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Jeremy Siegel, Ph.D. The Future for Investors

Banks Must Come Clean

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Very Good (264 Ratings): 3.405304/5

Posted on Tuesday, March 3, 2009, 12:00AM

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.

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106 Comments

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__A_YAHOO_USER__ - Sunday, March 8, 2009, 12:31AM ET Report Abuse
- Overall: 3/5
Because of all the coveted secrecy, it looks to me like some global banks have been violating the economic sanctions against Iran. We deserve to know about it. Our free press, essential to a free society, is not doing its job. We the People have a right to know.
Yahoo! Finance User - Saturday, March 7, 2009, 11:09AM ET Report Abuse
- Overall: 4/5
Agree review by OUTSIDE experts is essential. Otherwise who will believe it and the effort will just be a waste of time.
pam - Saturday, March 7, 2009, 8:57AM ET Report Abuse
- Overall: 5/5
WHO LOANS MONEY WITHOUT A CREDIT CHECK? AND A FINANCIAL STATEMENT?????? What lender is told "we don't want you to know about our finances." --- Who gets treated that way by borrowers? .......ANSWER: "We the PEOPLE" of the USA.
Aimee H - Friday, March 6, 2009, 11:02AM ET Report Abuse
- Overall: 4/5
This is the best article I have seen in awhile. The only problem is that we already know what would happen if they did open the books! The big banks are Bankrupt. That is why they got bailed out in the first place,and by the figues in this article (best case senario) they expect real estate to drop by another 17% ? This is almost 3rd grade math. Citi is under a dollar, is anyone still holding bank stock. If you are Sorry for you loss
Robert S - Thursday, March 5, 2009, 2:12PM ET Report Abuse
- Overall: 4/5
Dr. Siegal should be used the government more frequently. He explains it in an honest straight forward manner that most of us understand . Transparancy is important and should have been done like he says back in 2007-08. Honesty is one of the legs holding up CONFIDENCE!! Right now we do not have much of it in the marketplace.
Yahoo! Finance User - Thursday, March 5, 2009, 2:03PM ET Report Abuse
- Overall: 5/5
One of the few sober-minded things I've read lately.
Yahoo! Finance User - Thursday, March 5, 2009, 8:38AM ET Report Abuse
- Overall: 5/5
Dr Seigel lays it out for you with good, fresh ideas and all many of you can do is talk bad... I'm sorry but I am hard pressed to find another financial reporter on Fox, CNBC, etc. who provides such in-depth knowledge with a fresh view. And usually backed up by data that he crunches! How could it be bad to have an independant audit of the banks books? It would only give the markets an idea reality, and we could start buying and selling stocks closer to what reality is, whether it is lower or higher... I just want to be closer to reality and not have the markets be in the dark!
JimmyP - Wednesday, March 4, 2009, 10:44PM ET Report Abuse
- Overall: 3/5
...but you know they can't! If they showed you what they actually had on their books....look out below. That's why there are millions of empty foreclosed houses out there. They don't want to tell for fear of writing them down,and showing a loss....but alas, it will come out. Oh, and the commercial real estate shuffle? That's the next shoe..sorry for the bad news, but at some point we may have to show our cards, and egad....do the right thing.?
tierartze - Wednesday, March 4, 2009, 6:48PM ET Report Abuse
- Overall: 2/5
The knee jerk legislation that was Sarbanes-Oxley brought us 'mark to market' accounting which if in effect during the banking crisis of the 80's, when 3000 banks failed would have brought major failures and spiraled that crisis out of control. At least a temporary suspension of 'mark to market' is in order or I'm afraid this toilet bowl effect will continue. The further one spirals down the faster one goes!
Yahoo! Finance User - Wednesday, March 4, 2009, 2:31PM ET Report Abuse
- Overall: 2/5
sounds good
Ian - Wednesday, March 4, 2009, 1:43PM ET Report Abuse
- Overall: 1/5
Pedagogic claptrap
Yahoo! Finance User - Wednesday, March 4, 2009, 1:04PM ET Report Abuse
- Overall: 1/5
DERIVATIVES!!!...DERIVATIVES!!!...DERIVATIVES!!! - Numbers can be manipulated in many ways. In this case, the assessments are meaningless if they don't offer true valuations for the derivatives, something the banks and the treasury have been unwilling to do. Only a truly independent audit will shed light on these and other troubled institutions.
