Fisher Investments Editorial Staff
US Economy

Don’t Stress the Tests

By, 05/07/2009
  Story Highlights:
  • Markets hate uncertainty. Colossal fear of the so-called bank stress tests built over recent months.
  • But as test results slowly leaked over the past days, markets have cheered the largely benign outcomes.
  • So long as yield curves stay steep and rates remain low, banks should become increasingly profitable regardless of stress-test results.

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Any patient who's waited for a prognosis knows time ticks by too slowly. It's probably just a freckle—but could be worse. Who knows? Even if the likelihood of major illness is slim, waiting is the hardest part. Vague threats cause fear. Our minds are adapted to seek surety and avoid the unknown. Same for markets. The ongoing bank stress test exercise shouldn't be stressful—but headlines and fears abounded for months leading up to the results.

Finally, the results are out, though not officially until sometime Thursday. According to early reports, some of the nation's 19 largest banks will be strong-armed by the government into raising more capital. Bank of America will purportedly need to raise $34 billion, Wells Fargo about $15 billion, GMAC Financial Services $11.5 billion, and Citigroup $5 billion. Many others including JP Morgan Chase, American Express, Morgan Stanley, Goldman Sachs Group, and Bank of New York Mellon reportedly don't need any capital. Despite many banks' reported need for new funds, the S&P 500 index of US financial companies rallied 8.1% Wednesday.

Markets were pleased to learn bank supervisors will be flexible, giving banks time to try to raise capital from private investors or to sell assets. Regulators further calmed markets by ruling banks can repay TARP funds—borrowed since the October panic—if they can attract private investors through equity or debt offerings without Federal Deposit Insurance Company (FDIC) guarantees. Banks who can't attract private capital without government support may be forced to convert preferred shares to common stock. That would leave the government in control of common voting shares and dilute existing shareholders—not perfect but on a limited scale, not the end of the world either.

Last week, the Federal Reserve, FDIC, and Office of the Comptroller of the Currency told us how the stress tests were conducted and previously assured us all 19 banks will be supported regardless of the stress test results. Investors knew the stress tests were designed to ensure bank solvency in economic scenarios matching economists' expectations, as well as a "more adverse" set of circumstances. But we know the Fed anticipates the economy to bottom and begin recovering this year, so the need for draconian forced capital-injections is more remote. The tests are more precautionary and have less to do with banks' present survival. A steep global yield curve and low interest rates mean banks should be profitable going forward.

Officials leaked information about the stress tests slowly, presumably to prevent further surprises and also to gauge market reaction. As test news trickled out over the last week, stocks reacted favorably and priced in the relatively neutral results. Markets don't like shifting regulatory environments which cause uncertainty. Clear, reliable, and enforceable rules allow markets to function more efficiently. Since last fall, government officials have learned this notion slowly, often dealing with problems on a case-by-case basis—that inconsistency often sowed greater market anxiety. But the feds seem to be getting the idea now, and with the stress test results out in the open, uncertainty is diminishing—good for financials and stocks generally.

Sometimes waiting for the diagnosis is worse than the prognosis. The bank stress tests are a classic case of uncertainty unnecessarily stressing investors.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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