qualsiasi miglior soluzione prevede che i risparmiatori perdano soldi...
Ten Reasons Why the Stress Tests Are “Schmess” Tests and Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed
Nouriel Roubini | May 8, 2009
What shall we make of the recently announced results of the stress test? Are they credible? Will they restore confidence in our battered financial system? Will the current approach to resolving the financial crisis work, be effective and minimize the fiscal costs of the financial bailout?
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 (see also my two recent op-eds with Matt Richardson in the
WSJ and the
FT):
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. Note also that the parameters for the more adverse scenario in the stress tests were a political compromise among the agencies involved in the stress tests; one of these agencies had found more realistic the hypothesis that the parameter for the unemployment rate in the more adverse scenario should be 12% rather than 10.3%. Moreover, the stress tests found that the 19 banks needed $185 bn of additional equity; the published figure of $75 is based on assets dispositions and capital raises of $110 bn that are still under way and, in most cases, not completed yet. Booking such increases in equity before they have occurred does not seem appropriate accounting procedure.
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. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario. Thus, ex-post capital needs will be significantly higher if net retained earnings turn out to be lower than assumed in the stress tests. While regulators resisted the banks’ attempt to use Q1 earnings (that were fudged via under-provisioning for loan losses, paper gains on securities via changes in FASB rules on mark-to-market, and accounting gains coming from the lower market value of bank liabilities) as proxy for the future profitability of banks it appears that such regulators were too optimistic in estimating what net retained earnings will be in 2009-2010.
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. Certainly in the last year regulators have been lenient and provided plenty of forbearance – on top of expensive formal guarantees of hundreds of billions of toxic assets for several banks – to reduce the amount of revealed losses on securities. Also, if one were to bring forward to today the writedowns/charge-offs for 2009-2010 estimated by the US regulators (an exercise that the IMF has done for all US banks in its recent Global Financial Stability Report) the TCE ratio for these 19 banks – and all US banks - would be effectively 0.1% today. So, the US regulators estimates of equity needs of these 19 banks are heavily depended on what net earnings before writedowns will be in 2009-2010.
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. The Fed is also losing a fortune on its three Maiden Lane funds that purchased toxic assets of Bear Stearns and AIG. On top of this major US financial institutions got a massive direct subsidy from the bailout of AIG. 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. Even taking into account the fact that not all of these resources will represent a net long term loss to the US taxpayer even a conservative estimate of the net subsidy to the banks’ shareholders and unsecured creditors may be above $500 bn.
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. A capital adequacy ratio is also certainly necessary for these banks as they are systemically important: every academic analysis of systemic risk suggests that banks that are systemically important should have much higher capital in order to internalize the externalities deriving from too-big-to-fail distortions. And while Basel criteria for capital adequacy have not been yet revised to include this need for additional capital for too-big-to-fail banks the G20 and the FSF have already acknowledge the need to charge more capital for such large institutions.
Indeed, some national regulators have already moved to increase the capital required from their own banks: for example Switzerland has already unilateral imposed a 16% capital ratio for its systemically important banks to be phased in by 2013, a ratio that is double the Basel criteria of 8% for Tier 1 and Tier 2. Thus, it would have been appropriate that US regulators request that these 19 banks – that are all deemed to be systemically important – should aim to achieve a TCE ratio of at least 6% - not 4% - equal to the one prevailing in the mid-1990s for all US banks (not just the systemically important ones). The capital needs of all US banks would have been an additional $225 bn (based on IMF estimates) if the TCE ratio were to be increased from 4% to 6%. For these 19 banks a 6% TCE ratio – the minimum justifiable for systemically important institutions – would imply about an additional $100 bn of common equity compared to the estimates of the regulators.
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.
Indeed, the problem with the current approach to the financial crisis is that the too-big-to-fail problem has become an even-bigger-to-fail problem and that moral hazard distortions from government bailouts have been sharply increased via trillions of dollars committed to backstop the financial system. First, while some significant support of the financial system was necessary and desirable to stop bank runs, reduce serious refinancing risks and avoid a more severe credit crunch the extent of the support and subsidy of the financial system has created the mother of all moral hazard distortions. Second, the current approach to crisis resolution has led to an even-bigger-to-fail problem because of the government inducing relatively less weak institutions to take over weaker ones. JP Morgan took over Bear Stearns and then WaMu; Bank of America took over Countrywide and then Merrill Lynch; and Wells Fargo took over Wachovia. And in the battle for Wachovia Citigroup aggressively fought Wells Fargo not because Wachovia was a sound banks (it was indeed insolvent and bust); it did so because taking over Wachovia would have made a too-big-to-fail Citi an even-bigger-to-fail bank with greater likelihood of government bailout. To put two weak – or near-zombie - banks together is like having two drunks trying to hold each other to stand straight. To resolve this even-bigger-to-fail problem a strategy of taking over near-insolvent institutions and then break them up in smaller, systemically-not-important pieces would have been appropriate. Alternatively, charging much higher capital ratios on too-big-to-fail banks – as optimal according to economic theory - would incentivize them to break themselves up in smaller pieces. But neither approach has been so far followed by US policy makers; and we have thus created the mother of all moral-hazard driven bailout distortions.
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. The IMF recently estimated the additional capital needs of all US banks to be $275 bn if the TCE ratio is to increased to 4% and $500 bn if the TCE ratio has to go back to 6% (it average level for all US banks before the credit bubble of the last decade).
