BUD BREWER
One Man's Opinion
STRESS TEST
May 8, 2009: Investors have been waiting in some anticipation for the U.S. Treasury’s report of the result of their audit of nineteen of our largest banks to determine just what financial condition they currently are in and what they will have to do in order to get to the baseline of solvency.This examination is being called a Stress Test and is being done, I suspect, primarily to generate some confidence for investors to believe that even in the worst economic scenario over the next two years, U. S. Banks and our financial system is ok although in some cases the banks will have to raise additional equity capital. The report also carried a requirement that some banks, among which are Bank of America and Wells Fargo, must complete a plan for raising $33 Billion and $17 Billion of equity capital respectively by the end of June and complete funding that plan by this fall.The best one can say about this process is that if, and that is a big if, the assumptions by the Treasury of their estimate of the worst case for housing prices, unemployment and economic activity to be experienced in 2009-2010 is reasonably correct, then the investors will be able to make conclusions about the survival of the financial system that have some foundation in logic.These assumptions, as they relate to the value, or potential ultimate proceeds to be recovered from sale or maturity of so called toxic assets, are at best informed judgments and may be understated or overstated at the present time.One other important factor, however, with the so called big Wall Street banks is that since short term interest rates are very low, and long term rates seem to be rising, their operating profit margin on interest revenue is huge and they are slowly but steadily earning their way out of the problem.So, if this spread continues for a few more quarters, the banks could rapidly add to their capital base and avoid potential insolvency and become healthy once again, although at a price of more or less dilution of shareholder interest depending upon which bank we talk about.During this period, once again under the Treasury’s assumptions, the banks should be able to pay back the entire amount of funds received since last fall under the “Troubled Asset Relief Plan” (TARP).This outcome will be considered a great victory for “Obamanomics” although it really has been a continuation of the Tim Geithner plan as originated by him last September while working under Henry Paulson in those critically last days of the Bush Administration.
Regardless of who the author is, the plan to keep these 19 banks from failing is indicative of the Obama administration’s “too big to fail” policy.This policy is also being applied to one or two of our largest industrial enterprises.While on the surface, it looks like a good idea, at least for the executives and employees of the automobile companies and Wall Street banks, removing the risk of failure for any corporation in any sector of our free market based economy will surely result in major motivational changes in how these companies are managed in pursuit of success.It also will create a reluctance of informed investors to associate their capital with such companies.Oh of course traders will buy or sell these stocks depending on their outlook for short term price movements but any individual or investment manager operating with fiduciary responsibility will be assuming a new or different degree of risk that the too big to fail policy is more about preserving a franchise and not about the enhancement of shareholder’s equity or prospective appreciation in market value. After all who wants to invest in companies for which management decisions are based primarily on business judgments made by bureaucrats either directly or indirectly?Who wants to invest in a company where management’s motivation is primarily based on serving the government’s wishes rather than those of its shareholders?
I know there is a genuine fear that if these huge companies are allowed to fail, the loss of jobs and dislocation of forces in their markets will be devastating.But is this really true?When any company, large or small, goes through a court jurisdiction bankruptcy, there are at least two potential outcomes.In liquidation, Chapter 7 of the bankruptcy code, the company’s assets will be sold and the proceeds distributed among those holding claim against the bankruptcy estate as adjudicated by the court.If there is a Chapter 11 reorganization of the company, an investor or investors will put up enough capital to create a successor entity that is going to own and operate the company subject to the adjudication and settlement of all claims against the bankruptcy estate.This means that reorganization requires new investment capital and the discharge or assumption of all or a major portion of the claims against the bankruptcy estate.Neither of these is pleasant for shareholders after the fact but the threat of their assumptive risk keeps management focused on what is best for the shareholders of the company, their primary obligation.