Stressed out by stress tests

The US Government has released more details of how it would conduct ‘stress tests’ and how it would give the banks six months to raise private capital and if they fail, the US government would provide capital and that too only preferred capital and not equity capital. Such capital would convert in seven years into common equity, if the banks want it.


The ‘stress tests’ would assess whether banks have enough capital and also the composition and quality of their capital. There is no explicit reference to ‘asset values’. It is fascinating. It shows a mental reluctance to come to grips with the real issue – the presence of assets in the books (there may be still some outside, who knows?) that have no value or little value.


Secondly, these ‘stress tests’ will be conducted by banks themselves. Why? Why cannot they be done by independently appointed experts and why cannot these be published?


I am afraid that as Paul Krugman wrote in his blog on 24.2.2009, these plans are about re-arranging deck chairs and hoping for the best.


In this one, he links to the criteria for stress tests that the FDIC has set out (there is a link to PDF file from FDIC). He examines the ‘stress scenarios’. They are not ‘stressful’ at all. So, they are meant to make the banks survive the stress tests? For me, it is somewhat unbelievable that they are refusing to face up to reality


See this one on ‘All the President’s zombies’:


The last sentence is exactly in line with the medical analogy I had used in my email yesterday:


            At most we’ll get a slow intravenous drip that’s enough to keep the banks shambling along.”


Of course, this quote is not from Dr. Paul Krugman.


If some one asks me whether there is value in the American banks or the European ones, my answer is: “why bother finding out?”. 


U.S. Sets a Six-Month Deadline for New Bank Capital (Update5)

2009-02-25 23:16:31.404 GMT



     (Adds context on conduct of tests in fifth paragraph.)


By Rebecca Christie and Robert Schmidt

     Feb. 25 (Bloomberg) — The government set a six-month deadline for the biggest 19 U.S. banks to raise any new capital deemed necessary after a mandatory review of their balance sheets.

     The regulators will oversee the so-called stress tests by the end of April, which will identify how much extra cushion each bank will need, the Treasury said today in Washington. Lenders will have six months to raise private capital or accept government funds and the conditions that come with it.

     “While the vast majority of U.S. banking organizations have capital in excess of the amounts required to be considered well capitalized, the uncertain economic environment has eroded confidence in the amount and quality of capital held by some,”

the Treasury said, announcing guidelines for new bank reviews.

     Any new government money will come in the form of convertible preferred securities, which would acquire voting rights if converted into common stock. U.S. officials, speaking to reporters after the announcement, said there would be no limit on how much money the program could provide banks, raising questions about whether the Obama administration will need to ask Congress for more bailout funds.


                         Conduct of Tests


     The banks themselves will analyze system-wide losses under two economic scenarios, along with forecasts for internal resources to absorb the losses. Supervisors will discuss the results with the companies and determine whether an additional capital buffer is needed, according to the Treasury.

     Federal Reserve Chairman Ben S. Bernanke said today that not all of the 19 banks will likely need new injections of government funds.

     The Treasury has used about half the $700 billion allocated by Congress for the banking rescue, and most of that was spent under former President George W. Bush.

     Banks receiving the new money would be pressed to show how they will lend more, officials said.

     In their assessments, regulators will incorporate off- balance-sheet commitments, earnings projections, risks of the banks’ business activities and the composition and quality of their capital, the Treasury said.

     “We wanted to bring a more consistent, more conservative, more forward-looking approach so that we help this cloud of uncertainty that’s hanging over our financial system that’s getting in the way of credit flowing again,” Treasury Secretary Timothy Geithner said in an interview today with public television’s “The News Hour With Jim Lehrer.”


                         ‘Wrong Strategy’


     Geithner also said nationalization is “the wrong strategy for the country and I don’t think it’s the necessary strategy.”

     Losses will be projected under two sets of projections.

Under the “baseline,” the U.S. economy will shrink 2 percent this year and expand 2.1 percent in 2010. The “alternative more adverse” set of projections has gross domestic product dropping by 3.3 percent this year, with a 0.5 percent expansion in 2010.

     Any capital investments made by the Treasury will be placed in a separate trust to manage the government’s investments in financial companies.

     If it acquires voting rights, the Treasury said it would release guidelines on how it will handle the situation before completing any transactions. The shares would convert either at a bank’s request or at the end of a seven-year period.


                      ‘Temporary’ Ownership


     “U.S. government ownership is not an objective” of the program, the Treasury said. In cases of significant federal investment, “our goal will be to keep the period of government ownership as temporary as possible.”

     While the biggest 19 banks will be required to undergo the stress tests and get more capital, smaller banks can also apply to participate in the Treasury initiative, known as the Capital Assistance Program.

     Bernanke said today that while the U.S. government may take “substantial” stakes in Citigroup Inc. and other banks, it doesn’t plan a full-scale nationalization that wipes out stockholders.

     Nationalization is when the government “seizes” a company, “zeroes out the shareholders and begins to manage and run the bank, and we don’t plan anything like that,” Bernanke told lawmakers in Washington.

     Today’s statement didn’t specify any potential limit on the amount of money involved. President Barack Obama late yesterday signaled that the administration will seek more money from Congress for the effort to break the back of the credit crisis.




