BofA, Citi, Wells and GMAC biggest losers in stress test leaks

If you haven’t noticed, the Treasury department seems to be leaking the results of the stress tests to reporters at the Wall Street Journal.  Richard Bove, a well-known bank analyst was on Bloomberg Radio this morning talking to Tom Keene and said he knows they have been leaking.  Yves Smith was on top of this a few days back.  With the results to be released tomorrow, we now pretty much know who the winners are and who the losers are.

The losers are Citigroup, Bank of America, Wells Fargo and GMAC. Bloomberg reports:

Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and GMAC LLC are among the companies judged to need additional capital according to results of regulators’ stress tests on the 19 largest U.S. banks.

Bank of America has the biggest shortfall, at $34 billion, according to people familiar with the matter. Citigroup’s requirement for deeper reserves to offset potential losses over the coming two years is about $5 billion, people with knowledge of that bank’s results said. Wells Fargo requires about $15 billion, while GMAC’s need is $11.5 billion, one person said.

Goldman Sachs Group Inc., Morgan Stanley, MetLife Inc., JPMorgan Chase & Co., Bank of New York Mellon Corp. and American Express Co. were deemed not to need additional funds, the results show.

Stocks rallied after the news, sending the Standard & Poor’s 500 Financials Index to its highest level in four months. The results are the culmination of weeks of investigations, led by the Federal Reserve, into the banks’ lending practices, funding strategies and securities and loan portfolios.

“The markets are telling us we’re in a recovery and the banks are beginning to heal,” William Isaac, former chairman of the Federal Deposit Insurance Corp., said in an interview today. The end of the stress tests after “three months of water torture” is providing investors some relief, he said.

The regulators put an emphasis in their reviews on tangible common equity. Citigroup’s assessment reflects the New York- based bank’s previously announced plan to convert some of its preferred shares into common stock.

Spokespeople for all of the 10 banks declined to comment.

It’s not as if any of these banks really are losers here.  This charade was pretty predictable. I said as much last week. 

Just one look at the credit ratings and stock prices of the 19 banks and financial institutions in the stress tests will tell you which are the weak institutions. So, why the charade?

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

Of those banks that need more capital, Bank of America was up 15%, Citi 14%, and Wells 13%.  Only GMAC suffered.  The word on the street is that investors are happy with the results and relieved that more capital is not needed. Congress and taxpayers won’t need to pony up either.  That’s a relief!

Bove doesn’t seem to think this is good news however.  Another Bloomberg story quoted him as seeing this as negative for expanding credit:

Forcing banks to boost capital in the midst of a recession will cripple lending and may delay a recovery, said Richard Bove, vice president and equity research analysts at Rochdale Securities in Lutz, Florida.

“How are they going to assist the American economy if they are shrinking?” Bove said today in an interview on Bloomberg Radio. “If you make all those banks shrink, which is what you’re really doing by forcing them to add capital, how are they going to lend money?”

Regulators determined Bank of America Corp. requires about $34 billion in new capital, the largest need among the 19 biggest banks subjected to government stress tests, according to a person with knowledge of the matter. Other institutions require capital as well.

“If you go beyond these 19 banks to the next 20, which is what they are going to do, you’re going to knock some of those banks out of business,” Bove said.

“By the time you finish, my guess is you will at least knock at least 150 banks out of business in the United States, shrinking the banking industry in the middle of a recession at a time when you want them to provide more lending to grow the economy,” Bove said. “It makes no sense at all.”

In theory, Bove is correct, but there have been significant reports that Bank of America is selling non-core assets and that they will convert all of their preferred stock into common in order to meet the tangible common equity guidelines laid out in the stress tests.  So, ultimately, even Bank of America, the most under-capitalized of the banks is not going to have to raise any outside capital.  This is why bank shares were up big-time.

But, wait a minute.  Isn’t the preferred, equity that Bank of America already has on its balance sheet?  Why is moving items around like a massive shell game going to make this organization better capitalized?  Paul Kasriel has the answer. It’s called accounting alchemy (pdf):

Congress currently is in no mood to authorize more funds to help recapitalize the financial system. The Treasury says this will not be a problem. If financial institutions need additional capital from the taxpayers to remain solvent, the Treasury will simply shift the preferred shares it already owns in financial institutions to common equity shares. Voila – capital adequate financial institutions! Really?

Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus common equity. That is good for starters.

But suppose the Treasury believes that Gotham should have a ratio of common equity to total assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance Sheet Two. Now Gotham is well capitalized, right? Wrong. The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off. Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.

Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. In fact, Gotham now has an equity "deficiency" of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case. As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.

In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating preferred equity shares into common equity shares is accounting alchemy.

Problem solved. There will be no train wreck. Move along, nothing to see here.