Fed Lays Trap for Itself With Bank Stress Tests: Jonathan Weil

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Last week gave us one of the oddest pairings of financial news stories in some time. The better the earnings of U.S. banks, it seems, the more nervous investors get about the banks’ health.

First, we learned from the Federal Deposit Insurance Corp. on Nov. 22 that U.S. lenders had their most profitable quarter since mid-2007. The same day, the Federal Reserve sought to bolster confidence in the financial system with new stress tests at the 31 largest U.S. banks. The Fed said it will publish the results for the 19 biggest bank-holding companies next year, marking its first such exercise since spring 2009.

Ordinarily, those two developments shouldn’t be coming at the same time. If U.S. banks’ profits and capital levels were robust, there would be no need for stress tests of this sort. Investors might believe the banks’ numbers. And the Fed wouldn’t have to make a display of convincing anyone the system is strong.

Yet here we are again. FDIC-insured institutions reported third-quarter net income of $35.3 billion, up 49 percent from a year earlier. Meanwhile, Bank of America Corp. and Citigroup Inc. shares are down to March 2009 levels. The 24 companies in the KBW Bank Index, which has fallen 27 percent this year, on average trade for just 69 percent of book value, or common shareholder equity, according to data compiled by Bloomberg.

Earnings Quality

Partly that’s because the quality of earnings at many large banks has been weak, just as Europe’s debt crisis is threatening global economic growth. Bank of America, Citigroup and JPMorgan Chase & Co., for example, booked large accounting gains last quarter from declines in the market values of their own debt. Put another way, their profits were higher because the market deemed them more likely to go bust. Likewise, the low price-to-book ratios tell you the market believes huge writedowns lie ahead and that the industry has been too slow to recognize its losses.

As for the stress tests, we probably can count on the Fed to do a more credible job than Europe’s regulators have done with theirs, though that isn’t saying much. The French-Belgian lender Dexia SA passed its European Banking Authority stress test with ease in July, and needed a government rescue three months later. Last year the biggest Irish banks got passing marks shortly before taking bailouts.

The Fed avoided those kinds of embarrassing errors in 2009. Although its tests were widely criticized as too soft at the time, that mattered little in the end. The government had expressly committed to provide additional capital to any of the banks on the stress-test list that needed it and couldn’t raise enough on their own. By making clear they wouldn’t let anyone go under, the Fed and the Treasury Department made it far easier for some of the biggest U.S. banks to raise new equity from the public markets, which was the main goal all along.

Ten of the 19 companies tested in May 2009 were found to have inadequate capital. Within six months all but one of the 10 had met or exceeded their required capital buffers, through stock sales, converting preferred shares to common equity, or other means. Wells Fargo & Co., for example, sold $8.6 billion of common stock the same week it was told it needed more capital.

This time the regulators can’t promise such backstops, at least not explicitly. The Treasury Department’s Troubled Asset Relief Program expired in 2010, and the Dodd-Frank Act passed by Congress last year restricts the government’s ability to take equity stakes in financial companies. If a bank’s capital is deemed inadequate, the Fed can direct the company to take actions to improve it, but not much else. So what happens if the bank is unable to boost its capital enough? When I put that question to a Fed spokeswoman, Barbara Hagenbaugh, she declined to comment.

Severe Stress

The most severe stress-test scenarios outlined by the Fed include an unemployment rate of as much as 13 percent and an 8 percent drop in gross domestic product. There will be plenty of other benchmarks available for investors to gauge the tests’ credibility, too.

Shares of Bank of America, for instance, trade for just 26 percent of book value. Regions Financial Corp., another company on the list, trades for 37 percent of book -- and still hasn’t repaid its TARP money from three years ago.

If those banks somehow get passing marks, investors may well conclude the tests were a farce. Yet if Regions or Bank of America flunks, and can’t raise enough capital to meet the Fed’s requirements, well, then what? The answer is anyone’s guess.

Sure, we can assume Fed Chairman Ben Bernanke will try everything in his power to ensure that no systemically important bank fails, whether through secret liquidity lifelines or other tricks. Yet the point of the stress tests is to boost confidence. For that to happen, skittish investors will need to be convinced that it’s safe to put fresh capital in weak banks, when the government no longer has the discretion to do so itself.

That could prove to be a tough sell. It would be nice if the Fed would tell us what its backup plan is.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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To contact the writer of this article: Jonathan Weil in New York at jweil6@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.