Investing Caffeine

Who Will Pass the Stress Test?

May 1, 2009 at 8:28 pm Leave a comment

The Government, including the Federal Reserve and U.S. Treasury department, is conducting a review of the 19 largest banks that pose “systemic” risk to the overall financial system. Although there will be no “Pass” or “Fail” grade given to the institutions, the government will clarify whether capital-raising will be necessary to weather a worsening economic storm. Scenarios under the stress test will contemplate the impact on the banks’ balance sheets and request capital increases for the weaker banks. The pessimistic case for the banks considers the following hypothetical setting:

Gross domestic product (GDP) declining by -3.3 percent in 2009 and growing by +0.5 percent in 2010.
Unemployment rate reaching 10.3 percent
Home prices to fall by another 29 percent, by 2010.

Right now the government is negotiating with the bank management teams regarding how much, if any, capital-raising will be necessary over the next six months. If the banks are unsuccessful raising capital on their own, then the government will standby to inject government money in to the banks. Rather than using tax-payer dollars, I’m in the camp that the banks’ bondholders should share the pain by converting their debt into equity – thereby relieving the burden on our debt-strapped government and taxpayers. Larry Summers, the Director of the White House’s National Economic Council, has hinted the administration is exploring this route. Regardless, the government needs to strengthen the equity positions of the banks if Bill Ackman at Pershing Square Capital Management is correct in estimating the financial system needing to repay $300 billion in debt coming due in 2009; $280 billion in 2010; and $250 billion in 2011.

In some respects this “Stress Test” is a “Lose-Lose” proposition because if certain banks are forced to raise large sums of capital, then the public will lose confidence in the banks. Conversely, if all the banks come out of the test with a clean bill of health, then the public will lose all confidence in the credibility of the tests themselves. Results will arrive soon enough – let’s hope the stress-test provides relief, not a migraine!

Entry filed under: Banking.