Jeremy Siegel, Ph.D. The Future for Investors

Bank CEOs get no respect. When CEO Vikram Pandit of Citigroup decided to suspend dividends on preferred shares in response to calls to build up common equity, Citi's shares collapsed. When Bank of America CEO Ken Lewis categorically states that his bank needs no more government help, investors dump the stock.

The truth of the matter is that investors are rightfully fed up with the rose-colored view of the world that financial CEOs have presented over the past year. Didn't the heads of Bear Stearns, Lehman, and AIG all claim that their firms were "fully solvent" just days before they collapsed?

In order for the banks to regain investors' confidence, they must divulge all their assets and liabilities and present a realistic assessment of how much they are worth. And these valuations must be corroborated with outside experts, not just with governmental supervisors and bank management, as the new Capital Assessment Program envisions.

"Stress Test" Critical

The Capital Assessment Program (CAP), or "Bank Stress Test" as it is more popularly called, is designed to determine the capital adequacy of banks and is perhaps one of the most important audits that our regulators have ever performed. The plan is to examine the balance sheets of banks with over $100 billion in assets under two economic scenarios: one, the "consensus" forecast of private forecasters, and two, a "worst case" recession.

The consensus assumes that real GDP will contract 2 percent in 2009 and rise 2.1 percent the following year, that unemployment will rise from 8.4 percent in 2009 to 8.8 percent in 2010, and that home prices will decline 17 percent further by the fourth quarter of next year. The "worst case" scenario sees GDP falling 3.3 percent this year and rising only 0.5 percent next year, unemployment rising to 10.3 percent by 2010, and home prices falling 27 percent further through next year.

This audit could quell investor fears that the assets of many banks are so bad that recognizing their true value will totally wipe out the equity of the firm. For the large banks such as Bank of America and Citigroup, the book value of the equity (preferred plus common shares) on the balance sheets is nearly $200 billion. But these banks have assets of nearly $2 trillion.

If the value of these assets has gone down just 10 percent, then equity holders , including the government's stake in preferred shares, have been wiped out. And any further decline means that bond holders, more specifically those that hold the "junior" or subordinated debt, will likely take a hit if the banks are liquidated. (Fortunately, deposits and other short-term lending have been guaranteed by the government, and this guarantee has prevented the collapse of the banking system that would have undoubtedly occurred last fall.)

The CEOs of the banks maintain that the value of their assets has not fallen below the equity capital and that their deposit and financial services, as well as much of their credit card and other lending, remain profitable and offset the losses in their toxic assets. This sentiment was echoed by Fed Chairman Ben Bernanke, who in recent Congressional testimony stated that the franchise value of Citigroup and Bank of America was substantial and capable of overcoming their portfolio and lending losses.

Who's Right?

It is now time for words to give way to hard evidence. Before the taxpayers give any more money to the banks, the government should force the banks to completely open up their books not only to government examiners but also to outside experts in valuing financial assets.

But such open examination is not contemplated. The CAP calls on federal bank and thrift supervisors to "meet with senior management at each financial institution to review and discuss the institution's loss and revenue forecasts."

Unfortunately, government agencies have often been co-opted by the management of these banks and have not had the expertise to override management's assessment. Bill Gross, head of PIMCO, offered his valuation services to the government last fall when Hank Paulson originally proposed the TARP program. He and others that have expertise in valuing illiquid assets should be invited to have their knowledge and judgment brought to bear on this program.

Results of Audit

When a thorough independent assessment is made of the banks' assets, I would not be surprised if results are better than the market now expects. Currently, much mortgage-backed debt is over-discounted due to the illiquidity and complicated payoff provisions of these assets. If an independent accounting shows that banks have sufficient capital to weather the storm, we will see a vigorous recovery not only in the financial stocks but also in the entire equity market.

If, instead, such an accounting shows that bank capital is insufficient, the CAP mandates that the institution must issue convertible preferred shares to the U.S. Treasury, or obtain private capital within six months to cover the insufficiency. Such an outcome will likely keep the price of the common shares depressed and would probably require a "reverse split" to bring bank stock prices up to levels that allow them to continue to trade on exchanges.

The government's plan to provide more capital makes it clear that the administration is doing all within its power to prevent bondholders of the banks to take a "haircut" and convert all or part of their debt into equity. If this is so, then subordinated debt of the banks, much of which is selling for nearly 50 cents on the dollar and at yields near 20 percent, might be the best way to play the banks' recovery.

Final Thought

The Capital Assessment Program is long overdue and should have been initiated last September when the severity of the liquidity crisis became apparent. But only if we open banks' balance sheets to outside experts will this program be truly useful. We need an honest, independent assessment to tell us who we can believe about the future of the U.S. banking system.