Wall & Main


My perspectives as an investor and consumer

Stressing out the banks


One of the programs created under the TARP is the Capital Assistance Program (CAP).  The CAP was designed to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  A stress test, called the Supervisory Capital Assessment Program (SCAP),  was crafted and implemented by the Federal Reserve and the Treasury to aid them in assessing said capital cushion.  Details of the stress test were released to the public by the Federal Reserve on April 24th, through a 21-page white paper.  I present here a synopsis of the white paper.

All domestic bank holding companies (BHCs) with year-end 2008 assets exceeding $100 billion were required to participate in the SCAP.  According to ProPublica, 19 firms fell under this requirement.  They are listed in the second table below.  These 19 firms hold 66% of the assets and 50% of the loans in the US banking system.  They were asked to project their losses, and available resources for absorbing these losses, for 2009 and 2010 based on two economic scenarios — a baseline scenario and an adverse alternative.  The table below lists the components of the economic scenarios and the effect of the baseline and adverse conditions on each of them.  The supervisors, then, assessed whether their capital was adequate for them to function during this period.


Step 1: Loss Projections. BHCs were asked to project losses for 2009 and 2010 for 12 separate categories of loans held in the accrual book, for loans and securities held in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios, and in some cases for positions held in the trading account.  The losses were to be consistent with the economic outlooks in the baseline and more adverse scenarios.  The BHCs were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (“cash flow losses”) rather than discounts related to mark‐to‐market values.  The required assessments were broadly classified as:

  • First and Second Lien Mortgages: institutions provided detailed descriptions of their residential mortgage portfolio risk characteristics – type of product, loan-to-value (LTV) ratio, FICO score, geography, level of documentation, year of origination, etc.
  • Credit Cards and Other Consumer Loans (e.g., auto, personal, student): portfolio information included FICO scores, payment rates, utilization rates, and geographic concentrations.
  • Commercial and Industrial Loans: based on the distribution of exposures by industry
  • Commercial Real Estate Loans: included loans for construction and land development, multi-family property, and non-farm non-residential projects.  Information such as property type, loan-to-value ratios, debt service coverage ratios, geography, and loan maturities was provided.
  • Other Loans: farmland lending, loans to depository institutions, loans to governments, etc.
  • Securities in AFS and HTM Portfolios: majority are public-sector securities such as Treasury securities, government agency securities, sovereign debt, and high-grade municipal securities. Private-sector securities include corporate bonds, equities, asset-backed securities, commercial mortgage-backed securities (CMBS), and non-agency residential mortgage-backed securities (RMBS).  Supervisors focused on evaluating the private-sector securities.  Loss estimates were based on an examination of 100,000 of these securities.  Loss estimate, and subsequent “write-down” to fair value, for each security was determined based on credit loss rates on the underlying assets, consistent with loss rates for unsecuritized loans listed above.
  • Trading Portfolio Losses: estimated by applying market stress factors to the firm’s trading portfolio based on actual market movements that occurred between June 30 and December 31, 2008.
  • Counterparty Credit Risk: the risk that an organization is unable to pay out on a credit-related contract when it is supposed to, which directly impacts a firm’s earnings and the value of its assets.  The action taken by the firm to account for this risk is referred to as credit valuation adjustment (CVA).  Supervisors focused specifically on a firm’s loss estimates for mark-to-market losses stemming from CVA associated with market shocks applied to assets in trading books.

Step 2: Resources to Absorb Losses. Institutions were also instructed to provide projections of resources available to absorb losses under the two economic scenarios.  These include the pre-provision net revenue (PPNR) and the allowance for loan losses over the two-year horizon.

  • PPNR is the income after non-credit-related expenses that would flow into the firms before they take provisions or other write-downs or losses.
  • BHCs supposedly had some allowance for loan and lease losses at the end of 2008.  They were required to estimate what portion of this allowance would be required to absorb potential future credit losses on their loan portfolio under each economic scenario.  This calculation could either result in depletion of the year-end 2008 reserves (if there is adequate allowance) or indicate the need for building the reserves (if the allowance is inadequate).

Step 3: Determination of Necessary Capital Buffer. Supervisors examined two main elements as indicators of capital adequacy – pro forma equity capital and Tier 1 capital.

  • Pro forma equity capital was estimated by rolling tax-adjusted net income (PPNR minus credit losses minus reserve builds) for the two-year horizon through equity capital.
  • Tier 1 capital is composed of common and non-common equity, with the dominant component being common stockholder’s equity.

The initial assessment of the capital adequacy, or lack thereof, was conveyed to the BHCs in late April and is expected to be released to the public on May 4th, 2009.  As yet it is uncertain whether the publicized results will reveal much about the banks.

Filed under: Business, Economy, Government, , , , ,

Redefining the paradox of thrift

cycleschange41There is a story in The Scriptures about a man named Joseph, who had the gift of interpreting dreams.  One unfortunate event after another led him to the king’s prison where he had served for two years.  One night, Pharaoh, the king of Egypt, had two dreams both of which troubled him inordinately.  In one dream, seven healthy cows, standing by the river Nile, were devoured by seven sickly ones, which were none the better for it.  In the other dream, seven plump ears of grain were consumed by seven thin and blighted ones.

Of all the wise men in Pharaoh’s court, Joseph turned out to be the only one who could interpret the dreams.  He explained that both dreams referred to the same thing – two consecutive time periods, each seven years in duration.  The first seven years would be ones of plenty but they would be followed by seven years of hunger and famine.

