The Bank Stress Tests Worked!

I’ve said it before and gotten all sorts of criticism, but the simple fact is that the Supervisory Capital Assessment Program, a.k.a. the bank stress tests, worked. Period. Bank of America’s (BAC) plan to repay the TARP is just more evidence proving this point.

You have to judge any endeavour on its own merit. That is, judge it on whether it achieved its goals. For example, its unfair to judge the Clone Wars cartoon series for what a moronic character Asoka is or for how Anakin doesn’t seem to be a consistent character with the movies. Hell, I was watching with my 5-year old and at one point Yoda seems to imply that the clone troopers might be Force sensitive. Seriously? But its all OK, because my 5-year old loves it, and that’s for whom the show is targeted.

Similarly, the SCAP was never meant to cure all that ailed the banking system. The purpose was to make it possible for banks to raise private capital. Before the SCAP, no one knew how much capital the big banks needed. Not just because of potential losses on balance sheet (which the SCAP did nothing to address), but because no one knew how regulators were going to react to those losses. No one had any idea that Fannie Mae (FNM) and Freddie Mac (FRE) were about to be nationalized and suddenly preferred and common shareholders were wiped out. Rhetoric was coming from all corners that banks needed to be nationalized as well, including from a certain Nobel-prize winning economist who many thought could be influential with the in-coming president.

Plus remember that the big banks were forced to take TARP money regardless of their financial conditions. What was stopping the government from simply declaring that it didn’t like a certain bank’s balance sheet and forcing it to take even more dilutive government investment? How could anyone invest in new bank common equity with such a high degree of uncertainty?

The only way to re-open access to private capital was to tell the market exactly how much capital the government thought a given bank needed. You knew that if the government said it was comfortable with a capital ratio of x, then investors didn’t need to fear sudden nationalization if the capital ratio were actually x + 1. Sure, a bank could start out at x and then the situation deteriorates to x – 1 but that’s the kind of thing analysts are comfortable with calculating. The whims of government? That’s something else.

What happened after the SCAP? Investors knew that if bank losses were in the range of those projected by the tests, they didn’t need to worry about dilution. Only about profitability. And with bank book values so low and the yield curve so steep, investors were willing to make that bet. Even with sketchy banks like Regions and Fifth Third.

Now is everything bright and bi-sun shiny in banking? Obviously not. I’ve written several times that I still think banks are quite vulnerable. But as a tax payer, I’m pretty happy to be getting out of banks. The alternative was much worse.

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