Bank stress tests: the aftermath and consequences

On May 7, 2020, the Obama administration, hand-in-hand with the Federal Reserve, broke the long-standing precedent of trying to maintain confidence in the banking system and published what was essentially a list of “bad banks”, including some of the largest banks in the country.

Banks failing the Fed “stress test” were: Bank of America, Wells Fargo, Citigroup, Regions Financial, SunTrust, KeyCorp, and Fifth Third.
An old American custom ...

This is reminiscent of that old American custom, “tar and feathering” and “riding one out of town on a rail”.

The function of the Federal Reserve Bank is to protect the US banking system. Supposedly, it is exempt from political influence.

However, since Q4 2008, the Fed has repeatedly shown that it is not isolated from politics. Under the Obama administration, the stature of the Fed Chairman has been diminished, as the initiative has passed to Congress, the President, and the Secretary of Treasury.

The TARP funds, which Professor Bernanke helped to promote, have not been used as initially proposed, but instead have been transformed into a lever of power for the Obama administration.

Central bankers should strive to protect a bank's reputation ...

In acquiescing to the publication of the bank stress tests, the Fed Chairman seems to have forgotten his duty to protect the reputation of the banking system — unless, of course, the intention is to close the whole system down. Perhaps Ben Bernanke never heard the old saying, “Don’t foul one’s own nest”.

On May 8, 2020, the WSJ, the largest serious newspaper in the country, published a first-page, six-column banner headline, “Fed Sees Up to $599 Billion in Bank Losses”.

The article went on to say that the Federal Reserve had ordered ten of the largest banks to raise $74.6 billion in equity capital.

The Fed also gave its seal of approval as “passing the stress test” to a few large banks: US Bancorp, JP Morgan Chase, BB&T, and Capital One.

However, the “stress tests” were applied only to nineteen of the largest banks. No such tests were applied to the 3,000 or so other banks.

Furthermore, and most importantly, for the banking sector to escape the clutches of the Obama administration, about $197.7 billion (as of May 8, 2020) in TARP preferred shares will have to be redeemed, plus interest costs, and fees payable on the redemption of warrants.

In other words, it will cost the banking sector more than $272.3 billion to get out of hock with Uncle Sam.

Questions raised

The questions raised are these:

  1. Will these “bad banks” be able to raise equity, or will they be nationalized by the conversion of TARP preferred shares?
  2. What effect will the forced sale of $74.6 billion in new equity have on the stock market?
  3. What effect will the disclosure of the list of bad banks have on the position of the US as a leading financial center?

Would you invest in this bank?

By the end of the first 100 days of the Obama administration, potential buyers of equity to be issued by the “bad banks” had been forcibly made aware of the following by the government and the press:

  • These banks were imprudent stewards of shareholders’ and depositors’ money, having approved multi-billions of dollars of loans to unworthy creditors. These were the “bad guys” to blame for the crisis. Not Barney Frank or Chris Dodd or ACORN. It was the greedy bankers. They must be punished. No more dividends. No more executive bonuses.
  • In their willingness to sell-out their own shareholders in the Chrysler bankruptcy, by taking less than their fair share as a preferred creditor, in favor of the United Auto Workers, these banks demonstrated a profound disregard for the rule of law and fiduciary responsibility.
  • In the case of Bank of America (the bank with the most equity to raise), the top executives and directors apparently agreed to absorb Merrill Lynch, keeping secret (reportedly at the behest of the government) the amount of “toxic assets” that were being foisted on their shareholders. None of these directors/executives resigned in protest.
  • All of these banks have preferred shares held by the government, which means, in some cases, that the government can nationalize the banks at any moment. To completely be free of government debt, in some cases, will require much more money than can easily be raised within the next few years.
  • Unusual political pressure

  • The Obama administration and the Democrat-controlled Congress have clearly indicated that they are anxious to revive the flow of credit to those less likely to repay loans. President Obama has deep ties to ACORN, a shake-down group living off of government subsidies, reportedly having invaded bank board rooms to intimidate directors into making loans to the uncreditworthy.
  • The Obama administration has announced plans to raise taxes on corporations, on big investors, and on business doing business overseas.
  • Representatives of the Obama administration have threatened non-TARP investors with destroying their reputation by “unleashing the Washington Press Corp” on them unless they agree to forgo their fiduciary duty to shareholders. President Obama, himself, has come out attacking such principled fiduciaries as “speculators”, saying “I don’t stand with them”.

