Treasury Secretary Geithner -- Master of Disaster?

Tomorrow Secretary Geithner will release some details of the Big Bank “stress test”. How will the financial doctor measure the health of the banks with more than $100 billion in assets -- the ones required to get on the treadmill? Will Secretary Geithner disappoint the markets yet again? Hopefully not. But his previous appearance was disastrous.

If we're lucky, investor concern surrounding the banks will ease a lot after details of the Geithner stress test are revealed. However, no matter what he says, the idea of a single stress test for all our largest banks is a dumb idea. Moreover, it's likely he will introduce a new capital ratio to measure bank quality, and this is another dumb idea.

Why? First, the big banks are alreadyexamined and stress-tested by their on-site examiners-in-charge. These people are in a far better position to assess each bank’s unique characteristics and evaluate each bank's inherent risk. They are on the ground with the banks and able to know and learn far more than people conducting tests from high altitudes.

Second, there's plenty to question when it comes to the new ratio Geithner might adopt. It's probably a ratio of tangible common equity to risk-weighted assets (TCE/RWA). It seems Treasury has decided to look at TCE/RWA because spooked investors are determined to view banks in the worst possible light and are obsessed with the number. As general rule, it's a bad idea for investor anxiety to drive regulatory policy.

Regulators usually avoid pulling new measures out of the air. In the 1980s, the Fed, the OCC, and the FDIC each had their own capital ratios and minimums; it took years of analysis and debate among them to decide which measures were most important. (They were Tier 1, total capital, and leverage.) It doesn’t seem to be good regulatory practice to adopt a new during the current crisis.

Thus, there's little reason to put faith in the test or the new standard Treasury plans to use. Nevertheless, here are a few thoughts:

The economic assumptions -- the “stress” in the Geithner stress test will translate into an economic forecast that includes a 10% peak in unemployment rate, a 40% decline (peak-to-trough) in U.S home prices and a recession that lasts until late this year. These are the assumptions that surfaced in the New York Times yesterday. Surprise, surprise, they are also the parameters adopted by JPMorgan Chase for its in-house stress scenario.

Maximum cumulative loss assumptions by loan category over some period -- hopefully the government will adjust these cumulative loss assumptions by institution to account for factors such as loan geography, experience, underwriting practices, pricing, and so forth. If it doesn’t, the output of the test is apt to be arbitrary.

Maximum cumulative loss forecasts will then be measured against an institution’s existing loss reserves, pre-tax, pre-provision earnings, as well as various measures of capital.

Two capital ratios will become the focus. The resulting pro forma maximum income or loss over the test period will then be used to calculate estimated stressed Tier 1 capital and TCE/RWA ratios.

The moment of judgment. For a bank to pass, it will have to show pro forma, stressed ratios above certain minimums. Those minimums are likely to be 6% for Tier 1 capital and 3% for tangible common equity to risk-weighted assets.

The fate of those that fail. If an institution fails to meet either of those two minimums, it will have to raise new capital by some deadline, perhaps April 15. It might raise new equity in a secondary offering, for example. Or, the bank might convert its existing TARP convertible- preferred into mandatory convertible preferred at an exchange ratio based on the common’s price as of a certain date. That date will be important. It's possible it will be the date Geithner first discussed the plan -- when bank stock prices were higher.

If the capital hole still unfilled, the Treasury might require an investment of new capital via a newly issued mandatory convertible preferred with even more severe operating restrictions attached. Any institution requiring the issuance of new preferred on top of the existing preferred will have to replace its CEO.

This table shows the effect that conversion of existing TARP preferred into mandatory convertible preferred would have on 2008 year-end tangible book value per share and tangible common equity to risk-weighted asset ratios of 102 large-bank TARP recipients. Obviously, a full conversion at today’s prices would deeply dilute book value per share. But for most companies, conversion would provide a big cushion to absorb losses uncovered by the stress test.

Again, assuming full conversion of the TARP preferred for all 102 companies -- which will not happen -- this group of banks would see its ratio of tangible equity to risk-weighted assets ratio settle at an average of 10.3%. The group is correctly trading at 1.1 times pro forma book values.

There's reasons for skepticism. The stress test is likely to rely too much on cumulative loss forecasts by loan category and will likely be overgeneralized and too severe. However tomorrow’s disclosure of the test’s details should be good for bank stocks. Why? Because investors are likely to gain confidence in the capital strength of our largest banks and their capacity to weather the most severe credit storms.

We shall see. We shall see. Can the disappearing Treasury Secretary reappear and undo the damage of his last national presentation? Here's hoping there are no more disappointments.