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After the Stress Tests

Interviewee: Roger M. Kubarych, Adjunct Senior Fellow for International Economics and Finance, Council on Foreign Relations
Interviewer: Lee Hudson Teslik, Associate Editor, CFR.org
May 8, 2009

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On May 7, U.S. regulators released the much-anticipated results of the series of stress tests they had carried out to determine the health of the nation's top nineteen banks. The tests revealed that these banks could suffer losses of up to $599 billion if the economy fares worse than expected. Regulators called on ten banks to raise a combined $75 billion as a capital cushion for themselves. In this interview, CFR's Roger M. Kubarych assesses where the banking industry stands following the stress tests. Kubarych says he found a fundamental flaw with the tests, in that they didn't strike him as particularly "stressful." Looking forward, he outlines a few "clouds" that will continue to hang over banks in the years to come--most notably their holdings of securitized U.S. commercial real-estate mortgages and their holdings of debt from municipal and state entities like the city of New York and state of California, which Kubarych says seem likely to continue to experience financial distress.

The U.S. Federal Reserve just this afternoon announced the results of its stress tests, gauging the health of major U.S. banks. First, I was hoping for your initial reactions.

Stress testing is a good idea. What's a little puzzling about this particular exercise is that it wasn't very stressful, and yet it generated quite a lot of negative reactions from the banks. I'm baffled by this because the banks must have known that assumptions far worse than the ones they're presented with could have been put in front of them. So in a certain sense they could have been looking at a state of the world that was much worse than the one they had to consider.

Ten of the banks will need to raise capital following these stress tests. I'm curious--how do you see them doing that? Is this going to be primarily through share offerings or do you think there will be more bailouts on the horizon?

The key question is what kind of capital they need to raise and how quickly they have to raise it. If the ambition of the whole exercise is to get these banks, whoever gets identified, having more straight equity capital, then there are only really three places to get it. One is through access to the public markets, and of course they could have done that without the stress test, but at what prices you don't know. Secondly, by conversion of outstanding types of financial instruments, which include both preferred stock and various kinds of subordinated debt that traditionally could have been swapped for equity, what you might call debt-equity conversions or debt-preferred stock conversions. And that has been widely touted as being the most likely source of more equity--by essentially going to creditors and saying, "You get equity, and we get a break in having to pay you interest or a preferred stock dividend." The third way is to say, "We can't get it from anybody else. Dear Treasury, please make us whole."

So you don't see that third option as likely?

I can't imagine that would be the Treasury's first choice, because the remaining funds under the TARP [Troubled Asset Relief Program] are dwindling. Basically the whole idea is to find somebody out there that believes in these banks and wants to recapitalize them.

What do you see this meaning for some of the banks that were determined to be healthier? We've seen already Goldman Sachs trying to pay back some of the money that it received from the government, in an effort to rid itself of some of the strings that were attached to that money. Do you think other banks that were determined to be relatively healthy will try to do the same? If so, is that a good thing?

The reason that so many banks got TARP funding in the first place was the notion that if there were [only] a small number of banks [that got bailout funds] everybody would run from them because they would be ipso facto considered to be weak and in danger of failing. So you put some good ones into the mix so that you can honestly say there's both good and bad and somewhere in the middle. Now they're basically going to be filtering out the ones that they feel are on the weak side by requiring them, not asking them, to raise more capital. So if it were a serious concern last October [that people would run from banks determined to be unhealthy] it's surprising that it isn't a serious concern now. If you get a free pass and you're a regional bank, then people will start asking, "Well, what kind of deals will they make? Who will they try to merge with? Will they try to take over some of the weaker banks? Will they try to get together with other clean banks to make a bigger clean bank which then might take over one of the weaker banks?" There are many different routes that may emerge once this thing is over but they tend to lead to a more consolidated banking system and one in which the role of the government is heavier.

The goal of some of the strings that were attached to the money was to try to get the banks lending to one another again, and lending in general again. So if they pay back these TARP funds and therefore get rid of the strings attached to those funds, does that take away their incentive to do that? Would that be a problem?

There are different kinds of banks. Goldman Sachs is a traditional investment bank, which only became a bank holding company because that gave them direct access to the Fed [Federal Reserve] without any of the kind of rigmarole and special treatment that had become more and more questioned by people in Congress and the media. But Goldman Sachs isn't going to change the way they behave. They have massive trading operations; they do massive internal investing. On a balance sheet basis they look more like a hedge fund than like a commercial bank.

