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Deciphering the Results of Banking ‘Stress Tests’

June 9, 2009 at 6:20 PM EST
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NewsHour economics correspondent Paul Solman explains how stress tests played into the government's decision to let ten big banks pay the Treasury back for the money they received from the federal rescue.
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JIM LEHRER: That follows more on our top story of the day, the big banks paying back the government. Key to that were what became known as the stress tests for banks. The NewsHour’s economics correspondent, Paul Solman, explains what they were all about as part of his series on making sense of the financial news.

PAUL SOLMAN, NewsHour Economics Correspondent: Well, the stress tests are behind us, measuring how our biggest banks will fare if the economy continues to worsen all year and barely recovers in 2010. The good news was: They all passed. The bad: 10 out of 19 needed more capital.

But some folks are skeptical of even these results; others have no idea what more capital actually means. So we’ve concocted our own questions, like the ones you send in to the “Business Desk,” for a video Q&A to clarify an issue that promises to be with us for quite a while.

First question: What is a stress test?

Answer: an analysis of a bank’s balance sheet. And, luckily, we have a balance sheet right here, balancing assets and liabilities. Let me get out of the way so we can fill it in.

Assets are what the bank lays claim to: cash, fixed assets, like buildings, ATMs, rugs, plus the bank’s investments, mainly its loans to businesses and mortgages to consumers. Assets are “good,” as the word implies, but liabilities aren’t “bad.” They’re just the sources of the bank’s money, loans to the bank, mainly your and my deposits, investments in the bank by shareholders, retained earnings, profits the banks actually earns and holds on to.

Those last two, investments and retained earnings, are the bank’s capital, the difference between what it owns — its assets — and what it owes.

And, in fact, since the stress tests results were announced in May, the banks have been aggressively raising capital by selling more stock to investors, $85 billion thus far.

'Capital is the bank's cushion'

PAUL SOLMAN: But let's not get ahead of ourselves. As Karl from Germany writes, "Why was capital so crucial to the stress tests?"

One of our major assets in our attempt to answer the question: bank analyst Chris Whalen.

CHRIS WHALEN, Institutional Risk Analytics: Capital is the bank's cushion for losses. It's the cash they put aside in case somebody defaults on their loan, a security goes bad, whatever it is.

The regulators want 8 percent to 10 percent cash capital underlying a bank's assets. So for every $100 in assets, whether it's loans or investments, they want to have about 8 percent to 10 percent worth of real cash underneath that.

PAUL SOLMAN: So there's the capital cushion, stuffed with investor money and earnings.

"But what's it cushioning against?" writes Show Me from Missouri. The answer: It's cushioning against too many toxic assets, which are simply bad loans, says economist Simon Johnson.

SIMON JOHNSON, MIT Sloan School of Management: Well, of course, the bank has some reserves or a cushion, right? And it's very important. And if your loans go a little bit bad, that's OK. Loans go bad all the time, a little bit.

But if they go bad in a big enough way, then that cushion kind of gets eaten into or deflates or whatever happens to cushions, and then you're kind of in trouble.

PAUL SOLMAN: Now, the vulnerability of the capital cushion has become a national joke. "Saturday Night Live" led with an impersonation of Treasury Secretary Tim Geithner the other week, mocking the stress tests' capital requirements with these fantasy answers to the pretend written portion of the test.

WILL FORTE, Imitating Treasury Secretary Tim Geithner: If federal bank examiners determine your bank to be undercapitalized, the bank's board of directors should, Goldman Sachs wrote "flee the country"; State Street of Boston said "shred documents"; and Capital One said "eliminate eyewitnesses."

Toxic loans

PAUL SOLMAN: All joking aside, writes Clueless in Seattle, "Don't banks make a provision for toxic loans?" Yes, they do, with an additional cushion called loan loss reserves so that banks don't add inflated earnings to their capital.

Again, Chris Whalen.

CHRIS WHALEN: They will usually have about 2 percent of assets in loan loss reserves, so that's the first line of defense. Well, your typical community bank in good times would have maybe a 0.25 percent loss, a third of a percent, somewhere around there, very low.

Currently, the industry is several times higher than that, and they're going to go much higher. Bank of America, for example, had 2.8 percent charge-offs in the first quarter of this year. That's much, much higher than it was even a year ago.

PAUL SOLMAN: And, says Simon Johnson, the charge-offs for bad loans could push the loan loss reserves a lot higher than that.

SIMON JOHNSON: Well, the thing is, Paul, that they have another business over here off balance sheet. This is the so-called SIV, S-I-V.

PAUL SOLMAN: Special investment vehicle.

SIMON JOHNSON: Exactly. And what this has is a balance sheet, just like the bank. It has assets, and it has liabilities.

Now, the assets are some mortgages which, you know, to be honest, have now turned out to be junk. And it also has investments from the bank, or loans. And the question now is, will they have to take this SIV back onto their balance sheet with the junk assets, which is going to reduce their profits and lower their capital so they're going to have to raise more?

Calculating loan losses

PAUL SOLMAN: They'll have to raise more capital, that is, if the loan loss reserves exceed the profits, prompting Muddled in Mississippi to write, "Wait just a cotton-pickin' second. I thought banks were reporting profits. How can they simultaneously be losing money?"

Because the profits or earnings are being reported before subtracting the loan loss reserves, what a bank makes on its loans before they've been adjusted for the likelihood of nonpayment. Just look at Citigroup, which is estimating $40 billion in profits this year.

CHRIS WHALEN: Citigroup's got about $100 billion in revenue, if you look at it over the next 12 months. Their cost, or what we call administrative costs, all of the business expenses for running the bank, is about $60 billion. Last year, they put aside $33 billion in provisions for future losses, so do the math. They're consuming almost all of their revenue. They put aside $9 billion in the first quarter this year.

PAUL SOLMAN: OK, we did the math: $100 billion in revenue, subtract $60 billion in expenses, profits of $40 billion, but a loan loss reserve of $9 billion a quarter times four quarters, that's $36 billion, almost all of the profits.

If the expected losses were to go higher, all Citi's earnings would be canceled out by its expenses and loan loss reserves. And then any more bad loans would start de-feathering the bank's capital cushion. That, in turn, might goose depositors to swoop in and take back their ever-so-short-term loans, their money in the bank.

Again, Simon Johnson.

SIMON JOHNSON: So it's all demandable deposits. Take the money and run.

Run on the bank

PAUL SOLMAN: As in bank run, which happened at IndyMac last year before the FDIC took it over, or at Washington Mutual.

CHRIS WHALEN: You had people outside the branches of WaMu waiting in the morning. I hadn't seen that since Mexico during the crisis 20 years before, to actually see people physically outside a branch, and they wanted to know that they could get their cash.

PAUL SOLMAN: But there haven't been any runs recently, except in places like Ukraine, largely because the U.S. government has pledged allegiance to our banks.

CHRIS WHALEN: The government has basically guaranteed their entire balance sheet so that investors, whether they're depositors or investors of bonds, are satisfied at the moment.

PAUL SOLMAN: The guarantee comes at a price to taxpayers, though, should there ever be another bank run. So short term, the capital cushion -- and don't worry, I'm not going to mess up my suit again -- is to protect our money.

But the larger reason to replenish bank capital is longer term: to get the banks to lend once more.