Ninth, the current muddle through approach to the banking crisis is predicated on the assumption that forbearance and time will heal most wounds of most systemically important banks: generous assumptions on net retained earnings before writedowns – and hope that the economy will rapidly recover - will allow banks to earn their way out of their current massive capital shortages. But while the government will now let banks found to need more equity to raise such equity in the next six months the ability of such banks to do that will be very limited: very few private investors would want to provide capital to a bank with massive expected writedowns, large capital needs and where such private capital investments will be further significantly diluted by a government that will need to increasingly convert its preferred shares into common equity. As it is the government will already soon own 36% of Citigroup and more in the future if Citi needs much more capital and is unable to raise it from private sources. A similar fate awaits Bank of America that now needs to fill an equity gap of almost $35bn.
Tenth, to avoid creating Japanese-style zombie large banks that are near insolvent and kept alive by trillions of dollars of government bailout support it would have been better to take different approaches that minimize the long-term government ownership or control of the financial system. 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.
The logic of the current muddle through approach is clear (leaving aside the fact that Wall Street is still partially capturing the US regulators and policy makers): providing unlimited liquidity and deposit guarantees to avoid bank runs and refinancing risks; subsidize banks and their rebuild of capital via near zero funding rates, a steep intermediation curve and rising net interest rate margins; hope that the economy recovers faster than otherwise expected (as the green shoots are rising) so that eventual bank losses are lower; hope that forbearance and time will heal most wounds by reducing the eventual level of charge-offs and writedowns and letting bank rebuilt capital via earnings before provisions; ignore moral hazard distortions in the short run while the banking crisis is still simmering and try to reduce such distortions in the medium term with a new and better regime of supervision and regulation of financial institutions; avoid takeovers of large institutions that would be disorderly in the absence of a special insolvency regime for such large banks; avoid the risk that, even in the presence of such special insolvency regime, unintended consequences of a takeover of a large bank lead to Lehman-like consequences; hope that fiscal costs of massive subsidies and bailouts of banks are contained if a virtuous cycle of economic recovery and restoration of confidence in the financial system rapidly emerges; subsidize restoration of securitization (with the TALF) and subsidize the separation of toxic assets from the banks’ balance sheet via government leverage and non-recourse loans (PPIP); avoid a more severe credit crunch via sensible supervisory and regulatory forbearance (mark-to-market suspension of FASB rules; closing regulators’ eyes on the true value of loans and assets; avoid forcing banks to recapitalize too fast and let capital adequacy ratios to slip in the short run; etc.); deal with the too-big-to-fail problem only if/when the crisis is over with higher capital charges once banks can better afford them ; eventually reform the system of regulation and supervision of the financial system.
However, the current muddle through approach of colossal regulatory forbearance and bailout of the financial system has some serious risks and shortcomings (see my two recent op-eds with Matt Richardson in the
WSJ and the
FT for an elaboration): it significantly increases the fiscal costs to the taxpayer of bailing out financial institutions (their shareholders and creditors); it creates the mother of all moral hazard distortions as literally trillions of dollars of financial resources have been used to backstop the financial system and bailout reckless bankers and traders and investors; it ends up with a persistent and possibly long-term government control and partial ownership of parts of the financial system; it does not resolve the too-big-to-fail problem as big banks are not broken up or given incentives to break themselves up; it risks to keep alive zombie banks leading to a more persistent credit crunch, economic stagnation, deflation and debt deflation; it leads to problems of medium term fiscal sustainability as the large fiscal cost of the bailout of the financial system creates serious public debt dynamics problems over time; it creates a serious exit strategy problem for monetary policy as the tripling of the monetary base and the central bank purchase of toxic and illiquid assets risks to eventually lead to price inflation or to another asset and credit bubble unless the massive creation of liquidity is mopped up as soon as the real economy recovers; and it may end up with a cosmetic reform of the regime of regulation and supervision of the financial system as soon as the financial crisis looks like beginning to bottoming out.
Indeed many Wall Street voices are starting to argue that the crisis is over, that bull times are back, that they don’t need further government support (while still being on the government dole in twenty different Fed/FDIC/Treasury bailout/subsidy programs/funds), that they can repay TARP money (using the $350 bn of funds that they borrowed at near 0% interest rates with a FDIC full guarantee of interest and principal), that the government should not over-regulate the financial system, that controls on bankers compensation are misguided, that no fundamental change of the financial system and of its regulation is needed. This is the self-serving chatter that we are starting to hear from the same reckless lenders, bankers and investors whose greed and wildly distorted bonus/compensation schemes – together with regulators that were asleep at the wheel and believing in self-regulation that means no regulation – caused the worst economic recession and financial crisis since the Great Depression. This is the new spin of those whose fake (as not being risk-adjusted) gains/profits/bonuses were privatized in the bubble times when fake wealth and bubble profits were created and whose trillions of dollars of losses have now been fully socialized and paid for by the taxpayer. Their arrogance is only second to their shameless Chutzpah.
One can only hope that policy makers will resist these siren calls can and design a reform of the regime of regulation and supervision of financial institutions (more capital, less leverage, more liquidity, incentive compatible compensation with a bonus/malus system, higher capital charges to deal with – and possibly break-up – too-big-to-fail financial institutions, global regulatory standards that prevent jurisdictional arbitrage, etc.) that reduce the risk that a financial crisis of this proportion will happen again.
che il sistema sarebbe arrivato alla catastrofe. 
