U.S. banks stress management

What was all the fuss about U.S. banks stress management?

Until the end of the first quarter of 2009, the banking sector in the U.S. and abroad was in a state of apocalypse. There were numerous casualties in the finance sector, starting with Bear Stearns and somehow ending with the conclusion of the Madoff case, which coincided with that seemed the end to all the trouble.

In truth, what other bad news could there be after it was found out that 50 billion dollars had vanished without anybody noticing, like a forgotten ice cream con on the beach?

So U.S. banks have rallied dramatically since, and one major element of support has been the stress management tests that the U.S. Government ordered for them to do. Treasury Secretary Geithner declared that after 19 banks had run stress testing measuring their ability to sustain a worsening economy, it was found that they were stable and resilient.

Indeed they seem to be, as the five largest U.S. banks became profitable in the first quarter. But what must be understood here is that any such stress management simulation needs to be run with a number of assumptions. This is a risk management exercise to stress test any balance sheet, that is similar to a worse case evaluation. This cannot be done without setting some assumptions.

Now it turns out that some of the analysts who were allowed to examine the details of the stress tests think that the assumptions are too rosy, making the banks look healthier than they really are. They claim that both the stress tests and the new accounting rule were designed to make the banks look more attractive than they really are.

At the center of the rules are the so-called mark-to-market standards. What this means is that billions and billions of dollars in loans must be evaluated and as no one knows for sure if the borrower will default or not, the value of these loans must be based on the probability of default. And these probabilities were made more optimistic recently.

It is believed that without such accounting rule changes, Citigroup would have posted a loss in the last quarter. This would have been the sixth consecutive losing quarter for the largest (or what used to be the largest) U.S. bank. In other word, Citigroup escaped bankruptcy thanks to this Government indirect support.

For now it is working as confidence is building up. If the economy recovers and housing prices stop falling, banks will be able to return to true profitability as the quality of their assets improve. This is the bet that President Obama is making.

Let us hope he is right.