Simon Johnson: The Fed Just Muppeted Us All

Yes, I am going to start using Muppet as a verb, thanks for asking.

I was very pleased with the outcome of the Stress Tests last week.  Not that I actually read any of results, which I consider to be highly-massaged opium for the masses.  Rather, as an asset allocator (as opposed to a policy wonk) I was very happy with how the market reacted to “the news” – literally the only thing that truly matters for someone in my profession.  having a 4% position in the Berkshire B’s ($BRK-B) and a 3% position in JPMorgan ($JPM) certainly didn’t hurt my mood either.

But professional bank scold Simon Johnson has a different take on what we were fed last week.  In his view, allowing the banks leeway on capital reserves will only open up the door to the next disaster – a matter of when rather than if.  He writes in Bloomberg the following:

The truly dreadful news last week was conveyed in the results of the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan Chase & Co. were allowed to increase their dividends and buy back shares. Naturally, bank stocks rallied.

But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. Even then, you should ask the question that Anat Admati, a Stanford University finance professor, has been pressing: Why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world? If you leave shareholder equity on bank balance sheets, it still belongs to shareholders. Let it stay there as loss-absorbing capital in case the world turns nasty again.

Reducing bank capital, according to Admati and her colleagues, doesn’t help the economy. Bankers like lower capital levels because their pay is based on return-on-capital unadjusted for risk. Shareholders are willing to go along either because they don’t understand the risks of thinly capitalized and therefore highly leveraged businesses, or they expect to share in the downside protection that will be provided by the government.

Johnson goes on to explain that the rigors of the test make some pretty optimistic assumptions in terms of Europe’s worst-case scenario etc.  He may be right, but for now, the bulls got hooked up large on the heels of this thing.  Look at the scoreboard.

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