Breathing easier after bank stress tests? You shouldn't

McClatchy NewspapersMay 12, 2009 

WASHINGTON — Largely unnoticed in last week's government report on the condition of the nation's biggest banks was the disclosure that five of them, topped by Bank of America, could lose $99 billion from the kinds of exotic bets that sank the global economy.

Even that figure, however, could prove to be exuberantly optimistic if the economy hits new depths, a McClatchy analysis has found.

Moreover, the regulators' recent "stress tests" on bank holding companies didn't fully measure the cash squeeze those institutions could face if souring conditions forced them to post tens of billions of dollars in additional collateral on some of their insurance-like bets, known as derivatives.

The banks' financial reports to regulators for the quarter ending March 31 also tell a potentially ominous story about their holdings of derivatives, instruments whose value is tied to an underlying asset, such as a pool of subprime mortgages. Seventeen of the 19 largest banks reported that, in the event of an economic catastrophe, they face combined derivatives losses exceeding $568 billion.

The recent stress tests measured the ability of the 19 banks to withstand economic conditions more adverse than the present downturn. The results prompted regulators to order 10 of the banks to raise $75 billion in new capital as a buffer against a worsening economy.

Federal regulators have never before undertaken such a massive, singular look at the health of the nation's largest banks. And they've revealed far more information about banks' loans and investments than would normally be made public in the course of normal regulatory reviews.

Given the hundreds of billions in taxpayer dollars used in bank bailouts of troubled banks, however, there are growing demands for greater disclosure — whether it shows how banks are using bailout money or reveals what it was that regulators looked at to draw conclusions about the health of the banking system.

New questions about larger-than-advertised bank risks come days after the Wall Street Journal reported that federal regulators scaled back demands on the banks to raise new capital after several bank executives strenuously protested the test results. The newspaper said that Bank of America was ordered to raise more than $50 billion, but negotiated that number down to $33.9 billion during almost two weeks of intense negotiations.

Potential loss estimates on complex financial instruments vary widely depending on the scenario. The stress tests were premised on a sharp, but not catastrophic downturn that would shock the financial system.

The banks' quarterly regulatory reports, which speak to the worst-case risks, require financial institutions to assume 100 percent losses on their derivatives exposures as if a systemwide collapse occurred with no government intervention.

The question is which scenario is more likely.

Several banks publicly or privately dismiss as exaggerated the loss estimates that were suggested by the stress tests, particularly those they could incur from derivatives trades with private partners called counterparties. These two parties engage in swaps, a practice of betting on the likelihood of loan defaults or movements in interest rates and currency exchange rates.

Bank of America reported to regulators that as of March 31, its current worst-case potential losses for its entire derivatives portfolio was $79 billion. Under the stress tests, Bank of America faced losses of $24.1 billion in the category of "trading and counterparty," which includes derivatives and private equity holdings.

The bank said it considers concerns about its risks for major losses from derivatives to be overblown.

"We think the Federal Reserve's estimated losses in the counterparty trading line were too high, primarily because they used a one-size-fits-all model in key categories," said Scott Silvestri, a spokesman for Bank of America, based in Charlotte, N.C.

The other major recipient of bailout funds, Citigroup, was found in the stress tests to face $22.4 billion in potential losses from exotic bets. A Citigroup spokesman declined to comment.

Bank examiners found in the tests that three other banks had big derivatives risks. They were Morgan Stanley, at $18.7 billion, Goldman Sachs, at $17.4 billion and J.P. Morgan Chase, at $16.7 billion. Bank of America, Citigroup and Morgan Stanley were all ordered to raise more capital, in part, because of the risks of losses from exotic bets.

"The results are what they are. We can go around and around in circles to debate them after the fact. It is time to move on," said Scott Talbott, the senior vice president of government affairs for the Financial Services Roundtable, a trade group for big financial institutions. "Some were upset and some were not. It is what it is."

A Federal Reserve official, speaking on the condition of anonymity because of the matter's sensitivity, said that supervisors used the same hypothetical shock factors for each of the firms. They applied them to each firm's trading portfolios, which are all different and thus yielded different results.

Other critics of the "stress tests" think that the banks' exposure to possible losses is understated and want greater disclosure.

Bert Ely, a veteran banking analyst, likened the results to a striptease act.

"You get this initial revelation, but then you say, 'What about this? And this?'" said Ely, predicting there may be pressure for more detailed results. "If that skepticism comes to grow . . . it seems to me they may be forced to reveal more information."

"These are black box numbers," Ely said. "I can't attest to them in any way whatsoever."

For example, the tests did not measure the banks' potential obligations to post tens of billions of dollars in collateral on so-called credit-default swaps — insurance-like protection that they guaranteed — if a loan defaulted or if a company's debt was downgraded by a credit rating agency.

It was downgrades on subprime mortgages and other assets that triggered collateral demands on swap contracts and sent American International Group to the brink of insolvency in September, leading to a $150 billion Federal Reserve-led rescue of the insurance giant.

In most areas, the "stress test" results were easy to follow since they simply applied an estimated percentage loss and then divided it against the value of loans outstanding. For credit cards, for example, stress testers measured how banks would perform if there were a default on 20 percent of their credit card debt.

Derivatives are by their nature complex and opaque, and thus make loss estimates subject to great interpretation.

The adverse scenario contemplated by the Fed was hardly a worst-case scenario, and collective risks assumed by banks cited in the McClatchy analysis suggest catastrophic losses if the economy returns to the chaos of last fall. Right now, with economists projecting recovery late this year, that seems unlikely.

But as last year showed, the unthinkable is possible.

ON THE WEB

Stress test final report

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