Nemo - Wednesday, March 4, 2009, 12:19PM ET Report Abuse
- Overall: 5/5
Thnk you for clear, detailed, yet concise explanation. I think you're the best columnist in the lot.
Yahoo! Finance User - Wednesday, March 4, 2009, 9:48AM ET Report Abuse
- Overall: 1/5
Why didn't you write this 6 months ago?
Yahoo! Finance User - Wednesday, March 4, 2009, 9:32AM ET Report Abuse
- Overall: 1/5
Siegel, Dec 2007: Financials will outperform the market and the US will avoid a recession. Could have done better taking advice from one of those magic 8 balls.
IhatetheMets - Wednesday, March 4, 2009, 9:30AM ET Report Abuse
- Overall: 3/5
Why isn't anyone being prosecuted for civil and criminal penalties under Sarbanes-Oxley. Didn't these CEO/CFO's attest to the adequacy of their control structures? Banks under FDICIA were doing this long ago and still capital structures are failing? Only if they fraudulently completed their assessment. FAS 107 was requiring fair value disclosure for years now. Weren't those disclosures supposed to be independently evaluated by the auditors? I want my pound of flesh; and I WANT IT NOW!!! PUT THE BUMS IN PRISON!!
Mao - Wednesday, March 4, 2009, 12:11AM ET Report Abuse
- Overall: 2/5
It is too late to come clean! What we need is a solution to stablize the housing market as IT IS the source of the crisis. First--there should be a massive tax deduction base on housing price (not mortgage interest) to encourge people to buy --not just a $8000 tax credit in 2009. Second-- govertment should NOT give any money to the banks, but loan that money to the people who have a job and willing to stay in a home with negative equity for the next 10 year without interest. Without a stable house market, all actions by the Fed are useless to solve the banking cirsis.
Yahoo! Finance User - Tuesday, March 3, 2009, 10:20PM ET Report Abuse
- Overall: 4/5
The leverage on mortgage backed securities is way high! Trillions of $$. The way they have been packaged is such that it may be impossible to value them properly.
Yahoo! Finance User - Tuesday, March 3, 2009, 9:51PM ET Report Abuse
- Overall: 3/5
What do they mean, "too big to fail"? Isn't that just what they've done?
Yahoo! Finance User - Tuesday, March 3, 2009, 9:25PM ET Report Abuse
- Overall: 1/5
Do not trust the government either. No TARP, CAP, CARP . IT is all CRAP..
throwingstones - Tuesday, March 3, 2009, 9:24PM ET Report Abuse
- Overall: 4/5
Finally, a sane voice. However, I think Jeremy is way off in that Banks will fair much better after the stress test. They have billions of toxic of assets waiting in the wings that they have not revealed. Once they disclose the total number of toxic mortgages in Lis Pendens and Foreclosure status...it's going to shock the financial world. Without the government these banks would have been dead long ago. Let's face it...they are dead already and the government is just keeping them on life support. Take AIG for instance...at their current loss rate, they lost all the money we gave them and they are losing it at $60B a quarter. They are losing it as fast as we can give it to them. Time to pull the plug!!!
Jet - Tuesday, March 3, 2009, 9:19PM ET Report Abuse
- Overall: 2/5
Why do I have a sinking feeling that the "consensus" forecast of the economy is really a best case scenario and the "worst case" scenario is really the middle of the road estimate. Worst case should be more along the lines of the Great Depression as that has at least a 1 in 10 chance. Also, why do the executives of these sinking ships get paid at all? They should get $1 and some options for shares to be redeemed 5 to 10 years from today. Finally, instead of giving all the money to the moron banks and the moron consumers both of whom made really stupid moves, we should just give 5 to 10k to everyone. Those under water on their mortgage should be required to immediately put that money towards the payment. Those needing a refi should be required to use the money to change the loan. The rest of us should be free to use that money however we see fit.
GP - Tuesday, March 3, 2009, 8:56PM ET Report Abuse
- Overall: 3/5
