Bank Stress Tests & Other Terms

The political talk shows this past weekend generated lots of economic, financial and accounting terms such as Bank Stress Tests, Mark to Market Valuation, Cash Flow Valuation, Positive Yield Curve and 3rd Tier (Capital) Assets to name a few.  I wonder how many viewers understood those terms.  I would like to take this opportunity to simplify them for the reader.

The bank stress test is what the Treasury Department will conduct on banks and other financial institutions to determine which institutions are undercapitalized and whether they have enough reserves to weather adverse scenarios such as the rise and fall of the stock market, interest rates and currency fluctuations and exposure to undisclosed risks.  Initially the Obama Administration indicated that the stress test would only apply to financial institutions with over $100 billion in assets, but due to the worsening economic outlook, all bets are off.

Mark to market valuation is the current FASB (Financial Accounting Standards Board) and SEC (Securities and Exchange Commission) standard of valuation of bank assets.  As an example, if Citibank is holding a mortgage derivative which was valued at $600,000 before the bubble burst, but is now only $200,000, regulations require the bank to report this asset (Capital) at Mark to Market which is $200,000.  If the bank is holding many of these derivatives, Geithner’s office may declare the bank as “in distressed” and force it to take additional capital from the government in bail out money.  Many economists such as Larry Kudlow and Lou Dobbs now advocate the Cash Flow Valuation instead of  Mark to Market on the ground that the $600,000 asset still yields the same return for the bank although it is now only valued at $200,000.

The Positive Yield (interest rate) Curve is the normal yield of investments.  Longer term maturities usually have a higher yield than shorter term.  When the yield becomes negative or inverted, it spells trouble for the banking system as what started happening in late 2006.  The incentive for depositors to leave their money with the bank for longer periods of time, say 5 to 10 years is to earn a higher interest rate.  If the interest rate is the same for 5 years as it is for 1 year, this incentive is gone.  Geithner’s job now is to classify banks’ assets into tier 1, 2 or 3.  If Geithner’s agents reclassify too many of a particular bank’s assets from tier 1 to tier 3, that bank may be classified as a distressed bank and may be forced to take bail out money as additional capital.  Tier 3 assets or capital are the most risky investments the bank holds.  Examples of these are uncollateralized debts such as credit card debts and unsecured personal and business loans.

What we have seen from Bush and Paulson to Obama, Geithner and Pelosi is that our government tends to overreach in its desire to restore stability.  The Obama administration goes one step further by taking advantage of the crisis to put through its social agenda.  As Rham Emmanuel clearly stated, “we should not let a crisis go to waste.”   As recently as a week ago, many banks including Citibank and Bank of America announced that they are not in bad shape; that they are actually making money; and that they don’t need any more government bailout money.  I hope, for our own good, that such announcements and the positive yield curve will prompt investors to pull their cash out of their mattresses and home safes and hand it over to their friendly neighborhood bank.

Any opinions and views herein are the sole responsibility of the writer.

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