“Bad Banks” are now highly motivated

Although it seems unlikely that anyone would buy shares of these banks, some will indeed. In fact, there are a number of ways these banks may meet the government mandate.

Both good and “bad” banks are highly motivated to escape the TARP trap, as it becomes increasingly clear that the motives of the Obama administration are not to save the banking system, but rather to control it for political purposes, as became crystal clear with the Chrysler bankruptcy.

Trapped; desperate to escqpe ...

To save themselves, banks may try to convince non-government preferred shareholders to convert to common.

They may take advantage of the post-Glass-Steagall environment to use their captive broker-dealers to foist shares on borrowers.

How about this idea: priority in the loan line to those wearing an “I’m a XYZ Bank Shareholder” pin?

In the 1960s, Banco Brasileiro de Descontos, at the time the largest bank in South America, had hundreds of thousands of shareholders because of implied preferences given shareholders, big and small, in lending and other banking services.

They could try to issue equity with preemptive rights at a 50% discount from market value — virtually forcing current shareholders to take up the issue. See: Preemptive rights: Better than bailouts?

The “bad banks” are highly motivated to escape further water-boarding by the Obama administration and are likely to do just about anything to raise the amounts stipulated.

They probably will be successful.

However, the $272.3 billion (plus) needed to meet capital requirements and pay back TARP funds would seem to be beyond reach any time soon.

How much is $74.6 billion in a flow-of-funds context?

The Federal Reserve Flow of Funds table F.213 (Corporate Equities) shows net annual purchases and sales of these instruments. The table, below, shows these number summarized for the period 2005-2008 (annual average) and for the most recent year, 2008.

Federal Reserve Annual Flow of Funds for Equities F.213
2008 2005-2008
US$ billions average
Buybacks (issuance) (254.2) 195.5
Government 273.1 68.4
Foreign investors 20.5 93.0
Insurance Cos. 72.3 72.6
Funds 95.5 185.7
Bankers & brokers (34.0) 2.9
Total 173.2 618.1
Households (112.5) 443.6
Pension funds 285.7 174.5
Total 173.2 618.1

All of these figures have been radically distorted by the demise of stock buybacks in Q4 2008, and by the massive intervention of the US government in the stock market.

The table, based on recent market behavior, shows only three possible sources of private sector purchasers for the $74.6 billion in mandatory bank equity issues: Funds, Insurance Companies, and Foreign Investors.

The nature of equity purchases by funds changed in Q4 2008, switching from managed equity funds into exchange-traded funds (mostly index funds). Equity funds went into net redemption. The problem with index funds is that they are un-managed, following blindly the composition of stock indices. As bank stocks fall in value, there is less money available for bank equity purchases by index funds.

Next on the list is foreign investors. However, here we have the problem of the designation “foreign” and banking laws restricting ownership of US banks by foreigners.

Finally, we have the possibility of insurance companies, traditionally the most savvy of equity investors. This group has seen their equity portfolios ravaged by the Crash of 2008 and have their own regulatory requirements to worry about.

In any event, $74.6 billion is a big chunk out of net equity flows for any year, and more so in the context of Q4 2008, the current recession, and the general de-leveraging of the economy.

Secretary Timothy Geithner

To raise the required capital and repay TARP funds, will require more than $272.3 billion. Based on equity flows in the US market over the last four years, it seems unlikely that enough equity could be raised to break free from government intervention in less than two or three years, although some funds will be generated out of profits.

This leaves the private banking sector with the option of selling off assets, paying back the government, and becoming smaller. With smaller banks and stricter leveraging requirements, this means that banks may have less available to finance recovery.

With less help from the banks, non-bank enterprises (many of which are also over-leveraged) will also have to float equity in order to survive.

In other words, the forced issuance of bank equity in this volume, plus related efforts to get free from TARP financing, and the consequent need of non-banks to raise equity, does not seem to be good news for the stock market, at least in the near term — even if buyers are found for the immediate capital requirements of the “bad banks”.

Why did stock prices rise on news of the stress tests?

