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 The Federal Reserve is expected to spell out the parameters of the stress tests it has been conducting on the country's 19 largest banks on Friday, but it's looking like the the big banks on Wall Street may be getting graded
on a curve to the detriment of the smaller regional banks.However, according to a document obtained by The Associated Press, the stress tests are rating the loan portfolios typically found in the regional banks tougher than the more complex debt instruments and assets found on the balance sheets of Wall Street banks, which could easily have the effect of making a more stable regional bank score lower than a large institution that depends on more leverage. The AP reports: "under one scenario, the tests assume banks will see 'no further losses' on the complex securities, according to the document obtained by AP. By contrast, it estimates that individual loans will lose up to 20% of their value. Regional banks are holding more individual loans and fewer of the securities Wall Street giants specialize in - complex derivatives backed by huge pools of mortgage-backed loans and other debt." However the Fed's weighting of debt products such as CDOs, MBOs and derivatives as less likely to decline in value than a loan portfolio risks undermining whatever confidence the stress tests might build into Wall Street's banks, as well as the government's grip on the situation. As Naked Capitalism notes: "Why is being hard on loans but not on securities a distortion? Many structured products (and most of the troubled securities fall in that category) have what is known as embedded leverage. That means an increase in defaults, or other fall in cash flow can have a disproportionate impact on the value of the instrument. That's why, for instance, some CDOs were downgraded from AAA to junk in an afternoon. That's an impossible occurrence with a loan book, absent a catastrophe like the Yellowstone caldera blowing up. Even when loan books decay, they do so in a linear fashion. Complex securities often decay much faster (with structured securities, particularly when certain levels are breached)." Weighting of assets isn't the only factor being criticized in the testing parameters, as The Deal's Bill McConnell writes: "Another wild card is the Fed's recent switch to the tangible common equity ratio as a gauge of a bank's strength. The ratio shows what common shareholders would receive if a company was liquidated and is generally considered a more conservative measure than alternative indicators such as Tier 1 capital. Unlike Tier 1 capital, TCE excludes preferred stock, goodwill and other intangible assets. But Tier 1 capital has been the primary gauge of bank health for 15 years and has allowed them to determine their own capital needs based on internal assessments of the risk in their portfolios. The switch is generally applauded by advocates of stricter assessments of bank health but if strictly implemented could pose serious strains on banks that are found to need more capital." Regulators have to walk a fine line with the stress tests. Announcing results that say the major banks are healthy will most likely be dismissed as a clear whitewash, while at the same time announcing that a major institution could be insolvent could result in capital fleeing from the bank, triggering another scenario similar to Lehman Brother Holdings Inc.'s. That's an outcome the Fed and Treasury would like to avoid at all costs. - George White See AP story See Deal Pipeline story on stress test parameters See Naked Capitalism post
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