Good enough article. I have a couple thoughts of my own. First, any bank that is "too big to fail" should immediately be split into multiple banks. The anti-trust laws should be written in such a way that a bank cannot grow to be so big that we cannot allow it to fail. Second, there is a fundamental problem with what Bush and Obama have been doing. If they only offer "fair" deals -- being a deal that the taxpayer will come out roughly even -- to the banks, it isn't enough to keep many banks alive. This will cause many banks to fail and perhaps cause much harm to the economy. Things like reverse auctions sound great on the fairness rule but will kill many banks. If they give the banks the help they need, it will cost the taxpayers billions and billions of dollars, reward terrible banks, provide the executives of those banks large sums of ill-earned money and anger the people to no end. In addition, it could easily make the country weaker in the long run due to debt problems and the idea that there isn't any reason for a bank (or any one else) to behave in a responsible manner. I personally think we should take the risk of not bailing them out. However, there isn't any real way of knowing what is best for what time frame. It all goes back to too much debt at every level in the USA. We, as a country will pay dearly for the last 30 years and next 10 years of absurd borrowing.
Yahoo! Finance User - Tuesday, March 3, 2009, 8:52PM ET Report Abuse
- Overall: 1/5
the only way to fix this problem would be to outlaw short selling and leveraged products and base valuation on a standard set by statistical data not supply and demand therefore making supply and demand obsolete...the tough part would be to print our own us currency based on the new value of the land which is the basis for all production of food shelter and all other precious metals and resources....this would eliminate the oveleveraged corruption because the harder you work and produce the more you would earn and their would be limits on how much one can produce and how much is really needed......in other words you couldnt drive the prices up and down by over and under producing deliberately while investing in those stocks....this would stabilize jobs around the world....as well as get rid of the pork eating fat bastards in the senate and congress....who the hell needs them anyway?
Yahoo! Finance User - Tuesday, March 3, 2009, 8:26PM ET Report Abuse
- Overall: 1/5
and why should we trust a silly government acronym called CAP? TARP, CARP, it's all bull! the current crisis of confidence is due to the the Obama admin. allowing the same crooks and thieves to continue to manage these banks, while the government throws more and more bailout money to them. no on ever talks about justice or removing the corrupt heads of these banks and mortgage companies, that's why Wall Street and the market has no faith in Obama's plan to save these institutions. he is not transparent and they have not been transparent! it's still a game of smoke and mirrors provided by the rich guys and the new Presidente.....comrades, we are getting !
Ben - Tuesday, March 3, 2009, 8:04PM ET Report Abuse
- Overall: 1/5
This is the guy who urged people to buy stocks when Dow was around 14,000 and promoted "Buy and Hold", "In for the Long Run". Just look at the topic lines of his previous posts. He may be ignorant, but his victims sufferred no better than Madoff's.
Yahoo! Finance User - Tuesday, March 3, 2009, 7:13PM ET Report Abuse
- Overall: 2/5
Shouldn't these Bank Stresses have been happening on a regular basis as part of govt oversight and regulation ? Shouldn't it be done as well by people not having a vested interest in the outcome ? I would think buyers of all this debt and preferred would have done and would be doing these tests on an on-going basis as a matter of prudent business practice.
Yahoo! Finance User - Tuesday, March 3, 2009, 6:00PM ET Report Abuse
- Overall: 1/5
Gee, tell us something we don't know. Get rid of this guy, get some people who KNOW stuff, not just rehasing old news....phd indeed,,,,
Yahoo! Finance User - Tuesday, March 3, 2009, 5:44PM ET Report Abuse
- Overall: 3/5
Seems that one commenter is right: the FDIC should have been testing bank balance sheets all along. The sentiment is right. The notion that a new test is needed when we already have one the banks have been able to sidestep is wrong. Also, the idea this is all due to the fact that banks mortgages via a community re-investment program seems silly. Look at the loans they gave to commercial property developers -- all of which are about to belly up in the next 12 months.
Yahoo! Finance User - Tuesday, March 3, 2009, 5:44PM ET Report Abuse
- Overall: 1/5
Yahoo DOESN'T HAVE a financial experts section anymore! Just backward, too little, too late garbage articles not worth the pixels they're printed on. Can you believe this?

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