WHERE"S THE STRESS?

So here is the question ……if you wanted to gauge your fitness and asked your doctor to put you through a treadmill “stress test,” would you be comfortable with the results if the treadmill was set at four miles per hour? What about three miles per hour? Two? Well, the FDIC, with as assist from the White House, has just designed a stress test for the nation’s top nineteen banks that will force those banks to get on a treadmill that is moving at just one mile per hour. And after a 10 minute march, that covers just one-sixth of a mile, Tim Geitner and Sheila Bair will look at the subjects and declare that each is healthy, each has the capital necessary to survive the coming storm, and each is worthy of further public investment. That’s it: walk 860 feet in ten minutes and if you aren’t breathing heavily, you get a lollipop. In a nutshell, this is the administration’s grand plan to save the banks: Develop a test that cannot be failed, pass every participant with flying colors, and hope for the best. In essence the nation has now adopted a banking policy that mimics its education policy. How’s that for “change?”

If this is all news to you, let me explain. The FDIC is set to adminster a test that will gauge how a bank’s balance sheet performs under a gloomy scenario. In this case, the Department is “stressing” each balance sheet with an assumption that GDP will shrink 3.3 percent in 2009 and will be up slightly in 2010. On the employment front, the test is assuming that rates will rise to 8.9 percent in 2009 and 10.3 percent in 2010. Do these assumptions really qualify as “stressed?” Flat GDP in 2010? That is stressed? Sounds more like “optimism” to me. Better yet, sounds like “fantasy” to me. So, rather than developing a test to determine whether the banks have the capital to survive another leg down, or three legs down, the FDIC has drafted a test that does nothing of the sort. And the reason is really pretty simple: a rigorous test, one that assumes GDP will fall four percent, and maybe another four percent in 2010, would come back with failures across the board.

One such example is Suntrust, a bank with assets of almost $190B. At the end of the 4th quarter, Sunny had just $10B of Tanglible Common Equity, leaving it with a TCE/Total Assets ratio of 5.2 percent. Under the FDIC’s stress test, Sunny will continue to absorb losses as they did throughout 2008. Non-performing assets will continue to rise. Hits to common equity will ensue. But the losses will be manageable and Sunny’s capital levels will probably remain above minimum thresholds. After all, Sunny could absorb a four billion doillar hit to TCE and still have its TCE/TA ratio above three percent, the level that the government has tacitly endorsed as sufficient

But this is what you need to know: in the fourth quarter Sunny took a billion dollar provision for loan losses. AND IT WASN’T ENOUGH! After a billion dollar provision you would think that Sunny is adequately reserved. Well, they are not. In fact, their allowance, as a percentage of non-performing loans, is just 61 percent and NPA’s are exploding. Now, unemployment is accelerating, the housing mess is spreading quickly to Suntrusts’s Southeastern lending base and Sunny still has $9B of loans extended to private homebuilders. Those particular losses alone could be staggering. And what if things don’t turn around in 2010 as the FDIC’s test envisions? Yeah, Sunny only absorbed 2B in loan losses in 2008 but the way conditions are worsening and NPAs are building, it’s possible that Suntrust will have 5 billion in losses this year and another 5B in 2010. This “test,” my test, would nearly extinguish the company’s common equity.

I don’t mind so much that the FDIC won’t incorporate my skepticism in their test because to do so would force the banking industry to immediately raise capital based on a forecast. But what I mind is the FDIC using a test, and one that doesn’t pass the laugh test, as a marketing tool to assuage the concerns of investors and the public. Let’s be honest with ourselves: this test is a political bandaid that serves little purpose other than to stamp these banks with a federal seal of approval. And if conditions end up being worse than envisioned by the FDIC, there is no way any of these banks are going to pass the next test, the all important 2010 solvency test.