Busch: April's Cruelest Joke

Did anyone notice how grumpy all the financial CEOs looked after meeting with President Obama last Friday?

The meeting must have been quite unpleasant as the Obama administration is informing these private sector giants that they need to change the way they are running their business. The government wants more lending and less executive pay. Also, several banks indicated that they want to return the original TARP money and the Obama administration is telling them no.

While it may not have been explicit, the implicit threat was large. The FDIC is in the middle of stress testing the 15 largest financial institutions in the country. This testing is being undertaken to understand how these entities balance sheets react under the duress of 10.7% unemployment, -3.3% GDP, and peak-to-trough drop in housing prices of 47%. How do you think they will do? How would you do under those metrics?

The structure of the test appears to be designed to ensure that no bank can pass it and therefore no bank will be allowed to return TARP money. The Fed/Treasury/FDIC/White House may decide that it's in the best interests of the country to not only make the banks keep the money, but also to have these banks scrub their balance sheets by selling "toxic" assets to the new Treasury program. This would be done under the motive that once the banks shed these assets, they can then start lending.

This appears to be a very good idea, but potential abuses lurk. The legacy security and loan program by the US Treasury needs to have both buyers and sellers of assets. Under the loan program, I only see the FDIC as the one major seller of assets due to acquired loans from failed institutions. Currently, these loans are getting sold for less than 40 cents on the dollar.

However, other owners of these type of distressed loans are not necessarily going to sell them. If a bank has written down the loan to 30 cents on the dollar, the return on equity of this asset is very good and the hit to earnings has already occurred. If the bank hasn't written down the asset, then they would have to take the hit to earnings. Either way, there is very little incentive to act......unless they are forced to.

This is where trouble can happen. Remember, the US government has a dual role with the Treasury plan. They are both a regulator and investor.

Hmm, does that sound like a recipe for disaster?

If this is the case, then why haven't all the major banks come out and said they are worried about what is happening? Again, I would speculate that the quid pro quo may be to have been implicitly promised to receive a glowing stress test result and therefore to remain solvent. This means that common shareholder equity won't be wiped out and they will be allowed to live another day.

With the ouster of the head of GM, these bank CEOs know what's at stake. The results of the stress test are expected to be released by the end of the month. Until then, the uncertainty surrounding the outcomes will continue to weigh upon the financial sector stocks.

April Fools Day appears to have been put off until then.

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Andrew Busch
Andrew Busch


Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.