Not only did Joseph have an interpretation, he also had a plan to address the inevitable downturn.  For the first seven years, the time of abundance, the Pharaoh was to collect 20% of the harvest throughout the land of Egypt and save them in storehouses.  These “savings” would be used to feed not just the people of Egypt, but also of neighboring lands who were going to be affected by the dearth during the subsequent seven years.

As the story goes, Joseph’s interpretation of the dream was accurate and the implementation of his strategy positioned Egypt to not only survive the famine but to provide for her neighbors.

I am reminded of this story every time I hear the phrase, “the paradox of thrift” in the media.  Paradox of thrift is also referred to as the “paradox of saving” and was presented by the economist, John Maynard Keynes.  According to this paradox, if everyone saves more during times of recession, then aggregate demand will fall resulting in reduced savings by the population as a whole because of decreased consumption and economic growth.

Here is an example of the paradox in microcosm.  When you save more now than you did last year (as a percentage of your income), you do so by reducing spending because the chances of one’s income rising in a recession are low.  One of the ways you reduce spending may involve cutting expenditure on dining out.  As a result, your local restaurant feels the pinch.  It responds to the altered environment by cutting pay for its employees, reducing work hours or laying some of them off.  Regardless of the nature of the restaurant’s response, the employees’ incomes are reduced.  They, in turn, spend less.  When taken in aggregate, this could lower economic growth as represented by Gross Domestic Product (GDP), because 70% of GDP is based on consumer spending.

Economists of the Keynesian vein believe that spending needs to come from somewhere to stimulate the economy during a recession.  If the consumer has decided to clamp down on spending, it’s the government’s responsibility to pick up the slack.  Herein lies the impetus for the American Recovery and Reinvestment Act of 2009.

I don’t dismiss the paradox outright as do economists that follow the Nobel Laureate, Milton Friedman.  However, the context seems to be turned on its head.  There are certain principles in the story that I recounted earlier that seem to have been abrogated by our society:

  • Always remembering that nothing continues in perpetuity i.e., there is a cycle or season to everything.
  • Times of recession follow periods of growth and vice versa.
  • Preparing for famine needs to be a part of living in abundance.
  • If you have prepared during good times, then you will be in a position to support your community during tough times.
  • If you are in a position to help others during the community’s or nation’s dearth, then you ought to do so.

To me, this is how the paradox should be played out during a recession.  The key is for us to act from a position of strength, not weakness.  A strong position would mean low or no debt and cash reserves sufficient not merely for ourselves but also to support others.  Unfortunately, most of us find ourselves in the contrasting position – that of minimal cash reserves and a mountain of debt.  Opportunities for investment, career advancement or change, societal impact, etc., are all presenting themselves, yet we feel impotent.

However, our story need not end there.  That is the beauty of cycles.  When one passes, another one arises.  What is required of us is a reaffirmation of the principles we once abrogated – to build towards a position of strength and then, operate from that position.

If you are operating from a position of weakness, don’t allow economists to guilt-trip you into spending under the guise of saving the rest of the population.  You can’t help anyone when you are withering.  If, however, you find yourself in a strong position these days, then use this opportunity to impact your community whether it be through investments, doing business with local establishments, or supporting your favorite charities.  Those of us who are not in your position will be inspired by you and aspire to join you in these efforts during the next cycle.

Filed under: Economy, Government, , , , , , ,

House of Cards

3008220063_3399805fc0_medHave you had a chance to see the new CNBC documentary, “House of Cards,” by David Faber?  If not, I recommend catching one of the reruns.  Faber presents the various elements that contributed to the housing-induced credit crisis and recession.  It is evident that there is plenty of blame to go around.  Factors include, but are not limited to:

  • historically low interest rates
  • consumer desire to fulfill the dream of home ownership at any cost
  • congressional legislation to facilitate that desire
  • Wall Street salivating at the prospect of additional revenue streams through formulation of loosely regulated/unregulated structured products
  • rating agencies operating under conflict of interest
  • investors reaching for the holy grail of high yields and “no risk” which they thought were encapsulated in these structured products

One element which was not covered in the documentary but, in my opinion, should share responsibility is the National Association of Realtors, led by David Lereah, which kept trumpeting the “buyer’s market” mantra.  Such rhetoric only exacerbated renters’ fears that they were going to miss out on the greatest real estate boom in history.  Now, as a private consultant, he admits he was wrong.

As consumers, we need to develop the ability for critical thought.  We need to learn to ask the right questions:

  • Is this in my family’s and my best long term interest?
  • Can I truly afford this?
  • Do I really understand what’s in this document?
  • Can I trust someone who benefits from my signing the document when they tell me not to worry about the fine print?
  • Am I making this decision based on fear or greed?

The primary interest of publicly traded companies is not necessarily the consumer.  They are beholden, first and foremost, to the shareholders.  Consumers need to be cognizant of this fact and hold themselves and the counterparty accountable.  Otherwise, we will find ourselves exhibiting the same systemic problems down the road albeit in another form.  Alan Greenspan, the former Chairman of the Federal Reserve, even states this as a foregone conclusion:

There is no doubt that somewhere in the future we’re going to have this conversation again.  It will not be for quite a period of time.  But, it will occur because the flaws of human nature are such that we cannot change that.

Filed under: Economy, Real Estate, , ,