Friday, April 24, 2009

Stress Test aka Simon Says

Well, details are now out about the summary conclusion of the health of US banks (Surprise! It's good) and the methodology used for the evaluation (Surprise! It's bad).

And thanks to this information, any remaining doubts I had about whether or not we are becoming a Banana Republic are now scarce.

I want to highlight a few key passages from the CNBC breaking story "Most Banks Have Enough Capital After Stress Tests: US":

The US government, releasing details of how it conducted "stress tests" on the nation's 19 largest financial institutions, said “most banks currently have capital levels well in excess of the amounts needed to be well capitalized."

The report said the tests are a “forward-looking exercise designed to estimate losses, revenues and reserve needs” under two different macroeconomic scenarios, including an adverse one.

According to the report, the "banks were asked to project their credit losses and revenues for two years." The process "involves the projection of losses on loans, assets held in investment potfolios and trading-related exposures, as well as the firm's capacity to absorb losses in order to determine a sufficient capital level to support lending."

Let me address these excerpts one by one:

First, in regards to these banks having more than enough capital, I'll simply say stay tuned. If this is the case, not one more dime of taxpayer money should be allocated to bailouts in kind, loans, or any other forms of guarantees against losses.

Of course, this will not be the case, and if I was stupid enough to be a shareholder in any of these banks right now for anything other than a quick trade, I'd have my attorney on speed dial with my finger hawking over the button.

And the simple reason is this: there is not remotely close to enough capital in the banks based on the deterioration of the economy and their assets as they are correlated. And one of 2 things (or both) is going to happen: Outright nationalization whereby common stock is zeroed out, and/or further issuance of common stock or conversion into it, thereby massively diluting shareholders.

Second, the scenarios are essentially a joke. Nouriel Roubini has already noted that many of the scenario conditions / metrics have already been superceded by the actual conditions / metrics that we have deteriorated so quickly to.

Third - and this is my favorite - was the statement I highlighted above, "banks were asked to project their credit losses and revenues for two years."

Wait, maybe I should re-read that again just to be sure that it wasn't a joke. Hmm, no subsequent punchline.

Uh oh.

Let me put this in very simple perspective. The Treasury was conducting a test. This test was to assess the potential that an financial organization had for future success or failure. MUCH LIKE THE WAY ANY SCHOOL TEST ASSESSES THE SAME FOR A STUDENT.

Were you ever given a test where the administrator asked you to tell them what you think the answer should be? And then it was? This is not a test. This is a game.

And that is what we have become. A land of fiction and fantasy, where the potential for any company is limited only to their imagination (and self-interest, of course).

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