The Real Reason to Be Stressed Over Banks

NEW YORK ( TheStreet) -- Think next week's release of the Federal Reserve's "stress test" will clear up any questions about the strength of bank balance sheets? Think again.

The problem with the tests is that no one seems to agree on what they mean.

If, as expected, the results are good, bulls will trumpet them as proof that, as they have been saying for months, banks are scandalously undervalued. Bears, on the other hand, will say the game is rigged, and the test is easily manipulated by banks and their regulator. If the results prove worse than expected, bulls will say--as they have already been saying--that the test was unrealistically harsh, while bears will say things are even worse than the test makes them look.

For those few members of the public unfamiliar with the Fed's Comprehensive Capital Assessment and Review, it is an annual assessment by the top bank regulator of the ability of 19 largest U.S. banks to withstand massive shocks to the economy.

The test, mandated by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, is supposed to show what would happen to Bank of America ( BAC), Citigroup ( C), Goldman Sachs ( GS) and 16 other financial giants if, among other things, GDP fell by 8%, unemployment peaked at 13%, home prices fell by 20% and equities dropped by some 52% below where they were in the third quarter of 2011.

To pass the test, these institutions will need to show that their so-called Tier 1 common ratio would remain above 5% under the above scenarios.

To get a bank's Tier 1 common ratio, regulators combine common stock and retained earnings, then divide by its risk-weighted assets. The measure has drawbacks, according to Boston College Finance Professor Ed Kane, because both risk-weighted assets and retained earnings can easily be manipulated.

Kane argues retained earnings are the weakest of the three components of the Tier 1 common ratio.

"They make very risky loans which accumulate high yields as if they've been earned, and then later these things aren't paid back," Kane says. "Retained earnings isn't as good as net worth, but even net worth can be cooked because you play games with assets to not write them down when they should be written down."

While the requirement of the stress test represents an effort by Congress to force banks and their regulators to come clean about the strength of financial institutions, Kane argues that task is essentially impossible.

"You can't force people to do something they don't want to do. If regulators discover weakness and are embarassed by it or don't know what to do about it they can conspire and have conspired in the past with banks to hide their weakness," Kane says.

Rochdale Securities analyst Dick Bove isn't won over by this argument, however.

He argues that looking at the unadjusted capital, assets and Level 3 assets (referring to assets deemed impossible to value) shows "that the banking industry in the United States has more common equity as a percentage of assets than at any time since 1938" and that cash and government-backed securities are at 35-year highs.

"It takes professors who live in worlds that have nothing to do with where human beings live that come up with wacko theories about what these wacko accountants put together," Bove says, adding, "who gives a damn? It doesn't mean anything."

So, in short, whatever the results late next week, they are likely to answer little about the health of the banking industry.

Nonetheless, investors will watch closely to see how much permission is granted to the different institutions to increase dividends and buy back shares. Most banks are expected to get at least some additional leeway in this area, though one big question mark will be Bank of America, which was embarrassed when it emerged from the last round of stress tests without permission to hike its payout.

Bank of America has said it will not seek permission from the Fed to deploy capital.

-- Written by Dan Freed in New York.

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