The Stress Tests: Establishing new standards for banks

On April 24, the Federal Reserve revealed some of the details of the “stress tests” that will comprehensively analyze assets on the books of 19 notable U.S. banks. The results are expected to be released on Monday, May 4.1 (The banks already know the results in private.)

What the Fed white paper had to say was hardly surprising. While mentioning that “most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized”, it conceded that the recession and resulting market upheaval “substantially reduced the capital of some banks.”1 Which ones? We’ll find out the week of May 4.

Why is the government doing this? It wants to determine which banks might have the greatest risk of failure if the recession worsens. Can certain banks survive worst-case scenarios?

No banks will “fail” the test, but some could receive more TARP money as a result – which could mean a lot more money poured into TARP.

How realistic are the stress test scenarios? Even if the government uses computer-generated models to make economic projections, how accurate will they prove to be? Some economists and analysts think things could get worse, but many feel the economy will improve in coming months. Others have questioned the testing criteria. Many wonder if releasing too much information might diminish public confidence.

The first scenario assumes a 2009 with -2.0% GDP, unemployment hitting 8.4%, and home prices dropping 14%, then a 2010 with +2.1% GDP, 8.8% joblessness and home prices down 4%. The second scenario is rougher: -3.3% GDP, 8.9% unemployment and 22% lower home prices in 2009, then +0.5% GDP, 10.3% joblessness and a 7% downturn in home prices in 2010.3

The administration says the tests are all about the goal of stabilization - a cautionary move that could help banks avoid any chance of nationalization. In fact, any banks directed to increase their “capital buffer” will have to turn to the private sector first before going to the government. Recent evidence in the form of a Goldman Sachs bond offering of $5billion is that this may in fact be possible for certain firms, but it seems unlikely that what capital is available to banks is sufficient for some. So far, unconfirmed reports are that Bank of America (BAC) and Citigroup (C) are going to be required to raise an additional tens of billions of dollars from investors.

Bank of America's Lewis - Everyone's Scapegoat

While there is much to dislike about Ken Lewis, his decision to continue last December with the Merrill Lynch merger isn't one of them.

A recent editorial in the Wall Street Journal expresses the now standard view that Bush Treasury Secretary Hank Paulson and Ken Lewis, CEO of Bank of America, inappropriately allowed for the interests of the global financial system to trump those of BofA's shareholders by forcing the merger with Merrill Lynch after it was abundantly apparent that the company was in serious trouble and the Bank was overpaying for ML.

It is absolute hypocricy to pillory Lewis, given that if he had chosen to withdraw from the deal, the media, Congress and probably the WSJ itself would have assaulted him for his lack of patriotism and self interest. Indeed, it's hard to imagine that back in December (when we were all still terrified of Great Depression II), a collapse of the deal wouldn't have caused even greater instability than we experienced. But, now, all these months later, we've forgotten that the rulebook - whether it was the laws regulating finance or more fundamental Laws of Finance - was being thrown out as we "all became Keynesians" (I didn't) and it was very hard for anyone (especially the CEO of a money center bank) to know what was the "right" thing to do.

What this recent debacle suggests is that media and Washington elites now feel sufficiently confident that the financial system can absorb the kind of self-serving witch hunt that now is apparently unfolding. Perhaps we should find that encouraging. I hope they're right!

Liquidity without an IPO

Recent developments in the private equity markets are extremely encouraging for our clients who hold shares in companies that expected to IPO in the last few years. , but couldn't because of market conditions.

While exchange funds for private equities have existed for quite some time, (ex. the fine people at EB Exchange Funds seem to be doing a solid job providing that option) diversification isn't liquidity. And what liquidity options did exist, were limited to large blocks of equity.

Now companies like secondmarket and SharesPost seem to be making liqudity a possibility at a much lower level of shares than before.

Here is a NY Times article profiling Second Market.

The Begining of the End for Retail

Rather disturbing new iPhone application for retailers

Reselling Toxic Assets to Retail Investors

According to CNN/Money, the Treasury is exploring options to re-securitize (again!) toxic asset backed securities and make them available for purchase by retail investors. This is a political response to concerns raised by some that hedge funds and other institutions are the only potential beneficiaries of the government's public-private partnership program (TANF). Formany investors, this may be an attractive investment vehicle. If given the opportunity - I would certainly examine the alternative closely for clients. But the political liabilities - both in the short and long term mean that there will be so much hand-wringing over this that the Administration is likely to make the vehicle fatally flawed. The question is whether the consequences of the flaw will fall on the government or investors. If, like TIPS, the vehicle is flawed in favor of the investor - this may, in fact, be an outstanding opportunity. Let's keep our fingers crossed. Stay tuned!

The Ultimate Toxic Asset?

Came across an entertaining little article that I think illustrates the challenges facing banks in the current environment.
According to Bloomberg, the now-bankrupt Lehman Brothers has an extremely pricey but hard to value asset on it's balance sheet - enough uranium cake to make an nuclear weapon. Apparently they entered into the highly restricted (and lucrative) market for weapons-grade nuclear material shortly before their collapse.
Now that the short list of potential buyers knows that a bankrupt firm is sitting on a decent chunk of it, the market has effectively collapsed.
According to Bloomberg:

Lehman “tested” the uranium market after its bankruptcy filing in an effort to raise cash, pulling back after it did because “everyone was low balling,” Marsal said. With $10 billion in the till today from other asset sales, Lehman isn’t in a hurry any longer to sell uranium, he said.

Sound very much like the problem with banks and sub-prime mortgages?

