Streetwise Professor

May 8, 2009

Tinkerbell Goes to Wall Street

Filed under: Economics,Financial crisis,Politics — The Professor @ 7:59 pm

Banking stocks have experienced a big rally, given impetus by the anticipation, realized in the event, that the “stress tests” would show that big financial institutions were solvent, and would require only modest additional amounts of capital.   Indeed, the conventional wisdom now appears to be that the banks can earn their way out of the hole in relatively short order.

I have my doubts about this Alfred E. Neuman “What, Me Worry?” rally.   Indeed, the entire stress test exercise resembles Kabuki Theater, and the market response seems to be more appropriate to a matinee presentation of Peter Pan (“We believe, Tinker Bell!”)

Here’s one thing that feeds my doubts.   A bank is insolvent if its liabilities exceed its assets.   This would be easy to determine if the assets in particular were easy to value.   But many are not, so we cannot get a snapshot of the current solvency of banks.

But, apparently the whole idea of the stress test is to estimate bank solvency under alternative scenarios of future unemployment, economic growth, interest rates, housing prices, etc.  

So, apparently we are to understand that it is impossible to determine bank solvency at the current moment because we cannot value the assets, but we can estimate their future value under various future economic contingencies.

Just how is that possible?

Or maybe there is another interpretation.   Maybe one can interpret the stress tests as an attempt to determine the current value of these assets by estimating a distribution of future cash flows under alternative economic scenarios, taking an expected value across them, and discounting back to the present.     This interpretation would suggest that the operating assumption of the analysis is that current market prices (to the extent that they exist) do not reflect the true value of the assets, due perhaps to steep liquidity discounts.   This is the line the Fed, the banks, and Treasury have been pushing since the beginning of the crisis.  

But, if it were that easy to determine the “true” value of these assets, why is it that they are so illiquid, 7 months post-Lehman, and after the Fed has created unprecedented amounts of liquidity?     How could there be such a big disconnect between “true” asset values and market prices?   Are these just rating agency models writ large?   What assumptions underlay the modeled relations between asset cash flows and economic outcomes?   How do the stress tests capture how defaults and recoveries on various kinds of loans (commercial real estate, residential real estate, credit cards, etc.) will vary depending on economic conditions?   Given that we are going into unexplored economic territory, skepticism is almost mandatory.     History may provide little guidance.   Defaults and recoveries on debts incurred during a period in which it was widely believed that a severe economic contraction was highly unlikely will be quite different from those experienced in severe recessions in the increasingly distant past.   How much will they differ?   Who knows?  

I would suggest that there is an acid test for such beliefs.   If the banks are really solvent and don’t require much additional capital because their assets are really worth pretty close to the values banks have currently assigned to them, then both banks as sellers and numerous investors as buyers would be willing to participate in the PPIPs program.   Investors would be willing to buy the assets at close to the prices implicit in the stress test results, because the government is supplying on very generous terms the liquidity necessary to carry these assets.   Banks could sell assets firm in the knowledge that these prices investors are willing to pay would not be so low as to prove to the world that the banks are insolvent.  

Until investors and banks put their money and assets where their mouths are, and start buying and selling these assets at prices close to the values at which banks currently value them on their books, I will be deeply suspicious of the stress tests, and any other bank or government assurances that the toxic asset problem is modest and containable.

Here’s a more skeptical—indeed, cynical—explanation of what’s going on.   There is a confluence of interests between the banks, the Treasury, and the Fed.   The banks, of course, want to have the option to earn, not to say gamble, their way of their current predicament.   The Treasury and the Fed realize that there is no Congressional support for additional funds for troubled banks.   They further realize that the operational and legal challenges involved in resolving huge bank holding companies are incredibly daunting.   So, all concerned have an incentive to kick the can down the road.   To defer action in the hope that a turnaround in the economy or some stroke of luck—or a burst of inflation—will eliminate the necessity of winding up insolvent institutions.  

Hence, the Kabuki Theater of the stress tests.   Each side plays its part in a very stylized way.   The banks even put up enough of a stink to make it seem like something is being forced on them.   Professional wrestling looks authentic by comparison.

Viewed in this way, the rally in bank stocks is understandable too.   Of course, part of it can be “we believe” optimism that the economy is recovering, and that bank earnings will similarly rebound, or that the stress tests show that previous pessimism about the severity of the toxic asset problem was overdone.   But, it also makes sense to the extent that it is now quite clear that the banks will be allowed to continue to operate with little risk of resolution, bankruptcy, or nationalization.   To the extent that bank equity is effectively an option, the revelation that this option will not be terminated any time soon is extremely bullish news.   Moreover, since debt of insolvent banks is also effectively equity, and hence effectively an option, extending the option to gamble one’s way out of ruin also enhances the value of bank debt.   Immediate resolution would probably lead to the immediate loss of a good part of the value of unsecured bank debt, but survival could permit recovery of a good fraction of that value. This can explain the tightening of CDS spreads on banks—an indication that the value of their debt is rising.

Viewed in this way, the rally in bank securities is explained by the market’s estimation that the stress tests, and the apparent willingness of the government to eschew any efforts to restructure big banks, extends the life of the gamble to survive option.

But, if this view is correct somebody has the short position in that option.   Normally, an increase in the value of the gamble to survive option would benefit equity at the expense of debt.   But given the potential for a bailout that may provide some support for creditors in the event the gambles do not pay off, it is possible that extending the life of this option could help both bank debt and equity.    

Under this interpretation, that somebody holding the short position would be taxpayers, or the holders of dollar denominated claims who will pay an inflation tax.   Heads, the bank shareholders and bondholders win.   Tails, the taxpayers pick up the tab.  

Although there is no direct market in these things, Treasury securities prices do provide something of a signal.   Greater debt or greater inflation put upward pressure on Treasury yields, and we are beginning to see evidence of that.

So, I am highly skeptical about the stress tests, and their interpretation.   Given the very gloomy prognostications of the IMF and others about the total unrealized losses on toxic assets, the stress test results and the way they are being spun seem too good to be true.   Maybe we are in Neverland.   But maybe the banks, Treasury and the Fed have their own reasons to double down and hope for the best, and the stress tests are providing the cover to do that.   The artificiality of the stress tests, and the weird nature of the entire exercise (i.e., how can you value what banks will be worth tomorrow if you can’t value what they’re worth today?), make me suspect that the latter is a very real possibility.    

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  1. Yes…this is the high level kabuki theater. Many minor Kabuki theaters operate when the auditors(Big 4 and co) try to “independently” evaluate a company’s accounts. I am convinced that the auditors consulting the government on this issue had no trouble coming up with the bigger scale Kabuki theater idea 🙂

    Comment by Surya — May 11, 2009 @ 6:37 pm

  2. “Hence, the Kabuki Theater of the stress tests. Each side plays its part in a very stylized way. The banks even put up enough of a stink to make it seem like something is being forced on them. Professional wrestling looks authentic by comparison.” — Couldnt agree with you more on this. I have worked for of those accounting firms and you have no idea how many times this game has been played over and over again. lol. The accountant is well aware that the client pays their salary, but they don’t want to give the client the impression that all is cool. The client also understands this very well and plays its part, alternately being indignant and conciliatory. In the end they are all “Kumbaya”.

    Comment by Surya — May 11, 2009 @ 6:44 pm

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