The Geithner Principle

There are days when the government cannot get it right. Then there are days that make those days look like golden moments.

Last night President Obama spoke to the nation on CBS's "60 Minutes". He made the most chilling statement of his presidency. His scariest words in a presidency that has made extensive use of scare tactics and fear. President Obama said:

"Treasury Secretary Geithner is as sharp and as skilled a public servant as we have."

If Obama is right, we're in deep trouble. Maybe too deep.

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.

The Savings & Loan Crisis vs Today

In short, the Savings & Loan Crisis occurred because Congress took the worst possible path when deciding how to "help" the S&L industry. In fact, the nature of the S&L mistake was remarkably similar to the mistake made by Congress that led us to our current crisis.

The S&L Crisis was set off by the repeal of Regulation Q. Quick history. S&Ls were created during the Depression to assist homeowners. They were given a legal advantage over commercial banks in the area of mortgage origination. However, as a trade-off for the advantage in mortgage origination, the S&Ls were not allowed to offer commercial loans. Okay. That worked. The concept was good for a few decades.

However, in the 1970s the securities markets changed and the government took a place in the mortgage business -- Fannie and Freddie. The era of Securitization began in 1977. Wall Street was able to package Ginnie Mae mortgages and sell GNMA securities tied to those pools. Thus, the operating environment for S&Ls changed. The secondary market for mortgage loans was created. Thus, the bank or S&L that originated a mortgage was able to sell the loan to another party. Meanwhile, interest rates were rising and the S&Ls began losing money. The S&L industry was in tough shape.

The leaders of the S&L industry went to Congress for relief. They got it. In fact, they got what they wished for. During Jimmy Carter's administration, Congress repealed Regulation Q, which was the law that defined the differences between S&Ls and commercial banks. Suddenly S&Ls could offer the same loans as banks.

However, one barrier remained. It was not possible for banks to buy S&Ls. Big mistake. Suddenly S&Ls were in the commercial loan business competing with banks. At the same time, builders realized it was easy to gain control of an S&L and then get loans for any project imaginable.

Oil prices were rising and fueling a huge building boom in the oil states. Both residential and commercial properties were under construction. The S&Ls were lending to the oil drillers and the home-buyers. When oil prices cracked in 1983, the S&L real estate bubble popped. Things went downhill from there.

However, Congress could have handled things in a different way. It could have removed the obstacles that stopped banks from acquiring S&Ls. If banks had been able to buy them, the economy would have escaped most of the damage.

By the way, another key change that magnified problems was the increase in coverage offered by deposit insurance. Carter raised the coverage offered by the FDIC and the FSLIC to $100,000, up from $40,000. Unscrupulous S&L managements realized the amount of assets available to them for speculative lending activities was multiplied two and one-half times. They had won the S&L lottery.

In the current crisis similar mistakes were made. The worst mistake was opening the door to underwriting loans that were extended to people with lousy credit scores, no downpayment money and poor job prospects. Who opened the door? Congress. The first step was the 1977 Community Reinvestment Act, another time-bomb from the Carter presidency.

If anyone chooses to review that process that got us where we are, the reviewer will see that all laws were met. The documents describing the various troubled securitizations were complete and drawn up as required by the SEC. Moody's, Fitch and Standard & Poors rated the securities, which were then sold to institutional investors. But it seems nobody read the prospectuses and other documents. It seems that everyone put their faith in the ratings from the Rating Agencies. Bad move.

Meanwhile, no one from the Fed, the Treasury or the SEC took a close look at these securities or the markets to which they were tied. Why? Probably because billions of dollars of tax revenue was flowing into Washington as a result, and, at the same time, home-ownership was soaring. Who would tamper with that?