ALG Editor’s Note: In the following featured editorial from the Wall Street Journal, the urgent need—in the wake of the stress tests—to “get back to a financial system free of government guarantees, public capital and political control” is illustrated. Amen to that:
Stressed for Success?
At the Hotel Geithner, you can check in, but . . .
The Treasury released its bank “stress test” results late yesterday, and the good news is that the financial system has survived this very public undressing better than most analysts figured three months ago. We’d attribute the results much more to Adam Smith’s continuing workout than to this public strip-tease, but we’ll take relief wherever we can get it.
Stress-testing is what banks and their regulators are supposed to do as a matter of course, albeit more quietly. The current very loud and public effort was advertised to provide an extraordinary measure of transparency at a time when no one trusted bank books. Do markets trust them any better now? Judging by the run-up in bank stock prices from their oversold levels in January, they do. This is progress.
On the other hand, all we really have to go on is the word of the federal employees who looked at the banks and estimated their losses against certain economic assumptions. Did they go easier than they might have, and how much did they bend when the banks fought back? The Fed’s overview yesterday claimed they ran a “deliberately stringent test” and pegged potential “adverse”-case losses at the 19 largest banks at $600 billion this year and next.
Yet markets are also full of reports that regulators showed more than a little forbearance, especially after it became clear that President Obama had no desire to go back to Congress to ask for more public money. With only $110 billion or so in Troubled Asset Relief Program (TARP) funds left uncommitted, it’s probably no coincidence that Treasury now sees new net bank capital needs as a manageable $75 billion.
And maybe that optimism will prove correct. Most banks are earning healthy profits again, thanks to a low cost of funds and steep yield curve. They’re also taking steps to burn bad debt and clean up their balance sheets. Some banks that got too big during the boom are looking to sell some of their operations in order to raise cash. This is how a financial system shapes itself up under the market pressure of recession, with or without stress tests.
Not that there still aren’t plenty of financial risks out there. On the credit side, commercial real estate is ugly and both home mortgage and credit card losses are a long way from receding. While the economy seems to be bottoming out at last, unemployment will keep rising for several months, which will mean more bank losses.
But our biggest question concerns interest-rate risk. Thanks to the Federal Reserve’s emergency easing, short-term rates are close to zero. That can’t last forever, and the longer the Fed keeps rates this low the more likely it is that rates will have to climb higher down the road to prevent inflation. Remember how the Fed’s 1% rate of 2003-2004 rose to 5.25% by 2006 and what that did to housing prices and the cost of bank funds? Yet the Fed didn’t disclose the interest-rate projections for 2010 and beyond that it built into its stress test models.
On the interest-rate point, by the way, one omen was yesterday’s terrible 30-year Treasury bond auction. Treasury sold $14 billion of the securities, but investors demanded yields in mid-auction that were higher than forecast and bond prices fell the most since February. The 30-year yield hit 4.3%. With trillions of dollars in budget deficits still in the pipeline — even before health care — Treasury may find the world keeps demanding higher yields to offset the fear of potential inflation. Fed Chairman Ben Bernanke didn’t help on that score this week when he told Congress that it was too early to take liquidity out of the financial system because the economy was still too weak. By the time the economy is growing, it will be too late. Think 2004, again.
In the wake of the stress tests, the weaker banks will now have six months to raise private capital to fill the hole identified by Treasury. They’ll be desperate to do so, because the alternative is that Treasury will force them to accept more public capital. This will include the conversion of Treasury’s preferred stock, bought last year via the TARP, into common shares.
Under accounting rules, this gives the banks more “tangible common equity,” the measure of capital favored by Treasury. Yet it provides not a penny more in actual capital to absorb losses. Meantime, the feds would suddenly own big chunks of those banks via common stock, the way they now are the largest shareholder in once-proud Citigroup. We’ve called this a back-door nationalization, and it means Congress looking over banker shoulders. The silver lining is that bank executives are now so appalled by this idea that they’ll sell anything that moves to avoid such a fate.
As for the “stronger” banks, a major goal will be to flee as fast as possible from the TARP, also known as the Hotel Geithner. Banks can check in but it’s a lot harder to check out. Treasury has set up major hurdles before a bank can escape, even if it wants to. Clearly banks at risk of failing can’t be allowed to endanger the larger financial system, but banks that have adequate capital shouldn’t be held hostage to the political worries of regulators.
The best that can be said about the stress tests is that they’re over. Now the most urgent task is to get back to a financial system free of government guarantees, public capital and political control.
