Dr Doom: "How To Repair A Failed System"

Nouriel Roubini
Nouriel Roubini

the NYU Stern School of Business professor aka "Dr Doom" said that the stress tests for 19 major banksare not "stressful enough."

The results are supposed to be released later today and without even waiting for them - Roubini charges the tests lack credibility and don't even go far enough because the way he sees it, the actual economic data are far worse than the worst case scenario of these tests.

Today Roubini joins Viral V Acharya and Matthew Richardson fellow Stern professors and co-authors of “Restoring Financial Stability: How to Repair a Failed System” in writing this guest blog for Bullish.

Over the past few days, there has been a slow leak of the results of stress tests on the nineteen largest banks. While many in the media will view today’s formal announcement of the results as anti-climatic, it could well be a watershed moment of the financial crisis.

What Will the Stress Tests Tell Us? By Viral V Acharya, Matthew Richardson and Nouriel Roubini
What Will the Stress Tests Tell Us? By Viral V Acharya, Matthew Richardson and Nouriel Roubini

The reason is that the regulators will effectively be moving towards a model for separating the good banks from the bad banks.

As pointed out in the NYU Stern School of Business book project, “Restoring Financial Stability: How to Repair a Failed System”,this is a necessary step for resolving the financial crisis.

Up until now, the market has had to surmise which banks were in trouble based on whatever limited information was available.

Over the past year, using this information, the stock market has certainly picked winners and losers.

Of the nineteen banks, seven of them – Bank of America, Capital One Financial, Citigroup, Fifth Third Bancorp, KeyCorp, Regions Financial and SunTrust Banks -- have lost more than 70% of their value.

Because the market usually knows best, our guess is that these banks are at the forefront of those that have been told to raise additional capital. Of course, the chances that these banks can raise outside money are slim to none.

The reason is that, while it was not the government’s intention, the results of the stress test will show which banks are insolvent, that is, which institutions have expected future losses on loans and toxic securities in excess of their ability to cover them.

The government will try and spin the results positively, and argue that most financial firms are in good shape and no one firm “failed” the test. But the market should know differently. Because the stress tests applied consistent standards across banks, the relative ranking of the banks will be quite accurate. The losers will be out there for us all to see.

And that is all we need because there are four pieces of evidence that suggests things are much worse.

First, even with the recent economic news, the stress tests weren’t worst case scenarios; in fact, for some of the components, like unemployment, reality is actually already worse than the more adverse scenario. And at the rate at which job losses are taking place, the unemployment rate in the fall of this year may be already higher than the unemployment rate assumed in the more adverse scenarios of the stress tests for 2010.

Second, in just the past six months, the IMF has doubled its estimates of aggregate losses for loans and corresponding securities to $2.7 trillion, resembling our estimates at RGE Monitor of $3.6 trillion. If true, these estimates put the financial system on the brink because the financial sector holds half of the losses. Since the nineteen largest banks own the vast majority of assets, it therefore follows that they must also be holding the losses.

Third, each bank clearly had the incentive to sugarcoat their expected losses to regulators. Nothing good could come from aggressively marking down their books. So while the losses are calibrated to be consistent across all nineteen banks, the overall level of the losses will be downward biased. This explains why the stress tests don’t completely jive with either the above market estimates or the stock market drops.

It therefore follows that those who were ranked worst, and need the most capital, are most likely to be near insolvent.

And, finally, the market capitalization of banks will respond not just to announced capital needs (or lack thereof) but also to what news is contained for bank prospects in future. Whatever precise details are provided today will be crucial. Of particular note, the stress tests go out just two years while a number of assets on the bank’s balance sheets come due later, such as option adjusted rate mortgages in 2011 and leveraged loans in 2012 and 2013.

We have seen this issue before. Put simply, a bank may be deemed well-capitalized from a regulatory standpoint today as losses will be recognized only in future; however, investors will anticipate these losses and bank’s market capitalization may get eroded much faster. A case in point here is Bear Stearns which was deemed to be well-capitalized from regulatory standpoint even as its market capitalization approached zero in March 2008.

Banks deemed insolvent or near insolvent will thus find it hard to raise fresh private capital unless they take tough decisions to restructure their assets and convert some existing claims – notably debt – into equity capital.

It is unlikely that even forbearance, time and low borrowing costs because of government subsidies and guarantees, will heal their wounds. Now that deposit rates are close to zero, and banks have borrowed over $300 billion at cheap rates with FDIC guarantees, they can earn a net interest rate margin (the difference between their lending rate and borrowing rate). This will help rebuild capital with earnings before provisioning for loan losses. But such loan losses will be so large for some banks that time and high net interest margins will not resolve their insolvency problems.

It begs the question: when should we start dealing with these insolvent banks? The stress tests have addressed one market failure – they have provided information not available to markets and separated healthy banks from troubled ones. Governments and regulators should now address the second failure – put a stop to the waiting game played by controlling management of insolvent banks and enforce a “pre-packaged bankruptcy”, availing of necessary options such as asset sales, debt-for-equity swaps and good-bank/bad-bank separation.

Victor Hugo, perhaps the most influential French writer, once said: Nothing is stronger than an idea whose time has come. It is time to resolve insolvent banks.

Nouriel Roubini, Viral V Acharya and Matthew Richardson are the authors of “Restoring Financial Stability: How to Repair a Failed System”, and professors at the NYU Stern School of Business.

Questions, comments? bullishonbooks@cnbc.com