Cincinnatus BLOG *** Political Commentary - Social Commentary

The stress tests appear to be boiling down to one critical measurement of bank capital, Tangible Common Equity (TCE). While the assets themselves may be tangible, the intangible result could be a tectonic shift to a politicized banking system. To avoid any confusion it is probably best that I define my terms at the outset:

1. Tangible Common Equity  (TCE) equals book value minus intangible assets, goodwill, and preferred equity. Essentially this is the most conservative measure of bank capital and represents what common shareholders would have left if a bank were liquidated.
2. Tangible Book Value (TBV) equals book value minus intangible assets and goodwill. This measure would include preferred shares held by the government and private investors and gives a broad view of a bank’s hard assets.
3. Tier I Capital is defined as core capital, which consists primarily of common stock and disclosed reserves (retained earnings), but may also include irredeemable non-cumulative preferred stock.

The Fed and the Treasury have asked the following broad questions - What if unemployment rises to 10.3 percent? What if home prices plunge 22 percent? What if overall economic growth drops to negative 3.3 percent? Will America’s 19 largest Banks have enough capital? The criteria for “passing” the stress tests appear to be TCE equivalent to at least 4% of a bank’s risk-weighted assets under these adverse economic conditions. The level of Tier I capital may also be evaluated.

The exhaustive information being provided by banks includes details about their mortgage portfolios - from geographic location to home equity lines of credit and the credit score of the borrowers. Similar details about the banks’ industrial loans, their commercial real estate loans and credit card portfolios - including data about risk, payment rates and credit scores - were also provided.

The purpose of gathering all this information is to determine each bank’s potential losses in certain asset categories under these dire economic circumstances. Needless to say reasonable men will disagree about the size of the potential loss and thus the need to raise capital in this difficult environment. This will be a controversial process and instead of creating confidence in the system will likely cause some confusion and possibly increase the level of uncertainty.

Historical perspective is often helpful in evaluating the relevance of the current stress tests. Bank regulators recognize that TCE has been eroded in recent years, worn away by losses and a preference for preferred securities that count only towards their Tier 1 capital. In other words, if the Fed and Treasury are using the right criteria for evaluating the stress tests, the TARP money went to the wrong part of the capital structure. Stockholders should understand that their economic interest could be virtually wiped out regardless of how much Tier I capital is above them to protect depositors and the public.

In an article published in the Guardian it was reported that FBR Capital Markets estimates that TCE as a percentage of Tier I capital is currently just 53%, against an average of 91% from 1991 to 2006. For the 11 largest U.S. banks that TCE was 5.5% of risk-weighted assets in the first quarter down from more than 8% in 2007 and just below 10% in the late 1990’s. Clearly this is the problem that the Fed and Treasury are trying to address.

One obvious solution to this problem is time. The strong first quarter performance augurs well for banks reestablishing strength in their capital structure over the next couple of years. Critics however, would say that the first quarter results are potentially an anomaly and are probably not sustainable. If the critics prevail and banks are forced to bolster their capital, they could do so in one of several ways, including selling assets, selling more shares to the public or converting the government’s preferred shares into common stock. In the latter case that would only boost the company’s capital on paper and would make the U.S. government a major shareholder in the banks while diluting the value of the stock held by existing shareholders. For those who are tempted to cheer the misfortunes of the greedy Wall Street capitalists, you would do well to remember it is primarily your pension money we’re talking about.

In a sense this process has already begun Citigroup announced it was selling its Japanese brokerage business for about $7.9 billion, a deal that will boost the company’s TCO by about $2.5 billion. It is easy for most people to see the clear benefit from raising additional capital by either selling non-core assets or selling shares. The cash register rings and additional money comes in the door. The option of selling shares, at the moment, may only be available to the strongest of the 19 largest banks.

The value of a paper transaction where no new money enters the banks capital structure is less clear. If the government converts it non-voting preferred shares to voting common shares the TCE will get a cosmetic face-lift but without any increase in the banks cash. Some might view this tactic as being as effective as rearranging the deck chairs on the Titanic.

The only tangible difference that is apparent to the public is that the Treasury will gain a decisive say in the running of those banks that they force to make such a conversion. You may view that as desirable, if you think the current crowd is more knowledgeable and less political than the last crowd. If analysts are right this will include Citibank, Bank of America and may well include Wells Fargo, Regions Financial and Fifth Third Bankcorp.

The Treasury is apparently discussing different levels of governance depending on the size of the U.S. government’s stake. One is left with the image of Tim Geithner who seems marginally capable of running the Department of the Treasury managing at least five of America’s largest banks simultaneously. The array of politicos and bureaucrats sticking their two-cents into bank management boggles the mind. Will the banks be run in the interest of stockholders and the public at large or do they become just another political instrument to be used to pay off special interest and large voting groups? How could demagogic politicians of either party resist such manna from heaven?

The shift in the role of banks would be tectonic; they would no longer be focused on the needs of their shareholders and customers but rather their political overlords, who may have their own agendas. Maybe they can use a modified “earmark” process where each of the 535 Congressmen and Senators gets to payoff their constituents with “favorable” treatment by a captive bank!  The administration could use the weak banks to promote its social agenda - what a windfall! With all that power and money in their sights, Congress and the administration are just plain incapable of leaving well enough alone and letting time and the markets heal what ails the banks.

“It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress” - Mark Twain.