In These New Times

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The Fairy tale from Citigroup and the sham “stress” tests

Posted by smeddum on May 16, 2009

Financial wizardry is just smoke and mirrors
IrishTimes
Friday, May 15, 2009
SERIOUS MONEY: THE AUTHOR L Frank Baum was born on this day in 1856. His most enduring work, The Wonderful Wizard of Oz , was published in 1900 and more than a century later remains a favourite among children, writes CHARLIE FELL

Baum’s seemingly-innocent fairytale is viewed by many as an allegory about the rise of the free silver movement in the 1890s and their demands for a bimetallic monetary standard that would ease the restrictions imposed on monetary expansion via the link to gold and help avoid a repeat of the severe depression of 1893.

Fast forward to today and Baum’s parable continues to be relevant as the politicians in Washington or cowardly lions in Emerald City attempt to revive the banking system otherwise known as the wicked witch of the east. The results of the supposedly-stringent Supervisory Capital Assessment Programme (SCAP) have been released and demonstrate that investors were wrong to question the banking system’s solvency while accounting wizardry employed by the wicked witches has allowed them to report first quarter earnings well ahead of the most optimistic expectations. The confidence tricks appear to have worked but investors should note that the Wizard of Oz was a fake.

The financial sector’s first quarter earnings season was nothing short of a sham as accounting gimmickry was used to mask economic reality. The major banks were able to report greatly-inflated profits through a number of manoeuvres that included booking toxic assets at ridiculously high values, marking debt to market in order to post fictitious gains, pushing the bulk of bad debts into last years fourth quarter and understating likely losses in the current quarter.

Numerous banks employed one or more of these techniques but Citigroup used all of the gimmicks noted and the financial alchemy transformed a $2.5 billion loss to a $1.6 billion profit. The rosy earnings picture presented by some leaves open the question as to whether the worst of the creative accounting practices used by the likes of Enron and WorldCom is truly just a footnote in history. Peter Hahn, a former Citigroup managing director, is reported as saying, “When you look at the income numbers that have been put out recently they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment.”

The sham does not end with first quarter earnings as SCAP – or the bank stress tests – proved to be nothing of the sort while their integrity is called into question by the fact that those tested were able to have estimates of shortfalls scaled back. It is clear that SCAP was not a true test of banking system solvency but rather a confidence-building exercise that would make it easier for the banks to raise capital.

The stress tests reveal that 10 of the 19 largest banks need to raise a cumulative $75 billion within the next 6 months in order to increase Tier I common stock to the minimum acceptable level but the results are questionable given that the bar was simply too low and allowed the majority of banks to pass with flying colours. Are we truly to believe that both debt and equity investors were wrong to flee the banking sector earlier in the year? That simply beggars belief.

The stress tests fall short on a number of fronts. Firstly, unfavourable economic developments since the SCAP was designed question whether the “more adverse” scenario is a true reflection of a reasonable pessimistic forecast. The 3.3 per cent drop in GDP projected for this year is now close to consensus while the forecast unemployment rate has already been reached and sure to move higher through the remainder of the year. The half-percentage point growth in GDP estimated for 2010 appears more reasonable though still not representative of a meaningful “adverse scenario”.

Not only is the “adverse scenario” not pessimistic enough but the earnings projections appear to be too optimistic. The International Monetary Fund (IMF) recently estimated that retained earnings for the entire US banking industry would total $300 billion for 2009 and 2010 as against the $362 billion used in the stress tests for the 19 largest banks. Using the IMF estimate would result in retained earnings of roughly $200 billion for the banks tested and a significantly higher number for the shortfall in capital thereof.

The final objection to the stress tests is that the common equity requirement was set at 4 per cent of risk-weighted assets, which amounts to just 2.5 per cent of total assets. Excessive debt levels helped create the current mess though the employment of a leverage ratio of 25 times based on risk-weighted assets or 40 times using total assets suggests that the banking system can return to business as usual. Surely the minimum requirement should be far higher.

The US stress tests have proved to be a nonsense as the Obama administration continues to embrace short-run remedies that may well result in serious long-term problems. The government has announced that it will not allow any of the 19 largest banks to fail, creating substantial moral hazard issues in the process, whilst praying that the troubled banks will grow out of their problems. Such a flawed strategy was tried before in Japan. Investors should take note.

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