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Back-Door Nationalization?, Part 1

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Government makes uncertainty and fear the new normal for the US banking system.

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This is part 1 of a 2-part article. Part 2 can be found here.

On April 24, 2009, the Federal Reserve released a paper on the design and implementation of the Supervisory Capital Assessment Program (SCAP). SCAP will presumably be governing the financial system for here on out; my highlights from the paper can be found here.

In this 2-part article, I will provide an analysis of SCAP's potential consequences for the US banking industry, the financial markets, and the economy in general.

1. A plain analysis of the wording of the report confirms some of the worst fears of many in the financial community: Regulators of will be placing special emphasis on Tangible Common Equity (TCE) as the primary measure of capital adequacy.

2. This isn't the only problem. The bigger problem: Not only must the current and projected TCE ratio be adequate (not yet announced, but widely believed to be 3.00%); it must be adequate to cover the losses projected in the worst-case scenario. And presumably, if the actual situation turns out to be even worse, (which is very likely) the bank will have to raise capital and dilute shareholders again to meet the newly institutionalized TCE standard.

3. The report loosely outlines a methodology for projecting potential future losses. Because of the way the standards are established, and the considerable latitude that banks will have in estimating potential losses, the uncertainties surrounding the value of impaired assets won't be resolved on May 4, and will remain a source of intense speculation.

In addition, the report discloses that banks must not only project losses from traditional banking assets in a conventional manner, the report also highlighted the need for banks to include calculations projecting losses for all sorts of counterparty risks, including those incurred through complex derivative contracts.

This is a can of worms. In this environment of unprecedented systemic stress, nobody really knows how to accurately estimate the potential impact of these various derivative and counter-party exposures as they depend on contingencies that simply cannot be modeled econometrically with any degree of accuracy. While it is understandable that the regulators want to demonstrate that they aren't ignoring the issue, it is also true that any estimates of potential exposures disclosed on May 4 are likely to be hotly contended and will remain a considerable source of uncertainty for years to come.

4. It is fairly clear that under the worst-case scenario described in the document, many banks will require additional TCE as a buffer against projected losses.

This simply means we can expect dilution of the banks, as they will be forced to raise equity capital.

5. The most disturbing aspect of this new regime is that it places a permanent cloud over the banks. First, speculation will obviously be rampant prior to the release of the stress-test results, which will disclose the equity capital regulators will force banks to raise.

Second, and most disturbingly, the regime will promote endless speculation in the future. Given the fact that the "worst-case scenario" isn't really a worst-case scenario at all, rampant speculation -- that future dilutions will escalate as future estimates of losses increase -- is inevitable.

6. In theory, after being informed that they need to raise more capital on May 4, banks will be allowed 6 months to raise equity capital from private sources. However, the reality is that most banks won't be able to do so on reasonable terms, due to the great difficulties currently faced in the private markets (partially created by the regulators themselves). This means that the only avenue to raise capital will be through participation in the Treasury's Capital Assistance Program (CAP). This amounts to a backdoor nationalization.
No positions in stocks mentioned.
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