Skip navigation

Tag Archives: Ben Bernake

Several news items (WSJ’s Tishman Venture Gives Up Stuyvesant Project, Control of Stuyvesant Takes Center Stage and the NYT’s Fallout Is Wide in Failed Deal for Stuyvesant Town, As Doubts Grow, U.S. Will Judge Banks’ Stability) got me thinking about stress testing.

Stress testing is an approach to evaluating how a deal or a balance sheet will behave when selected factors are changed to induce a loss. It is done to answer the question what is the downside financial risk should a bad situation occur?

Around February 2009, the Feds and the Treasury impleted stress testing of the largest banks. This illustrates that stress testing is used in both the private and public sectors. And for those who are not familiar with this methodology, it is not a Republican or Democrat issue, as we can see that Ben Bernake is a Republican and Timothy Geithner is an independent having been a Republican.

Figure 1 illustrates a single factor that is used to stress test the deal or the balance sheet. I purchased some structured finance models a few weeks ago and was reviewing them. My observations about 3 important failings of the stress tests are based partly on these models:

Figure 1: Factors Skewed Right

1. Right/Wrong Distribution: I realized that the inherent assumption behind one of the stress parameters, the loss statistic, is that it is Normally distributed, because it is based on average values. In this example the mean is the 5.0% dashed green vertical line.  Therefore, this factor should behave like the red-dashed Normal curve in Figure 1. However, losses are skewed right and fat tailed per the blue curve. The mean is still 5.0%, however, the mode is 4.6% (solid purple vertical) with a long tail extending out beyond 17.9%.

2.  Insufficient: Stress testing multiplies the loss number by 2x to 10.0% or 3x to 15.0%. In this example 15.0% is insufficient to cover 17.9% tail loss.

Figure 2: Factors Skewed Left

3. Irrelevant: In Figure 2, we see that the skew is to the left. As an example some returns distributions can be skewed to the left. Therefore, the stress test has no bearings with reality. The stress test stresses the loss statistic in a manner that can never happen because it is outside both Normal and Left Skewed distributions, and therefore, the results are irrelevant to the real world.

So take care with your stress testing.

___________________________________________________________________

Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position neither is it to be construed as investment advice.

Contact: Ben Solomon, Managing Principal, QuantumRisk

___________________________________________________________________

To get jobs growth going, maybe what is required is a business solution and not an economic solution.

The exceptions are people like Ben Bernake who did a marvelous job of reducing the severity of this recession. Even then Bloomberg reports (05/29/09) that Bernanke’s efforts to bring down borrowing costs to revive the housing market and help the economy are stalling.

Let’s review TARP to find some answers. TARP, issued as preferred stock in the banks’ balance sheet, is tax payers’ public funds used to cushion private shareholders bank balance sheets so that the difference between the banks’ assets and liabilities does not fall below a specific value (at best) or go negative (at worst); because Assets – Liabilities = Equity.

As reported by the Washington Post (07/20/09), the special inspector general overseeing the government’s financial rescue program said that “many of the banks that got federal aid to support increased lending have instead used some of the money to make investments, repay debts or buy other banks”.

What TARP was meant to do was to give banks time to fix the Asset side of the Balance Sheet. If banks had to mark to market, my guess would be that their Assets were about 25% smaller than on July 2007. This suggests that at the worst period during the recession some banks would have had an insignificant or negative equity on the Balance Sheets.

With hind sight this inference makes sense for 2 reasons. (1) There was a huge outcry around April 2009 by the banking industry to move away from mark-to-market rule. (2) The special inspector general report mentioned earlier.

Therefore, we see that the role of TARP was to ensure that bank Equity would remain positive and above a specific Asset % and nothing more.

Now what the banks did with TARP makes business sense too, because TARP increased some banks’ Equity in such a manner that they needed to adjust the Asset – Liabilities side of the equation; that meant reducing Liabilities or “repay debts” and increasing Assets or “make investment” and “buy other banks”.

Could we blame the banks for making “good” business decisions to secure their own safety having received so much cheap money with no strings attached? Let’s flip sides, would you as a banker give free money to your customers?

Let’s think about this some more. The only way banks are going to stay profitable in an underperforming economy is to (1) shed more banking jobs, (2) close more branches, (3) foreclose more properties & (4) reduce risk of lending by reducing lending. All are undesirable outcomes. I suspect that even banks forget that they too need a functioning economy to be profitable.

It appears that the previous Treasury Secretary Paulson’s primary objective was to save the banking system, not the economy, and therefore did not attach any conditions to the TARP funds. I believe the thinking was that this was to be a financial transaction only, to save some banks.

By the time Secretary Geithner took over, some of the initial panic had subdued. There did not seem to be the need to push for more conditions. Even if one wanted, what additional conditions would one attach to the TARP funds? This was a new situation and everyone was learning on the job.

Looking back we can clearly see that TARP’s weakness lay in not aligning the banks’ interests with the tax payers’ interests. Banks are the primary source of credit for a functioning economy, and if after they were rescued, they continued to withdraw credit from the economy then something is amiss. Fed’s Non Revolving Credit Outstanding shows that until recently non-revolving credit had been shrinking. But the recent blimp could be due to the clunkers and other such programs and not so much a revival in bank lending.

Do you remember “what is good for GM is good for America”? We should not make that mistake with the banks either.  Now this is our challenge, aligning banks’ interest with America’s.

The banks’ balance sheets provide an answer as to how to align the banks’ interest with America’s interests. Monitor banks’ business loans and mortgage assets and implement an additional TARP condition that banks cannot return their TARP borrowings until their business loans and mortgage assets have increased by 25% (or some percentage the economist feel safe with). By this rule the government does not tell the banks how to run their business. It tells the banks that the government only recognizes that the banks are healthy functioning members of the economy when they have shown that they can increase these critical assets by 25%.

This rule will immediately stop banks from adjusting their balance sheets by raising capital without growing their business. Raising capital is equivalent to substituting TARP dollars for private money and does not prove that banks will avoid previous mistakes. This rule will (1) cause banks to focus on their critical role of credit provider for the economy. (2) Buoy home prices because spatial correlations dictate less foreclosures will put less downward pressure on neighboring home prices. (3) Facilitate a greater tolerance for mortgage delinquencies for those who have lost their jobs for reasons beyond their control, and therefore fewer foreclosures.

We need to take into consideration that most banking practices are derived from experience in a functioning economy, when everything else is going good. This recession is the exception to those practices and needs to be viewed in a different light.

___________________________________________________________________

Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

Contact: Ben Solomon, Managing Principal, QuantumRisk

___________________________________________________________________