Despite what would seem to be bad news, the stock market rose on the morning of May 8, 2020.

An ant doesn't know he's about to be stepped on.

This reminds me of the day in 1997 when the President of Bank Indonesia announced to an audience of over one thousand bankers and business people, many representing major international firms, that the government was no longer going to maintain the crawling peg on the Rupiah.

No one ran for the door. There was no panic. I was sitting in the audience and no one seemed to immediately grasp the significance of the announcement. I know I didn’t. To understand the significance, one had to be following arcane central banking statistics, and no one was, including the central bankers.

However, three months later, based on that one announcement, the whole country was virtually bankrupt.

Most people in the market have an ants-eye view of the world, failing to perceive the giant foot that is about to crush them.

Of course, in May 2009, everyone was expecting the results of the “stress test” and the word “billion” had become severely depreciated by the Obama administration. People were now thinking in trillions, not billions. Few read flow of funds tables, anyway.

The side effects of “bad bank” publicity

Now I don’t know about you, but I like to go first class (or, at least business class) when I can afford it. When I flash my bank card, I don’t look forward to pity or a snide comment.

A better bank ... and a free toaster!

I know that Citicorp deposits will be good tomorrow and probably for a long, long time. But still, I don’t know if I like being associated with a “bad bank”, even as a depositor. Especially, when I can switch to a “good bank” without much trouble and be welcomed and maybe win a free toaster.

So I would expect that some people, maybe many, will gradually move away from the banks that have been tarred and feathered by Ben Bernanke — to fresh institutions, unsullied by the “bad bank” label.

Now, I know that Bernanke didn’t actually call the banks that failed the stress test, “bad banks”, but the term has been bandied around by the press. As some have said, “words matter!”

If enough people switch away from Bernanke’s “bad banks” to other banks, the deposit liabilities of these other banks will increase, which if the process goes far enough, fast enough, means the “good banks” will need more capital.

In any event, the loss of deposits can not be helpful to the “bad banks”. Banks are all about maintaining an intangible reputation, built carefully over many years. Citybank survived their president being sent to jail in the Great Depression; they’ll probably survive this crisis. But still …

“Bad Banks” and dollar hegemony

It seems hard to believe that the “stress test” announcement will do much to shore up world confidence in the US financial system and in the position of the dollar as the world reserve currency.

Keystone Inspector Geithner on the phone ...

Someday, we may look back on this as a 21st century version of the Keystone Cops, with wild-eyed Hank Paulson coming before Congress with his three-page bill for seven hundred billion dollars, Turbo Tax Tim Geithner flubbing his lines as he tries to explain his plan, Professor Bernanke running this way and that, fleeing from inflation one day, deflation the next, the ACORN gang shaking down bankers, Barney Frank portrayed by Fatty Arbuckle, and lurking in the background, of course, the scheming Barack Obama, lusting for change … any change.

But this is today and it’s not very funny.

Despite the lack of confidence inspired by the current US government, the position of the US dollar still appears safe, not by design, but by accident:

  • To substitute the dollar as the world’s reserve currency, some other country, or countries would have to be willing to accumulate a trade deficit (a supply of the new world currency), renounce neo-mercantilism, and be willing to place currency stability before high employment in times of stress. So far, there are no takers — and even the US doesn’t meet all these criteria.
  • To substitute the dollar, a country would need to be welcoming to people from all over the world as a refuge, a safe haven where they could run and live off their hoard of reserve currency when war or political strife assails their homeland. Again, there are no nominations, other than the US.
  • To substitute the dollar, a country would have to have a strong national defense, so that foreigners can see it as as safe refuge, relatively free from threat of invasion. China is working on the strong defense angle, while Barack Obama is going in the opposite direction.
  • To substitute the dollar, a country would have to be large enough to support a trade deficit that could serve the whole world without risking domestic inflation. Only a few countries or economic unions are big enough to even be considered, but none other than the US, has rejected neo-mercantilist politics.

So, for the time being, the position of the dollar seems safe — not as strong as it once was — but safe enough, by default.

However, there are more than three and one-half years left in the current administration. Plenty of time to do irreparable damage.

Photo credit: Obama Acorn, flickr by kps186media
Photo credit: Step on ants, flickr by WoofBC

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