Bank Nationalization in America

Just take a look at where they have a table prepared by UBS on the Tier 1 capital adequacy (CA) ratios for many American banks. They also show tangible equity ratios. I do not know yet what constitutes tangible equity.


The issue whether these Tier 1 CA ratios, which look adequate, are worth looking at all,  without considering how bank assets are valued. We do not know how these asset values are computed, not to mention level 3 assets (assets for which there is no direct or indirect market price that can be imputed) and writeback of debt market value losses as capital gains! See Willem Buiter’s ‘shock’ at Barclay’s writeback of debt market loss as profits here.


The real question is one of whether they have adequate capital and if not, who will give it to them. In 2007 and last year, the banks tried Sovereign Wealth Funds. Now, it appears that is no longer feasible. SWFs have burnt their fingers very badly. They badly underestimated the layers and the quantum of leverage that the banks had created. No private investor now is interested in providing capital to the banks unless the asset values are deemed realistic and reasonable by them.


So, nationalization is not a choice. It is not an ideological debate here. It is a necessity. If private sector does not provide capital, then some one else must provide the capital once assets are properly valued.


Mr. Ben Bernanke (BB), to the extent I listened, said without batting an eyelid that the banks were adequately capitalized based on international norms and no congressman asked him whether the assets were valued correctly and realistically before their capital adequacy (or otherwise) was judged.


That was amazing to me. The markets rallied on a display of denial in Washington and the inability of the Congressmen to question him on that. Very surprising, indeed.


So, nationalization is the only option left to recapitalize them. Otherwise, they continue as zombies for a long period based on hope and waiting for luck, shrinking the balance sheets slowly and/or waiting for recovering economies to lift asset prices.


It does not look like much of a plan to me. Again, the conclusion is that Wall Street has won over national and economic interest.


I guess that is why nationalization is inevitable and the sooner it is done, the better for that would mean that some one is taking charge and valuing assets properly.


Perhaps, they are not doing it because the sums involved might be too scary now and that they have no option but to wait, hope and pray.


The following health analogy would help: if it is difficult to operate upon a sick patient because it might be too risky for the patient, then the doctor puts the patient on long and heavy medication. The sickness never goes away but they hope to keep it under check.


That is what the US government is doing to US banks. The heavy and prolonged medication is likely fiscal stimuluses unless they have some other plans to undertake nationalization eventually.


This does not look like the news on which markets should be rallying.


[p.s: William Pesek has written a good column recently in Bloomberg on why nationalization is proving to be trickier in the U.S. than it was in Sweden. He points out that America is not the same as Japan but possibly worse. Not all this is new. But, he has recaptured it again, for our benefit].

Outlook downgraded

S&P downgrading India’s credit rating outlook is not entirely a surprise. Some may take aim at the agency, given their diminished reputations. That would be a mistake. Their methodologies for sovereign credit rating assessment have not been criticised. 

Speaking to Bloomberg, Rajeev Malik of Macquarie Securities said that the new government should privatize, to reduce the deficit. I would add, rapidly and massively, to reduce government debt and deficit. More of us should be saying this more often.

I can only hope that among other things, this deficit and the ratings outlook downgrade cause sleepless nights to the economist in our Prime Minister.

Outlook does a economic report card on UPA

The lead article in ‘Outook’ (March 2, 2009) puts the grade at B-.  Perhaps, they were in a charitable mood. Then, there are columns by Dr. Pratap Bhanu Mehta (thanks to him for sending the link to his article), by Laveesh Bhandari of Indicus and an interview with Dr. Shankar Acharya. All three pull no punches, by and large.

Dr. PBM’s piece is concise and breaks the ‘Book of blunder’ into four parts: economic reforms/government finances, social programmes, secularism and integrity. While the piece on the whole pulls no punches, he lets them off finally with a slight wrap on the knuckles: 

The most appropriate indictment of this government is that they squandered the good times. 

I guess they did more damage than that. There has been regression in many areas. For that, one must  turn to Dr. Shankar Acharya’s interview. The title (‘Cost will be felt in the years ahead’) substantiates the message and supports the argument that the government caused more damage than merely squandering away good times. He points out the following:

This government stopped privatisation. There have been no major initiatives for sectors like banking and insurance. There was a rollback on issues like pricing of petroleum and energy. ..Take highways: there was much more progress during the NDA time than during this government’s tenure.

Yes, it is possible for ideas deemed to have arrived to be rolled back. That is what he is referring to. There was a rollback of reforms in petroleum pricing and in the power sector in general. Ideas once arrived can disappear in India unless they are nurtured. Successful leaders do that.

He lets them off somewhat lightly on the fiscal deficit aspect by mentioning only the quality of government spending. That is an endemic issue. Under UPA government, the quantum of government expenditure expanded prodigiously too without commensurate improvement in accountability and administrative capability.

On fiscal management in UPA, it is hard to match the clarity of this edit in MINT, of course.

Laveesh Bhandari starts off slowly with his ‘Inertia of Motion‘ but once he gets into stride, the facts and the arguments flow with such ease and felicity that can be mustered only by some one who is so intimately knowledgeable and in touch with the ground reality as he is.

