The Federal Reserve has released the summary results of its Supervisory Capital Assessment Program, affectionately known as “The Stress Test” and at first blush the results don’t appear nearly as dire as many had feared. Only 10 of the 19 outfits put through the rigors of the test came up light, with the government estimating that losses at the banks could total as much as $600 billion under its worst case scenario, requiring them to raise a collective $75 billion to cover shortfalls. And while $75 billion is a huge number in and of itself, it’s chump change when you compare it to what’s already been spent.

 

But I have some major issues with the testing and the results.

As I wrote two weeks ago, the testing was conducted under two assumed scenarios, the baseline and the adverse.

The key metrics used for the baseline scenario were an assumption that the GDP would contract by two percent this year and grow 2.1 percent in 2010. It also projected for an unemployment rate of 8.4 percent this year and 8.8 percent next year and house prices declining 14 percent and four percentdecline in housing prices in 2010.

The severe but plausible scenario assumed a 3.3 percent GDP decline in 2009 and 0.5 percent gain in 2010. It also projected that unemployment will hover at 8.9 percent in 2009 and increase to 10.3 percent in 2010, with house prices down 22 percent in 2009 and seven percent in 2010.

But even as the tests were being completed, economic data showed that the nation was moving beyond the stress test baseline. According to today’s jobs report, the national unemployment rate is already 8.9 percent as of last month. While the pace of layoffs is slowing, businesses are still reluctant to hire. So there’s little indication of any meaningful improvement some time soon. Home prices are also skewing towards the worst case assumptions and as prices continue to decline there’s an increased likelihood of a foreclosure spike. Thus, it seems entirely possible that we may reach the worst case scenario.

The other worrying assumption made in the testing is that earnings potential was forecasted based on first quarter numbers, which showed sharp improvement over the fourth quarter. I firmly believe that the first quarter numbers where severely skewed by cheap capital and business combinations essentially forced together by government wheeling and dealing. So I think first quarter earnings are an optimistic jumping off point.

I also can’t figure out quite how the Fed came up with its default assumptions for the various types of loans. For instance, the government is assuming that 8.8 percent of Wells Fargo’s first lean mortgages would go bad under the worst case assumptions, with 11.9 percent of HELOCS going south and 4.8 percent of commercial and industrial loans souring. While I think the HELOC projections are probably on target, considering the awful mortgage portfolio that went along with their acquisition of Wachovia, I can easily see more than the allotted share of first mortgages going bad. I don’t even know where to begin with the C&I loans – those assumptions are just unvarnished optimism given the state of business.

Below is a table of the 19 tested banks, their capital needs and market cap for comparison purposes.

Source: Federal Reserve

As you can see, the capital needs of some of these institutions represent a pretty substantial portion of their current market cap. An interesting conundrum is how to recapitalize though outfits where secondary offerings are clearly not a viable option. For instance, I would expect KeyCorp and Regions to have a difficult time raising anywhere from a half to a third of their current caps through share offerings.

While there is still about $100 billion available under current TARP authorizations, it seems unlikely that Congress and the administration will be well disposed towards giving more to troubled banks. Particularly now that both investors and the public seem to sense the economic situation not getting much worse even if it’s not getting better, simply handing more cash to the banks is a political fraught proposition.

Common equity is considered banks’ first line of capital defense against losses since, unlike preferred stocks or bonds, banks can opt to cut or even eliminate dividends and other distributions to stock holders in order to conserve capital. Common shareholder equity is a key component of calculating Tier 1 risk-based ratios and as the Federal Reserve points out in its report, Tier 1 common capital is where most of the banks shortfall lies. If a bank goes that route, while there are potentially severe ramifications on share prices, there’s no obligation to make back payments or risk of default. That makes common equity a key factor in determining capitalization ratios and establishing whether or not a bank is solvent.

One option to pretty up the balance sheet is for the government to convert a portion of its current holdings of preferred shares to common stock. From a theoretical accounting perspective, that has the immediate effect of bolstering capitalization ratios, making up the government projected shortfalls. From a practical perspective, it changes nothing. The conversion would have the immediate effect of boosting capitalization ratios, but it adds no new real equity (cash) into the equation. So in the event of failure, not only is the government out of the cash it has already injected, but also the FDIC would still be on the hook for making depositors shore up coverage limits.

Considering how overstretched the Deposit Insurance Fund is (and the quarterly banking profiles issued by the FDIC are misleading in this regard), there’s the strong possibility that the American taxpayer could end up backstopping these losses regardless of whether more cash is provided upfront or on the backend. So if the government insists on playing an active role in keeping these guys afloat, they should back it up with real assets. If they don’t, you and I will likely end up paying for it some where along the line.

Judging from the market reaction to the results announcement, it seems that the desired result has been achieved. The market seems more comfortable in thinking that the problems facing these institutions are quantifiable, even if not easily fixable. And the government doesn’t seem to be in any rush to address the issues because while banks in need must submit recapitalization plans within 30 days, no real action will likely be seen until November based on the government’s timeline.

All told this basically amounts to a public relations move with the government hoping to instill enough confidence to buy some time to let the market work itself out.

I don’t particularly agree with that strategy; if you just let time work the issues out you don’t address the underlying causes, leaving the system susceptible to future problems. If the government were willing to let market forces take their course and let the truly troubled institutions fail, I wouldn’t worry quite so much. However, if it insists on propping them up no matter what the cost is, I’d like to see something fixed if it’s going to be on my dime.