This afternoon, Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve will announce the results of an unprecedented review of the capital position of the nation’s largest banks. This will be an important step forward in President Obama’s program to help repair the financial system, restore the flow of credit and put our nation on the path to economic recovery.
The president came into office facing a deep recession and a damaged financial system. Credit had dried up, forcing businesses to lay off workers and defer investment. Families were finding it difficult to borrow to finance a new house, buy a car or pay college tuition. Without action to restore lending, we faced the prospect of a much deeper and longer recession.
President Obama confronted these problems with dramatic action to address the housing crisis and to restart credit markets that are responsible for roughly half of all business and consumer lending. The administration also initiated a program to provide a market for legacy loans and securities to help cleanse bank balance sheets. These programs are helping to repair lending channels that do not rely on banks, and will contribute to fixing the banking system itself....
We could have left this problem as we found it and hoped that, over time, banks would earn their way out of the mistakes they had made. Instead, we chose a strategy to lift the fog of uncertainty over bank balance sheets and to help ensure that the major banks, individually and collectively, had the capital to continue lending even in a worse than expected recession.
We brought together bank supervisors to undertake an exceptional assessment of the strength of our nation’s 19 largest banks. The object was to estimate potential future losses, and ensure that banks had enough capital to keep lending even in the face of a deeper recession.—Timothy Geithner, Secretary of Treasury,
In an opinion piece for the New York Times
The quote above comes from an opinion piece written by Timothy Geithner, describing the reasons why the US government is stress testing major banks. American government has not used the heavy-handed approach against banks for many decades. The last American government to punish banks to this degree was the government of FDR. Perhaps it is fitting that, somewhat similar to the 1920's, the banks and bank shareholders who caused severe damage to the American, and indeed the world, economy end up paying a price.
Some skeptics will argue the tests weren't stressful enough. I'm not a bank expert but if you stress the scenario further, I think it is unreasonable to bank shareholders—you end up punishing them for something that may not occur. As Ben Bernanke has pointed out, the banks have enough capital to satify banking regulations; it's just that the market doesn't trust the future.
Here are the results, courtesy The New York Times (click link for interactive table):
As you can see from the table, the damage is heavily concentrated in a few banks: Bank of America*, Citigroup (which already raised capital by giving up 36% ownership to the government), GMAC, and Regions Financial. It is probable that GMAC is toast and probably won't be able to fund Chrysler customers (one of the plans was for GMAC to ramp up auto lending once the Chrysler situation was sorted out.) This is not to say that GMAC is bankrupt but it likely means that its shareholders are going to be severely diluted. Wells Fargo also requires additional capital.
There are some prominent individuals that have not been supportive of the stress tests and have been highly critical of the government. Warren Buffett has been critical of the whole process but one should keep in mind that Buffett owns a huge chunk of Wells Fargo. Wells Fargo, as the results above indicate, is one bank with a lot of potentially toxic assets concentrated in first mortgages. Another person that has been critical of the approach is Bill Miller (I'll write about his latest shareholder letter, which covers his views, in the future.)
As for me—I'll write up more on this topic when I write up Bill Miller's shareholder letter—I think what the government is doing is reasonable. It may seem unfair to someone like Buffett who thinks Wells Fargo is a good bank, but no one is sure. Certainly the market is concerned about all the banks. I should also point out that the banks are getting a free ride from the taxpayers. On top of transferring wealth from savers to banks by keeping interest rates very low—the right strategy but, nevertheless, it is a transfer from savers,—the banks are borrowing cheaply from the FedRes, and also issuing bonds with government backing. Name an industry that can issue bonds where the government will pay if the bonds default.
I would urge investors to be really cautious with their investments. Seems like obvious advice but I notice many being very anxious to get back into the market. Although one may miss out on huge gains by not acting, one should be mindful of the potential downside. If you find a good investment with a big margin of safety, go for it. Otherwise, be patient. Many investors, including professionals I read in the paper or see on television, don't seem to understand why the 1929 crash involved a huge decline. Reading the book Anatomy of the Bear, my understanding is that the really big collapse in share prices, after the initial 1929 plunge, happened due to three causes (do note that everyone has their own theory of why something happens in finace or economics so you have to form your opinion.) There was an initial banking crisis; then there was a second banking crisis; and then finally, a gold drain. In the current crisis, we have had one banking crisis. It is absolutely essential that we do not get another one. What may trigger another one is higher-than-expected losses on consumer non-mortgage debt. I'm not expecting it but I'm watching.
* I had been mildly supportive of Ken Lewis in the past but, man, he must have made one of the biggest executive mistakes in American corporate history. It's unbelievable that Merrill Lynch could essentially bring down one of the strongest banks in America (Countrywide probably doesn't help matters either but my impression is that most of the losses are from Merrill Lynch.) Recall that Bank of America was not exposed to toxic mortgages in any major way. They were mostly a retail bank and only had minor business in secrutization of toxic assets. This will go down in history as one of the worst deals, and probably rival the Time Warner purchase of AOL in 2000.