You might have noticed that I haven’t said much about the stress tests since they were released. That’s mainly due to the fact that, as a market moving event, they are in the rear view mirror. I knew months ago that the government was teeing up M2M, the uptick rule, the PPIP, the stress tests and Fed talk to create this false sense of security surrounding our banking system. Of course, all of this was a great plan to recapitalize the banks. Bernanke and Geithner now know the TALF and PPIP will not work. They also know they can’t go back to Congress for money because the taxpayer has bailout fatigue. So what do they do? They create this environment of bank health where the banks can simply raise capital. It’s smart and it’s good for the banks (as you can see in their share prices).
Unfortunately, we have officially chosen to become Japanese with regards to our banks. We aren’t going to allow the bondholders to take the losses they so rightfully deserve. So, we’re going to hope the economy improves and let the banks earn their way out of the hole they got themselves into. But the fatal flaw here is that it does not change the potential long-term risks.
The major risk here is that the banks continue to take on more and more credit losses. We all know credit losses are going to increase in the coming quarters and possibly years. RBS, Lloyds and the balance sheets of Capital One and Bank of America confirm that. So the real risk to this whole banking solution is that the banks don’t sell their currently non-performing and underperforming loans and rack up even more losses as housing, credit cards and commercial RE losses continue to mount. The banks are assuming these non-performing assets will regain some of their former glory and become attractive assets down the road. But what if they don’t? What if the losses continue to mount? What if the economic rebound is very sluggish? The banks will need to be recapitalized again in a few months or years. And at that point it’s likely that FDIC receivership will be the endgame.
So, what have we actually accomplished with the stress tests? We’ve given a heart disease patient a heavy dose of aspirin. The underlying problem (the toxic assets) is still very much with us. What is most frustrating about this exercise is reports that the government caved to the bank demands in recent weeks. The market environment is very positive right now. Maybe as positive as it will get in 2009. Why not force these banks to take the losses now and recapitalize? Instead, there are reports that many of the banks were able to convince Treasury to reduce the size of their necessary capital needs. That makes no sense to me. Perhaps the worst result from all of this is that the banks are in a position of bargaining power. All of this government intervention has effectively ruined any potential positivity that might have resulted from the PPIP because the banks have absolutely no incentive to sell now. None. We might as well scrap that program before we dump a dime into it.
So, we can move on from the stress tests. I heard a good quote yesterday – I can’t remember where: “When I go in for a stress test it’s not the results I am most concerned with but the prescription”. We know the banks are at risk of a major heart attack and we’ve prescribed them aspirin when we could have forced them onto the operating table….Let’s hope this economic recovery is real because if it isn’t this market is going to start feeling like the twilight zone….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.