Financial wizadry is just smoke and mirrors
Riaz K Tayob
SERIOUS MONEY: THE AUTHOR L Frank Baum was born on this day in 1856. His
most enduring work, The Wonderful Wizard of Oz , was published in 1900
and more than a century later remains a favourite among children, writes
CHARLIE FELL
Baum's seemingly-innocent fairytale is viewed by many as an allegory
about the rise of the free silver movement in the 1890s and their
demands for a bimetallic monetary standard that would ease the
restrictions imposed on monetary expansion via the link to gold and help
avoid a repeat of the severe depression of 1893.
Fast forward to today and Baum's parable continues to be relevant as the
politicians in Washington or cowardly lions in Emerald City attempt to
revive the banking system otherwise known as the wicked witch of the
east. The results of the supposedly-stringent Supervisory Capital
Assessment Programme (SCAP) have been released and demonstrate that
investors were wrong to question the banking system's solvency while
accounting wizardry employed by the wicked witches has allowed them to
report first quarter earnings well ahead of the most optimistic
expectations. The confidence tricks appear to have worked but investors
should note that the Wizard of Oz was a fake.
The financial sector's first quarter earnings season was nothing short
of a sham as accounting gimmickry was used to mask economic reality. The
major banks were able to report greatly-inflated profits through a
number of manoeuvres that included booking toxic assets at ridiculously
high values, marking debt to market in order to post fictitious gains,
pushing the bulk of bad debts into last years fourth quarter and
understating likely losses in the current quarter.
Numerous banks employed one or more of these techniques but Citigroup
used all of the gimmicks noted and the financial alchemy transformed a
$2.5 billion loss to a $1.6 billion profit. The rosy earnings picture
presented by some leaves open the question as to whether the worst of
the creative accounting practices used by the likes of Enron and
WorldCom is truly just a footnote in history. Peter Hahn, a former
Citigroup managing director, is reported as saying, "When you look at
the income numbers that have been put out recently they contain so much
fudge and financial manipulation. You could say that the automobile
industry has a clearer future at the moment."
The sham does not end with first quarter earnings as SCAP – or the bank
stress tests – proved to be nothing of the sort while their integrity is
called into question by the fact that those tested were able to have
estimates of shortfalls scaled back. It is clear that SCAP was not a
true test of banking system solvency but rather a confidence-building
exercise that would make it easier for the banks to raise capital.
The stress tests reveal that 10 of the 19 largest banks need to raise a
cumulative $75 billion within the next 6 months in order to increase
Tier I common stock to the minimum acceptable level but the results are
questionable given that the bar was simply too low and allowed the
majority of banks to pass with flying colours. Are we truly to believe
that both debt and equity investors were wrong to flee the banking
sector earlier in the year? That simply beggars belief.
The stress tests fall short on a number of fronts. Firstly, unfavourable
economic developments since the SCAP was designed question whether the
"more adverse" scenario is a true reflection of a reasonable pessimistic
forecast. The 3.3 per cent drop in GDP projected for this year is now
close to consensus while the forecast unemployment rate has already been
reached and sure to move higher through the remainder of the year. The
half-percentage point growth in GDP estimated for 2010 appears more
reasonable though still not representative of a meaningful "adverse
scenario".
Not only is the "adverse scenario" not pessimistic enough but the
earnings projections appear to be too optimistic. The International
Monetary Fund (IMF) recently estimated that retained earnings for the
entire US banking industry would total $300 billion for 2009 and 2010 as
against the $362 billion used in the stress tests for the 19 largest
banks. Using the IMF estimate would result in retained earnings of
roughly $200 billion for the banks tested and a significantly higher
number for the shortfall in capital thereof.
The final objection to the stress tests is that the common equity
requirement was set at 4 per cent of risk-weighted assets, which amounts
to just 2.5 per cent of total assets. Excessive debt levels helped
create the current mess though the employment of a leverage ratio of 25
times based on risk-weighted assets or 40 times using total assets
suggests that the banking system can return to business as usual. Surely
the minimum requirement should be far higher.
The US stress tests have proved to be a nonsense as the Obama
administration continues to embrace short-run remedies that may well
result in serious long-term problems. The government has announced that
it will not allow any of the 19 largest banks to fail, creating
substantial moral hazard issues in the process, whilst praying that the
troubled banks will grow out of their problems. Such a flawed strategy
was tried before in Japan. Investors should take note.
This article appears in the print edition of the Irish Times
Financial wizadry is just smoke and mirrors - The Irish Times - Fri, May
15, 2009 (15 May 2009)
http://www.irishtimes.com/newspaper/finance/2009/0515/1224246553483.html