Forget Wall Street, beware the crash on Main Street

The stress tests point to a huge problem building within smaller banks in America.

WITH the official stress test due today, Institutional Risk Analytics overnight released stress tests of almost all US banking institutions indicating that 1575 of about 8000 are troubled.

Meanwhile, The Wall Street Journal has reported that Morgan Stanley, Wells Fargo and GMAC have joined Bank of America and Citigroup in the underfunded bank category.

The analytics report is alarming as it reveals that a huge number of banks scored an F, indicating they are severely stressed and threatening Main Street, while the US Administration and the media have concentrated on the big 19 banks crucial to Wall Street.

Institutional Risk Analytics' co-founder Chris Whalen said yesterday that smaller banks facing a crash have passed under the radar as the Administration concentrates on banks deemed too big to fail.

"We may have wasted valuable time trying to save Wall Street at the cost of Main Street," he said.

"The numbers indicate we need to seriously ask the question as to whether economic recovery for the United States can still come from repairing Wall Street — or whether instead we should be worried about addressing the underlying loss rates that are driving the provisioning behind these poor ROE (return on equity) results.

"Has the time come to shift the policy focus away from the things that we love, namely big zombie banks, to tackle those things that are truly hurting us?"

Whalen said US policymakers might have been distracted by tests designed to save Wall Street's banks and the world's central bank bondholders. He said a trend was emerging of a "viability crash taking shape under the radar".

"We've noted in the past that US banks have been migrating down the quality slope, taking an average of nine months to complete the journey from A to F on the stress scale."

So with more than 1500 smaller and regional US banks slowly starving on dwindling lending income, the implications for Main Street are apparent. As the risk analytics group noted, banks do not or cannot lend as they are unsure of the viability of other companies and financial institutions. While it is vital to ascertain the viability of the big banks so money starts moving through the international credit markets, the same is true for smaller banks that fuel the real economy.

Whalen said at a certain point in the business cycle, the carry-cost of the infrastructure outweighed the earnings rate, "then you start to see strange shifts to seek incremental income from service fees".

"This move often only serves to increase customer reluctance and mistrust. The end result is a stressed business model that can only be remedied by getting the core business, its lending engine, running again," he said.

"Counting the fourth quarter of 2007 when IRA's data indicates this phenomenon began to emerge, we are now 18 months — or one-half of a business cycle — dragging this massive boat anchor behind the US economy," the report states.

The analytics report is based on data collected by the Federal Deposit Insurance Corporation.

"The data indicates a dramatic climb in the industry aggregate average Bank Stress Index from 1.8 at the end of Q4 2008 to a whopping 5.57 coming out of Q1 2009, or half an order of magnitude above the 1995 benchmark. The reason for this is the number of banks which delivered negative net incomes in the first quarter of 2009 — 1575 of them," the report states.

Back on Wall Street and in Washington, there is growing disquiet over the apparent leaking of stress test information to The Wall Street Journal. Richard Bove, Rochdale Securities vice-president of equity research, wrote that neither Treasury Secretary Tim Geithner nor Federal Reserve president Ben Bernanke had any business experience, but "have apparently set up a hotline to The Wall Street Journal".

"Thus, daily, the Journal communicates their message concerning the stress test to the public," he wrote in an article on the internet.

"Based on feedback from these articles… (Geithner and Bernanke) delay the results of the stress test, change its structure (according to Journal reports), and try to figure out a way out of the dilemma that they have created before they crash the banking system."

Bove believes that when the stress tests are released, banks seen to be weak will be further weakened by an outflow of money to banks deemed safer. Thus Goldman Sachs, Bank of New York Mellon group and Morgan Chase may be further strengthened at the expense of Wells Fargo, Citigroup, Bank of America, GMAC and many others.

This is hardly what the Administration set out to do in February and raises the question as to whether the whole idea of the Government embarking on this course was wise.

Meanwhile, Institutional Risk Analytics has revealed the core problem: that essential ingredient of the business of America — business — is being lost in the fog machine pumped by two men with no experience in, er, business.

David Hirst is a journalist, documentary maker, financial consultant and investor. Planet Wall Street is syndicated by News Bites, a Melbourne sharemarket and business news publisher.