Fed’s Request for A Contingency Plan from Bank of America Highlights Serious Flaws in Stress Tests

Earlier this month, it was leaked that the Federal Reserve requested a “contingency plan” for Bank of America, including the possible spinoff of Merrill Lynch. Such a request is highly unusual, and highlights serious problems with the Fed’s “stress tests,” according to Campbell R. Harvey. ”The flawed stress tests have given the public, regulators and the banks a false sense of security. As a result, the banking system is unprepared for a realistic adverse scenario.”

This article was adapted from a post on Campbell Harvey’s “Garden on Econ” blog. Harvey is a Professor at the Fuqua School of Business at Duke University and Editor of The Journal of Finance.

Harvey has argued that recent actions by Bank of America are a result by the bank to get more capital. They are “scrambling” to deleverage, taking such extraordinary steps as exiting their international credit card business, selling their shares of China Construction Bank, taking a huge investment from Warren Buffett, laying off 30,000 people, and looking to dump their mortgage business.

Card business

Bank of America announced the sale of the international credit card business. While most understood the sale of European, Spanish and U.K. units, it was surprising that BAC sold the Canadian unit (which was low risk and within BAC’s geography). This signaled to the market that potentially drastic steps needed to be taken to increase capital.

China Construction Bank

BAC purchased a 9% stake in CCB in 2005. In June of 2008 (at the height of the financial crisis), it increased its holdings of CCB (total 25.1 billion H-shares or about 10.75% of outstanding equity). The agreement stated that they could not sell 6 billion of the new shares until August 29, 2011. On August 29, 2011, BAC announced the sale of about half of the CCB investment for $8.3 billion and stated that the deal would increase their Tier 1 capital by $3.5 billion.

Buffett Investment

Berkshire Hathaway Inc. purchased $5 billion of Bank of America preferred stock, which has a 6% dividend yield. Berkshire also received 700 million warrants with an exercise price of $7.14 with a 10-year expiration. When Buffett invested in Goldman in September 2008, it was widely thought that there was a real possibility that the latter was close to going down. The Goldman deal was very sweet for Buffett – and people understood why – Goldman was in trouble.

The Bank of America deal is sweeter, states Harvey, pointing to the major differences in the warrants. In September 2008, Buffett received Goldman warrants that were set about 10% out of the money based on the previous day’s close. With the BAC warrants, the exercise price was set above the previous close – so they were immediately valuable on exercise.

The Bank of America warrants have an expiration of 10 years whereas the Goldman warrants had only a five-year expiration. The longer the life of the option the more valuable it is. These warrants are hugely valuable. The bottom line is that the cost of this capital for Bank of America shareholders is massive and so is the risk.

Regulators fumble again

On March 18 , 2011, the Federal Reserve released the results of the most recent stress tests of the 19 large U.S. banks. Harvey has been critical of these stress tests because they don’t deal with a true adverse scenario. For example, in the most recent tests, the adverse scenario for 2012 GDP growth is 2.4% and 2013 GDP growth is 3.4%. There is no typo! Those are positive not negative numbers. This is hardly an adverse scenario – it is the good scenario.

At least Bank of America is able to raise capital. The problem is that we have no idea how much more it needs. This causes uncertainty – and given the size of BAC – systemic uncertainty. What about the other banks?

Realistic stress tests and higher capital requirements

Harvey recommends the fed needs to create realistic stress test. The current ones reveal very little information. They give the public and the regulators a false impression that our financial system is safe. The tests are not even useful for the banks because the results lead them to believe that they are prepared for a down draught – when they are not. He also believes that capital buffers need to be substantially increased. With less leverage across the system, there is a lower probability of a systemic crisis.

Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business, Duke University and a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts. He is also Editor of The Journal of Finance. Hear Cam on NPR’s On The Point, discussing Turbulence In The Banking Industry.


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