Stressing over the "Stress Tests"

Posted by: Ben Steverman on May 4, 2009

As bank investors await the results of the U.S. Treasury’s “stress tests” of the nation’s largest banks, this May 4 advice from Stifel Nicolaus (SF) analyst Christopher Mutascio seems valuable:

We could try and guess what the results of the stress test will be, but that seems risky to us given that the government has been all over the map during the financial crisis. We have seen many prognostications in recent days from some that believe specific banks need tens of billions in additional capital while others believe the stress test will be rather benign. In reality, no one knows and making bold predictions ahead of the results could make one look rather foolish.

It turns out that these stress tests are not just a symbolic move by the government. These tests decide which banks will be forced to raise more capital — and by how much. Raising capital will mean issuing more shares, a step that could massively dilute current shareholders’ stakes. Without knowing how many shares will be trading, it’s impossible to do something as simple as estimate future earnings.

But the results of stress tests don’t just matter for the top 19 banks. While market observers fret over Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC), it’s worth considering the next step for the U.S. Treasury. How will the government handle credit problems at smaller, regional banks?

As Mutascio implies, predicting the government’s next move may be as difficult as predicting the stress test results.

Bank analysts at Keefe, Bruyette & Woods (KBW) did conduct their own bank stress tests. They also tried to figure how much capital the entire U.S. banking system will need to survive a worst-case scenario. Their answer: An extra $1 trillion could be needed.

First quarter results at smaller banks were mixed. A KBW analysis of the 142 banks it covers showed 76, or 54%, missed Wall Street analysts’ earnings expectations. However, that’s better than last quarter, when 73% missed, or a year ago, when 66% disappointed.

On May 4, Standard & Poor’s Ratings Services placed 23 financial institutions of various sizes on “CreditWatch with negative implications,” meaning they have at least a 50% chance of seeing their credit rating lowered in the next 90 days. S&P added:

That said, we believe that most rated institutions will be able to earn their way out of these credit losses during the cycle.

The first quarter’s mediocre bank earnings (bad, but not as bad as feared) could be a tentative, positive sign that many banks can handle a tough recession. Or this could be calm period before even bigger losses hit bank balance sheets later this year.

One area of concern is commercial real estate and other commercial loans. KBW looks at 38 banks that provided data on commercial real estate loans: The non-performing ratio on those loans moved from 1.58% in the fourth quarter of 2008 to 4.36% in the first quarter of 2009. That’s quite a jump, and quite troubling.

Reader Comments

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Tomaso Spingardi

May 8, 2009 1:56 AM

Tomaso Spingardi in a recent interview at the London Financial Economics Roundtable presented the key conclusions of a work done for the Economics Centre of Financial Studies on the topic of financial risk controls in financial institutions.

This is an abstract from the research conducted by Tomaso Spingardi. Banks have the possibility, through a variety of means and instruments, to eliminate, or at least substantially reduced through the technique of risk transfer., a number of risks. Markets exist for many of the risks borne by the banking firm. Interest rate risk can be transferred by interest rate products such as swaps or other derivatives. Borrowing terms can be managed in order to effect a change in their duration and convexity. The financial institution can also buy or sell financial claims to diversify or concentrate the risks associated with its business practice and customer portfolio.

Tomaso Spingardi maintained that the recent crisis has shown that for many financial institutions the spreading of risk, one of the purported benefits of the originate-to-distribute model, proved to be much less extensive than many believed. When investors were no longer willing or able to finance new structured credit products, many of the largest financial institutions had to fund instruments they could not readily sell or had to meet contingent funding obligations for which they had not adequately planned.
Banks placed too much emphasis on the mechanical application of value-at-risk or similar model-based indicators. Sophisticated quantitative tools and models play an important role in good risk management, and they will continue to do so. But no model, regardless of sophistication, can capture all of the risks that an institution might face.
Tomaso Spingardi concluded that those institutions that managed to have better risk management results far better during the recent crisis placed relatively more emphasis on validation, independent review, and other controls for models and similar quantitative techniques. They also continually refined their models and applied a healthy dose of skepticism to model output.

jimmy T

May 9, 2009 11:03 AM

Speaking about Stress tests, the former shareholders of NASTECH now known as MRNA is more stress than any shareholder could take. How it still exists is a miracle within itself. After 25 years absolutely no significant progress and a decimated stock price & now under a new name with a new CEO. In the business of licensing and partnering re:RNAI. In order to qualify as an investor, you would need money, anger management courses, plenty of time, patience and a strong belief in POTENTIAL. Other than that, the company faces De-listing, has a second letter of GOING CONCERN, a high burn rate, and a stock price hovering around $.97 cents. Two years ago it was $20 dollars, but know because its cheap, the frenzy has begun with investors.
two partnership deals made but undisclosed. No sales growth improving and hardly any Revenue. In my opinion, even if you throw out their horrible balance sheets, fundamentals, & statistics, you need your head examined to invest in this company.
THIS IS WHAT MAKES THE MARKET, POTENTIAL OF STRIKING IT RICH!

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March 2, 2010 11:56 PM

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About

Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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