As we enter the homestretch for bank stress tests -- the Fed will release the results after the markets close on Thursday -- investors are placing their bets on a volatile outcome. For a while, it was being reported that six of the 19 banks under scrutiny were undercapitalized by the government's standards. Today, The Wall Street Journal reported that the government will now order 10 banks to raise capital -- down from the 14 it was targeting after initial results!
Settle down, please
How is it that the number keeps jumping around so much? To begin with, banks are actually negotiating with authorities over the initial test results, trying to convince them that the results are excessively harsh and don't reflect their true financial conditions. The idea of such negotiations strikes me as a bit odd since one of the causes of this banking fiasco was the excessive chumminess between banks and their regulators.
None of this appears to worry investors: Yesterday, the AP reported that Wells Fargo (NYSE: WFC ) -- one of the best-run banks -- would be required to raise capital; shares rose 24%. (Granted, Warren Buffett gave the bank a huge endorsement over the weekend at the Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) annual meeting.) Bank of America (NYSE: BAC ) shares gained 19%, while Citigroup (NYSE: C ) was up 7%. Even the shares of banks that aren't expected to need capital, such as Goldman Sachs (NYSE: GS ) and JPMorgan Chase (NYSE: JPM ) , were up smartly.
Did investors get things backward?
That we should witness that kind of pop just before the stress test results are made public is at least mildly puzzling. I can find only two explanations for this phenomenon: Either the market is letting euphoria cloud its assessment of the situation, or bank valuations going into this weekend reflected a truly extraordinary amount of pessimism. Given the massive rally we've seen in bank stocks since March 6, it's difficult for me to entertain the latter hypothesis.
Further bolstering the case for euphoria is the fact that the stress tests, far from being too harsh, appear to be too lenient -- at least as far as some of the primary economic assumptions are concerned. As Nouriel "Dr. Doom" Roubini pointed out in today’s Wall Street Journal:
… using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010.
High-stakes poker
In this context, I think we should expect bank shares to be volatile this week. More so than the "pass/fail" grade, the key result will be the amount of capital the "failing" banks will need to raise. For shareholders of those banks, that number could mean significant dilution. For the economy as a whole, the size of the required capital increases will partially dictate the pace at which the financial system returns to a healthy state. No small stakes!
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