View from the Lake: Stress Tests & Tight Lines

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The IRA is writing today from Camp Kotok, which is held each year at Leen’s Lodge in Grand Lake Stream, Maine. We are in Washington County, which is on the border of New Brunswick, Canada, and about 200 miles north of Bangor up Rt 9. This is Down East Maine, the land of Thoreau with rolling hills and lots of beautiful rivers and lakes.

The conversation this year is much the same as the narrative on Wall Street, focused on the new records for asset values and questions about what happens next with the Fed and the markets. Each day, analysts ask whether the markets can continue to climb the wall of worry to every higher (and more incredible) valuations. But at Leen’s we are concerned about more weighty matters.

This week brought the latest results of the Fed’s annual stress test circus, a strange coming together of financial media and regulators in a celebration of disinformation. The stress tests don’t test the ability of banks to withstand losses, but rather the skill of bank managers at responding to the inane procedures set forth by the central bank. The real risk in banks is not what you can read in published financials or Fed stress tests, but the unknown.

They key indicator of a bank’s ability to absorb loss is not capital, but income. During the 2008 financial crisis, the US banking industry diverted tens of billion of dollars from income to provisions for future losses. After a couple of years, the crisis was contained and banks regained profitability. In those cases where capital (or more specifically, confidence) was in doubt, such as Citigroup (NYSE:C) and Wachovia, the institutions failed.

The Street cares about stress tests because it is believed that good results will allow banks such as Citi to return more capital to investors. The fact that the Fed’s manipulation of credit markets and spreads via QE makes higher future credit losses likely for banks is not even mentioned. Indeed, the fact that stress tests don’t explicitly include the negative impact of monetary policy on bank loan portfolios makes a mockery of “macro-prudential” policy.

We should always remember that the bank stress tests were not meant to measure capital or loss absorption capacity, but rather to restore confidence. Investor confidence is a function not of capital, but of the degree to which investors believe that they understand risk. In 2008, markets disintegrated because trust was broken by acts of financial fraud contained in the “off balance sheet” liabilities of major financial institutions.

Today, markets are far too trusting of the clairvoyance of the leadership at the Fed and other government agencies. We are especially amused by reports coming out of China about official concerns regarding the credit quality of heavily indebted state companies.

China is a festival of bad debt and inadequate disclosure that makes the shenanigans of 2008 pale in comparison. As in 2008, what the markets don’t know is the real risk, not the amount of capital in published reports. You can be sure, however, that in the days and weeks ahead new surprises will keep emerging from China’s corrupt kleptocracy .

We continue to be cautious about the outlook for financials in Q2 2017 and beyond, in part because the catalysts behind the bull trade in financials early in 2017 have largely failed. Interest rates are falling, bank earnings are flat and new lending volumes are decelerating. Credit costs for consumer and business loan portfolios are rising. Yet it is still possible to find analysts who think that financials are the next big thing.

The one truth that remains unaltered is that financials are a reflection of the markets which they serve. We worry that by gunning the economy with years of unnecessary QE, the Fed has embedded significant future credit losses on the books of many banks and funds, raising questions as to whether the income and capital of today is adequate to meet the requirements of tomorrow.

Loan losses and future risks are currently understated, thus investors need to exercise caution in making asset allocation decisions. But fortunately, our main concern today is catching fish and wishing the readers of The IRA tight lines and a good weekend.

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