Figuring out 'stress tests'

The Treasury Department finally announced the way it plans to measure the health of U.S. banks, the first step in a process that supposedly will infuse more money into the banking system. A total of 19 banks will face this mandatory “stress test” to judge whether they have enough capital to survive another steep drop in housing prices or a sharp increase in unemployment rates. Those that don't would have six months to raise money from the private sector, or would take on additional capital injections from the government. The injections would involve securities that could be converted into common stock at a 10 percent discount to the price prevailing prior to Feb. 9th. (Such pricing is already being criticized as unfair to the taxpayer.)

There is no simple way to explain all this, which is one of the reasons the policy debate has veered into less important terrain, such as how much executives should make and why a Chicago bank that received federal funds sponsored an L.A. golf tournament that included a bunch of parties and concerts. Like that's what we should be paying attention to. What really matters is the type and amount of capital that these banks have – and whether it will be enough to contain the flood of losses from those toxic loans. From the NYT:

Until the financial system deteriorated last fall, investors focused on what is known as Tier 1 capital, which consists of common stock, preferred stock and hybrid debt-equity instruments. Now, however, they are focusing on what is called tangible equity capital, which includes only common stock, saying it is a better way to measure the risk in bank shares. The difference might sound like something only an accountant would worry about, but it lies at the heart of two questions confounding both Washington and Wall Street: Are the nation’s banks sound? And are bank shares a good barometer for the health of the financial system? Sheila C. Bair, the head of the Federal Insurance Deposit Corporation, said on Tuesday that the nation’s banking industry was safe.

What the government folks really want to know is whether the banks will remain safe should the economy worsen in the coming months, which is likely. Two economic scenarios will be used. One would have unemployment rising to 8.4 percent this year, economic growth contracting 2 percent and home prices falling 14 percent. The other, a worst-case scenario, would have unemployment hitting 10.3 percent in 2010, economic growth contracting 3.3 percent and home prices falling 22 percent. The stress tests are supposed to be finished in late April, at which point the banks needing to recapitalize will do so either through the private sector or with the help of the government.

So does all this amount to nationalization without saying as much? Well, sort of. Christopher Low, chief economist at FTN Financial, says nationalization is, in effect, being used to prevent nationalization. By converting its holdings into common stock, the government wants to avoid an ownership stake of more than 50 percent. Bloomberg columnist David Reilly says the government is sidestepping the issue:

During congressional testimony Tuesday, Federal Reserve Chairman Ben Bernanke said there was no rush toward nationalization. Senate Majority Leader Harry Reid struck a similar note when asked about nationalization in an interview with Bloomberg television Monday, saying there is “no need to even talk about it. It’s not necessary.” Reid’s remarks followed comments Friday by Senate Banking Committee Chairman Christopher Dodd that short-term nationalization was in fact a possibility. On Tuesday, Dodd said his remarks should have been “better thought out.” No wonder investors are confused and fleeing markets. Fundamental analysis of banks is now nearly impossible; it is all down to government whim. Investors may as well read chicken entrails to divine prospects for bank stocks.