Reminder: Treasury Guarantee Extends Until Jan

On March 31, 2009, the Department of the Treasury extended its temporary guarantee program for money market mutual funds through September 18, 2009. The program, which had been scheduled to expire on April 30, 2009, guarantees a participating money market fund's $1 per share value through September 18, 2009 for assets held in a fund as of the close of business September 19, 2008, or to shares held in the fund when a guarantee payment is made, whichever is less. Investors cannot acquire Treasury protection for investments made after September 19, 2008, and closing or transferring an account would mean losing the guarantee for those assets.

Encouraging Bit of News

According to the Wall Street Journal, AIG's Financial Products Division has indicated that it expects to have completely closed out its CDS exposure by the end of the year. As this division is largely responsible for the problems at the insurer, it's encouraging that we only have another six or so months of hand-wringing over this insanity.

The article goes on to discuss the ongoing question of whether they will be able to retain the personnel who got the company (and the American taxpayer) into this crisis. The logic is that they will be needed to unwind the complex web of obligations they've created. While I don't know the answer to this question, it seems to me that given the process of terminating the contracts seems fairly straightforward and their "expertise" isn't exactly required. Is there something I'm missing here?

Making Home Affordable (MHA) plan

Over the last few months, there have been dramatic differences in the interest rates being charged on "conforming" (up to $417,000) vs. "non-conforming" (over $417,000) mortgages. This relates to the federal government's subsidy of mortgages through Fannie Mae and Freddie Mac. Recent legislation aims to bring down interest rates on mortgages that reflects the higher average home prices in higher income areas.

In summary - I think it's highly likely that we'll see mortgage rates drop for loans up to $729,000 in California and New York over the next few weeks. In response to the many questions we've received on this, we thought the following information might explain how the government is indirectly and directly driving down rates through what is collectively known as the "Making Home Affordable Plan" (MHAP).

The MHAP is made up of two plans:
The Home Affordable Refinance plan provides access to low-cost refinancing for responsible homeowners suffering from falling home prices.
The Home Affordable Modification plan will assist homeowners in danger of losing their homes to foreclosure. The Home Affordable Refinance plan: While mortgage rates are now at historic lows, many homeowners with mortgages owned by Fannie Mae or Freddie Mac are unable to refinance their higher-rate mortgages because they have lost equity in their properties due to falling home prices. Under current rules, Fannie Mae and Freddie Mac cannot guarantee a mortgage that exceeds 80 percent of the home's value. The Home Affordable Refinance plan removes this restriction, allowing certain homeowners to refinance their mortgages. A homeowner qualifies for this refinancing if:  The property is owner-occupied and the existing mortgage is current  The existing mortgage is owned by Fannie Mae or Freddie Mac  The new mortgage balance will not exceed 105 percent of the home’s current value  The mortgage balance must not exceed $729,750 for single-family homes This plan runs until June 1, 2010. The Home Affordable Modification plan: The Home Affordable Modification plan will assist responsible homeowners who are now struggling to afford their mortgage payments and who cannot sell their homes because prices have fallen significantly, in many cases making the value of the property less than what is owed on it. The intent of the program is to offer loan modifications that will bring a homeowner's monthly payments to sustainable levels. To qualify, a homeowner must:  Be an owner-occupant  Have a mortgage created on or before January 1, 2009  Be in financial hardship or in imminent danger of financial hardship  Have a current mortgage payment (including taxes and insurance) that exceeds 31 percent of monthly gross income  Have a loan amount that does not exceed $729,750 for a single-family home (however, the loan need not be owned by Fannie Mae or Freddie Mac)  Apply by December 31, 2012 Homeowners with total "back-end" debt (including housing debt, car loans or leases, and credit card debt) equal to or greater than 55 percent of their gross income must enter a HUD-certified credit counseling program as a condition for loan modification. Lenders must reduce the borrower's monthly mortgage payment to not more than 38 percent of his or her monthly gross income. The U.S. Treasury will then share the costs of reducing the payment dollar-for-dollar to a debt-to-income ratio of 31 percent. This may be accomplished by capitalizing arrearage, dropping the interest rate to as low as 2 percent, extending the loan term to up to 40 years, and/or forbearing principal. (Principal forbearance will result in a balloon payment due on the loan's maturity date, upon sale of the property, or upon payoff of the interest-bearing balance.) The modified payments must be kept in place for five years, and then the interest rate can be stepped up by no more than one percent per year to the 30-year fixed conforming loan rate in place at the time of the modification. Loans that are delinquent or that are in imminent danger of default are subject to a net present value (NPV) test. This test compares the NPV of cash flows expected from the loan modification to the NPV of cash flows expected in the absence of modification (e.g., through foreclosure). If the NPV due to the modification scenario is greater, a Home Affordable Modification must be offered to the borrower. No modification fees may be charged to the borrower and unpaid late fees to the borrower will be waived. The following incentives are offered to accomplish modifications: • Mortgage servicers are offered an up-front fee of $1,000 for each delinquent loan modification meeting the guidelines. As long as the borrower stays current on the loan, the servicer will also receive a Pay for Success payment of up to $1,000 annually for 3 years. • Mortgage servicers will be paid $500, and mortgage holders will be paid $1,500, for each at-risk loan modified before the borrower falls behind on payments. • Borrowers who make timely mortgage payments will receive Pay for Performance principal balance reduction payments equivalent to $1,000 a year for up to 5 years. • To encourage lenders to modify more mortgages, cash payments to partially offset probable losses from home price declines will be made on each modified loan that remains active in the program. Additional incentives will be provided to extinguish junior liens on homes with modified first-lien loans. Compensation will also be provided to facilitate short sales or deeds in lieu of foreclosures for borrowers who fail to qualify for, or default under, modified loans. I hope that this has been helpful. Please feel free to contact us with any questions or if we can be of any assistance in refinancing your mortgage.