This article first appeared in the St. Louis Beacon, May 8, 2009 - Finance professors often tell students that stock markets are efficient. That is, stock prices reflect all available information, dutifully parsed by millions of investors until they collectively arrive at some price for some company’s stock. If all news is expected, stock prices do not react too much. If the news is unexpected, prices swing.
This is why important policy changes or sensitive information is announced after the market has closed. This gives traders time to digest the new information before they start pushing stock prices around.
There will be little heartburn from the announced results of the government’s stress test on the nations 19 largest banks. My guess is that — you can easily gauge the accuracy of this prediction — the official results of the government’s analysis will not affect stock prices very much. After all of the hype and hoopla, the results just are not that surprising.
The premise of the stress test was to see how biggest of banks would fare if the economy experienced an even-deeper recession. The test results indicate that the estimated cumulative loss would equal $600 billion over this year and next. That sounds like a lot, but it must be weighed against the banks’ potential resources to absorb these losses. On that comparison, the report estimates that the total additional capital needed to meet the buffer is $75 billion.
Those results are good news for several reasons.
First, it is unlikely that the recession will match the “more adverse” scenario that produced the estimated $600 billion loss. In fact, there are a number of signs that the recession may be nearing a bottom. Increased activity in the housing market, a slowing of unemployment claims and a smart rebound in stock prices are among the positive signs that economic activity is poised for a rebound.
Second, the administration’s report helped clear the air by “officially” identifying banks that many analysts already had marked as troubled. But it also marked those that are doing better than some expected. This information enables investors to properly price the stocks of banks in each group. And such pricing will facilitate the flow of new capital into the banking system.
Third, the commonly reported figure of an additional $75 billion in capital hides an important nugget in the report. The report finds that by the end of 2010, the needed increase in capital across the 10 troubled banks is actually $185 billion. But that figure uses the banks’ capital positions at year-end 2008. Because many of the 19 banks already have completed or agreed to asset sales and changes in their capital structure, the needed buffer against loss now is smaller. In other words, many of the troubled banks already have built their capital to adequate levels.
Lastly, the most troubled banks, among them Bank of America, Citigroup and Wells Fargo, now face explicit timetables to begin the cleanup. By June 8 banks that are deficient in capital must submit their plan to right the ship to regulators’ for approval. While this is likely a soft deadline — memories of the Big Three automakers? — it is a start. If the news stories popping up about CEOs being stripped of board power and banks already announcing stock sales are any evidence, the warning has been heard.
It is common knowledge that banks in the lower strata have weathered the storm quite well. Still, the stress test for the big boys was important to quell speculation and start the process of rebuilding faith in the banking industry. Perhaps now they will get back to business and help finance the economic recovery.
Rik Hafer is distinguished research professor and chair of the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.