senior official plays down concerns about the limited amount of additional government funds to backstop the capital raising – though few political analysts doubt the administration would ask for more money if the political window opens. “There are lots of sources of capital,” the official says. “You can raise more capital from the market, you can take your existing preferred stock from the government and convert it, you can convert other preferred, you can take more capital from the government.”
The big challenge, though, comes from critics who question the entire premise of the administration’s approach: the idea that it is intervening early enough in the crisis to fix the system without having to nationalise or bankrupt the banks and divide them into so-called “good” and “bad” banks along the lines of the Swedish model.
Describing that notion as a “fundamental misconception”, Simon Johnson, a professor at MIT and former chief economist at the International Monetary Fund, says: “The nature of the system has changed. Things that used to happen in 10 years, happen in 10 days or even 10 minutes.”
Kenneth Rogoff, a professor at Harvard and another ex-IMF chief economist, thinks it is absurd to say the banking system is not truly impaired today, when it is being kept alive by government funding guarantees, liquidity support from the Federal Reserve and a host of other props. Even the banks’ ability to generate large profits is based in part on their undertaking proprietary trading with Fed loans and implicit government guarantees against failure, he argues. “This is a policy of forbearance that could easily make the crisis last longer.”
Critics charge that the stress tests are just not stressful enough – that they are inadequate to prepare banks against a wide range of eventualities and thereby restore confidence in them.
Nouriel Roubini, chairman of RGE Monitor, points out that US unemployment, at 8.5 per cent, is on track to exceed the stress case scenario. Moreover, banks are asked to estimate losses on loans under this scenario only over two years – up from the usual one, but not covering the full lifetime of the loans.
Policymakers say the microeconomic assumptions are tough and warn against writing off the tests as a whitewash before these details are made public. Examiners, for instance, are asking banks to estimate what the appropriate level of reserves might be at the end of the two-year period – implicitly taking into account lifetime losses to some degree.
Officials are also considering adjusting for the faster-than-expected rise in unemployment by requiring banks to hold more equity than they would otherwise have done for any given set of stress-test findings.
Yet some policymakers admit that this is not a textbook “truth-telling” exercise in which banks are forced to write down assets to a worst-case value and then be recapitalised on that basis – a version of which is widely credited for catalysing the final recovery from crisis in Japan. It remains within the confines of a conventional form of bank accounting that some economists – and some policymakers – think provides a flawed picture of solvency.
However, even policymakers who dislike bank accounting believe that the US is a society of laws, and that the government cannot simply decide that it thinks banks are bankrupt and seize them. Officials think the capital increase determined by the stress tests will significantly strengthen the system, even if it is not enough to guard banks against a very wide range of plausible outcomes.
In addition, officials see the tests as having generated a lot of useful information and are pressing for this to be disclosed to the public, allowing for an informed discussion about bank solvency under different assumptions.
Policymakers are loath to amputate when they might be able to nurse a limb back to health. Some think in terms of reversible error – preferring to take steps that can be revised later if necessary – and there is a general aversion to taking high-risk steps that could do more harm than good. “Governments should practise the same principles as doctors – first, do no harm,” said Mr Obama this month, rejecting pre-emptive government takeovers that could threaten confidence.
An important feature of many policymakers’ thinking is that this is not their last shot – that they are still early enough in the life of the crisis to come back and try again with other, more forceful measures if it does not work.
Still, the administration’s capacity to muster what it takes to intervene decisively could diminish over time. At MIT, Prof Johnson says the politics of bail-outs could get worse rather than better, while Mr Obama’s approval ratings could diminish.
Yet even critics think the administration may get lucky and do just enough to allow the US to muddle through. The banking system has come back from the brink before – for instance in the early 1980s.
“It could all work out – who knows?” says Prof Rogoff. “But there is certainly a chance that what they are doing will end up costing more and prolonging the recession.”
Taxpayers’ curse may be to subsidise those who sell the toxic assets
Is the Obama administration’s plan to create a market for toxic “legacy assets” a scam designed to funnel large taxpayer subsidies to banks? Though the administration rejects the charge, many prominent economists say that is just what it is.
Jeffrey Sachs, a professor at Columbia, says the plan is a “thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks by buying toxic assets from the banks at far above their market value”.
The argument is that by providing non-recourse loans to finance most of the private-public purchases, the government will give its partners a strong incentive to overbid for assets of uncertain value.
This is because the private investor will share much of the profit if the asset turns out to be valuable but only a small share of the loss if it turns out to be worthless. The non-recourse loan in effect constitutes a “put option” or loss-limiting guarantee for the private partner.
Peyton Young, a professor at Oxford, says the auctions of toxic assets will ensure buyers pass on the subsidy to sellers – mostly banks. He calls this the “taxpayers’ curse”. Roger Farmer, a professor at UCLA, says the plan “will result in a subsidy to the unsecured creditors of the banks and will rightly be perceived as unfair”.
Critics are particularly troubled by provisions that would allow banks to buy each others’ toxic assets using the non-recourse loans. This could magnify overpayment problems and would shuffle assets around the banks rather than shifting them to other parts of the financial system where they may have less bearing on credit flows.
Even those who favour allowing banks to buy each others’ assets with non-recourse funds, such as Ricardo Caballero, a professor at MIT, say this amounts to providing insurance-style “guarantees” on bank portfolios.
Policymakers insist they are not trying to recapitalise banks by the back door. They say they are simply trying to eliminate the liquidity risk premium currently weighing on the assets. Pools of assets are always financed by non-recourse loans that embed a put option, they add. All they are doing is providing financing on terms the market would normally offer but will not during a crisis – an extension of traditional lender-of-last-resort activity.
Critics have jumped the gun in alleging big subsidies, they add, since they have not yet disclosed the terms on their loans.
Michael Spence, a professor at Stanford, says the loans do not represent a subsidy if the government recoups the value of the put option embedded in them, for instance through warrants. The option value depends on how uncertain the value of an impaired asset remains.
“Government therefore needs to confine the use and match the level of leverage to cases in which the value may be impaired but the uncertainty is low to moderate,” says Prof Spence
Most defenders of the plan expect there will be some subsidy, but less than the critics allege, and that it will be money well spent. Indeed, there may need to be a subsidy to persuade banks to sell.
Banks that are borderline insolvent will not sell volatile assets even at their full expected cash-flow value, because of the incentives created by limited liability banking. Their shareholders benefit if the assets turn out to be valuable but have little to lose if they turn out to be worthless. They would have to be paid a premium to part with this volatility.
“There will be some subsidy. There probably has to be,” says a non-US official. “The question is whether the plan is efficiently designed to pay only the minimum subsidy necessary.”
Copyright The Financial Times Limited 2009"
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