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No More Stress


Using first-quarter earnings as basis for stress test creates false sense of confidence.

Sophistry has been brought to a new level. Those that have the most riding on rebuilding confidence as a temporary respite from illiquidity in markets designed the rules to evaluate the amount of capital banks really have and the conditions under which that capital will be stressed.

There are many details I could go over, but I only need one to prove the point. The primary variable in the analysis is earnings: Earnings increase capital while losses reduce capital. The higher the base case for earnings, the better under any scenario of stress the banks will do.

It just so happens that the stress test used first-quarter earnings as its base case. First quarter earnings I have described as completely unrealistic. First-quarter earnings were greatly increased through the use of massive TARP funds employed in carry trades to make money. First-quarter earnings were greatly improved as FASB 157 was "loosened" to allow banks not to mark to market many toxic assets.

The next "psychological" ploy to increase confidence will be the great success of PPIP. It will be no problem finding government-friendly private capital to exploit egregious terms on risk-reward at taxpayer expense. Private capital will put up $100 of equity while the government will put up $100 of equity. Then the FDIC will essentially lend four to six times against that $200 of equity for the "partnership" to buy $800 to $1200 of troubled assets from banks.

Due to the leverage and the put afforded the private capital (they can only lose $100 on the $1000 of assets they buy), they're going to be willing to pay a higher price because of the reduced risk. This is a scheme to re-lever an already too levered system using taxpayer loans instead of going back to Congress and asking for more money.

Sophistry is not fact. Over the course of the next several months, "markets" (or what's left of them) will discover that difference.
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