The other extreme are some of these regional banks, some of which are in worse shape than others. When you look forward, out two or three years, and you ask, "What are the black clouds that still will be overhanging the U.S. economy?" it's pretty obvious where they will be. They will be state and local government budget financing, because those entities, cities like New York and Los Angeles, states like California and Michigan, are going to have financial difficulties for some time to come. That's going to raise doubts about their creditworthiness, and they're going to go through a number of highly publicized brushes with financial difficulty. So that's one black cloud, and that affects banks that deal in those states and with those entities.

The other black cloud is commercial real estate. We've had a tremendous mortgage mess in residential real estate. But commercial real estate has traditionally been riskier than residential, and you see how bad residential got. There's no way of telling how weak commercial real estate will get, and banks both big and small are very heavily involved in lending to commercial real estate, both for construction loans and acquisition loans and even in permanent lending. What happens to commercial real estate is not primarily a function of the unemployment rate. It's a function of many other things including the ability and willingness of ultimate investors who do invest in commercial real estate as an equity-type alternative. They view it as an alternative to putting money in the stock market or into commodities, and will those investors come out of the woodwork or will they stay a little reticent? This could have a big impact on valuations in commercial real estate.

Could you just give very quickly a sort of snapshot of where credit markets stand at this point? Has the TALF [Term Asset-Backed Securities Loan Facility] had any effect?

The TALF is the Term Asset-Backed Securities Loan Facility, and it's sputtering. It's sputtering for a couple of reasons. First, if you read, as I have, the actual terms and conditions for participation, it's a lot of work, and you would only do it if you intended to do many deals. Secondly, some of the institutions that most need that kind of coverage are very hard-pressed to be considered creditworthy in terms of the issuance. They would have to so overcollateralize asset-backed securities that there haven't been many issues done. Now they've expanded it, and what have they expanded it into? Commercial real estate mortgage-backed securities. Why? Because that's been pretty well frozen, and they're trying to unfreeze it. So that may inject some life into it, but the market reaction to the whole thing is: This is a lot of rigmarole, a lot of red tape. Why are we going to do this for just one or two deals? And basically people have been sitting on their hands.

I assume one of the big questions in terms of the banks' health is just what will happen to the economy in coming months and years. If things go very badly then you could see banks that these stress tests determined did not have so much bad debt actually having a lot more bad debt. I don't want to ask where do you see things going, but do you think these results that we've seen today are unduly rosy because of the last few weeks we've had that have been very cheery?

I don't want to quibble about forecasts, because naturally there are different possibilities and we have powerful fiscal and monetary stimulus at work. I'm not actually all that pessimistic about the recession. I think the recession will end this fall and the question will be how powerful and how self-sustaining is a recovery. I think it will be a mild one. I wouldn't say as bad as weak, but certainly mild and well under historical experience.

I think those who say, “We had a deep recession, we'll have a big snapback” are missing the fact that the wealth effects this time around, both in terms of lost housing wealth and lost stock market wealth, are multiples of any postwar business cycle. So just going on the basis of what has happened is a mistake because this is really much worse. The thing that really bothers me the most--and I'm not really critical of what the Treasury has done, what the Fed has done--one can quibble. But they have never done a very good job telling the public at large why we need big banks. They have in fact contradicted themselves by saying most banks are in fine shape, most banks are well capitalized, most banks do not have major constraints of liquidity or capital on their ability to lend money.

There are only two things that really big banks do that the rest of these banks don't do. One is essentially to finance hedge funds, and we need hedge funds because that's who are the big risk takers in the market on a day-to-day basis. If you want to have risk-averse customers have the ability to do things like buy options in order to protect themselves, you've got to have hedge funds on the other side of that trade. The other thing that big banks do is they finance deals: mergers and acquisitions, private-equity-type deals. And that's necessary to support and lubricate the restructuring of industry that's always going to be an important part of U.S. economic progress. Little banks can do these things but only very, very sparingly. They are technically different, and you can't just put together a consortium of little banks, smaller banks, and say, "Go out and start a new business line of financing hedge funds." Now you might add to this a third thing--that big banks can have trading houses, trading rooms like foreign exchange and derivatives and so on, but I'm not so sure about that. Probably to handle that it would be much easier to capitalize brand-new institutions who will come in and provide that kind of capital into the trading houses. I'm not even sure that the banks have a comparative advantage as traders.

If you really want big banks, then you really want them because you really think you want hedge funds and private equity. And if that's the case, then the best thing is to have more big banks and fewer weak big banks. And that requires a lot of flux: consolidation of smaller and medium-sized institutions into new big banks and the systematic stripping down of big banks who have made big mistakes and have shown themselves less than expert in managing that complexity.

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