Laveesh makes an important point that not many make. In fact, I have not seen any one else make that point: 

What has this government created, where has it innovated? Well, it has maintained and created greater incentives to consume, not to save and invest. Prices of expensive commodities such as energy were deliberately kept low. Interest rates first went up steadily and then went down dramatically. It has created conditions whereby rich and poor alike have lower incentives to save and greater to consume.

Indeed, that is a powerful indictment. For a government that wanted to put a human face to reforms (its claim and not mine – for me the prefix was superfluous; the unreformed and un-free economy that we experienced for more than 40 years after independence was inhuman), it ended up ensuring that the household savings rate peaked in 2003-04 fiscal year and that Indians took to consumption and accumulation of the trappings of wealth with such avarice and greed that the country ended up both with stock market and real estate bubbles.

While you are at all of these articles, it is hard to miss the blog post of Mohit Satyanand on Feb. 16th on the Interim budget: 

From a budgetary point of view, it is as if the good times of 2003-07 never happened.

This fiscal situation of course means that the government will have to be borrowing larger and larger sums from the market, crowding out private sector investment. In a scenario where global capital flows are drying up, this means that money for investment is going to get more and more scarce, and we can say goodbye to projections of 9% growth for a long, long time. [Bleak House Blues]

That about says it all. The problem with this government’s fiscal profligacy is not the the quantum of deficit but the attitude to fiscal deficit that it has likely engendered in future coalitions. The more disparate the coalition, the greater the fiscal deficit that it will generate.

Post-script: Given this state of affairs in the country, any Opposition must be fancying its chances. The BJP should ask itself why no one (including the party itself) considers it a shoo-in, in the forthcoming Lok Sabha elections. Its lack of clarity on the Indo-US nuclear deal and on economic reforms (the previous NDA government had an impressive track record on it) has left it too incoherent to exploit the colossal failures of the incumbent government. 

We, the people of India, are the likely losers, in the final analysis.

Martin Wolf asks the right question

In his column comparing Japan’s lost decade with what awaits US and UK in the coming decade, FT’s Economics Editor and Columnist Martin Wolf begins with the right question. It is a positive example of intellectual open-mindedness: 

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

He ends with these observations:

Last year marked the end of a hopeful era. Today, it is impossible to rule out a lost decade for the world economy. This has to be prevented. Posterity will not forgive leaders who fail to rise to this great challenge.

So, what should we do? here is my stab at the issue:  
Use fiscal policy. That is fine. How much and in what manner? Those are the questions more important than whether the US would prematurely resort to policy restraint. Unlikely even if policy-makers will become queasy. Surprising that Mr. Bernanke gave a speech to the National Press Club the other day that easy policy and liquidity can be rolled back quickly when two months ago the Fed told the world that easy money and low interest rates are here to stay for a very long time.

This is confusing.

Worship at the altar of growth has to stop for recovery to begin. In other words, policy should allow some growth disappointment not just for a year or two but even three, if necessary. 

Use fiscal policy, instead of as substitute to private demand, to put life back into private demand. In other words, return cash to the public via tax rebates or simple cheques. If they save it, so be it. They will put it in banks, provided banks are deemed safe. Which means, nationalize them. They are de facto worthless (I mean, the equity). Make it de jure.

Bank nationalization combined with fiscal policy that simply puts money directly into taxpayers’ pockets is the best of the worst possible things we (governments can do).

Continued insistence on supporting asset prices is wrong. That is where the US is going the Japanese way. Martin Wolf reminds us why the problem took so long to be recognised in Japan:

For years, people pretended that the problem was downward overshooting of asset price.
Why is the reluctance to ‘nationalize’, to fire management and to stop seeking to support asset prices? If you recall, Willem Buiter gave the answer some time ago. 

Derman’s delights

Emanuel Derman, former head of Quantitative Finance in Goldman Sachs and theoretical physicist now teaches both Industrial Engineering and Quantitative Finance in Colombia University. His blogs are short, crisp and both thoughtful and thought-provoking.

Here are two samples: (and)

Foreclosing foreclosures in America

Took a quick look at the Bloomberg news report on the plan to prevent foreclosures. Foreclosures occur when the borrower finds the loan value higher than the market value of the house and then he/she loses the incentive (because they can walk out of the mortgage, in some states in the US) to service the loan. Then the bank can foreclose the loan and seize the property. Alternatively, foreclosures occur when the borrower genuinely is not able to service the mortgage loan and defaults.

In other words, wilful or otherwise, foreclosures represent properties that should not have been bought, of course with the benefit of hindsight. In theory, it delays the bottoming of the housing market as supply of foreclosed homes depress home prices.

I have some problems with the tinkering going on here. Help on foreclosures can come from straightforward tax rebates or tax cuts. Put money in the hands of borrowers and make them service the loans. Let the housing market find its own level. Depressed prices do bring back buyers at some stage.

I am somewhat surprised that America has been willing to tamper with the price discovery process in almost all markets, in this crisis,  instead of adopting straightforward approaches.

Any thoughts?