The Stress Test: Time for Transparency

Like many people, I was disappointed by the Financial Stability Plan announced on Tuesday. But I think there is one glimmer of hope: the “stress test.”

A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected. (Emphasis added.)

The stress test is supposed to indicate which banks are healthy and which aren’t (so they can be fixed or closed). We need this for the reason most of you already know: nobody thinks the banks (meaning, mainly, the big ones) are healthy. The New York Times has a good summary of the situation. Nouriel Roubini thinks U.S. banks are facing another $1 trillion in write-downs. The IMF thinks it’s more like $500 billion. The only people who think the banks are healthy are the bankers themselves:

“Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent,” said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.

Edward L. Yingling, president of the American Bankers Association, called claims of technical insolvency “speculation by people who have no specific knowledge of bank assets.”

The first reason to ignore Talbott and Yingling is that whenever someone says something, but he would say the exact same thing even if it weren’t true, you should ignore what he says. (When Stan O’Neal said Merrill Lynch was great at risk management, what did you expect him to say? That they sucked?) The second reason is that even if they are right, it doesn’t matter, because no one believes them. The banks don’t face an immediate liquidity crunch because so many of their liabilities are guaranteed by the government: expanded FDIC insurance, guarantees on newly issued debt, the Fed accepting their junk assets as collateral. But even so, as long as people think the banking sector is sick, the economy will continue to stagnate, and the deepening recession will make banking assets worth less and less, until finally the banking sector really is sick. If Talbott and Yingling have some secret knowledge that their banks really are healthy, it won’t help them.

The stress test theoretically will prove once and for all who is right, and whether the banks can withstand a worst-case scenario (remember, every month the forecasts for the recession are always worse than the previous month). This is a core regulatory function, for two reasons. First, as long as the government is backing up bank liabilities, it has the right to monitor them in order to protect itself; this is what the FDIC does, and why it closes banks when they become insolvent. Second, insofar as the health of the economy as a whole depends on the banking system, all of us, in the form of our government, have the right to know if the banking system is working properly.

When the stress test is applied to Some Big Bank (SBB), it will have one of two outcomes. If the regulators determine that SBB is insolvent and has to be taken over, that would be a good outcome, first because the outcome will be credible to everyone (except maybe Talbott and Yingling), and second because then the government can clean SBB up (that is, transfer the bad assets off its balance sheet) without having to negotiate with anyone. If, however, they determine that SBB is healthy (or can be made healthy with a little extra capital), that could be good or bad. If they just assert it (“believe us, we’ve looked”), then we are right back where we started, because that outcome will have no credibility. Fairly or unfairly, there are already too many people who think that Tim Geithner is in Wall Street’s pocket. The only way to gain credibility in the event that SBB passes would be to publish all the details of the test: details about all of SBB’s assets (including all of the assets that underlie those assets) and all of the assumptions and models that were used in the test. That way independent researchers could come to their own conclusions. Of course, I’m not sure how feasible a stress test on this magnitude itself is, let alone such a massive exercise in transparency, and SBB’s traders would all scream. But I don’t see any other way out.

Calculated Risk seems slightly optimistic about this exercise.

Yves Smith, not so much.

15 responses to “The Stress Test: Time for Transparency

  1. Robert VanDerVelde

    The real test is whether Treasury will release the results of the stress tests. Experience with the National City Bank deal indicates that there will be considerable pressure to keep all quiet.

  2. Oh Big Bank? Dr. Geithner Is Here To See You

    http://politics.theatlantic.com/2009/02/stress_tests_and_nationalization.php

    Wishful thinking?

  3. I agree temporary nationalization (perhaps similar to an FDIC intervention for a smaller bank in trouble) would probably be the most efficient way to cleanse the banking system. Take over weak banks, separate good assets from bad, sell the good parts to private equity firms and hand over the bad assets to private money managers to sell. This would get bad assets off banks’ balance sheets(without the headache of valuing them immediately) which would remove uncertainty in the banking system so normal credit activity can resume. But once the government announces this policy, investors will flee the big banks because nationalization wipes out investors. The day the government announces this program there is a good chance Citi will collapse, along with Bank of America, Wells Fargo and Sun Trust (basically all the banks at the top of short sellers’ lists). The failure of these banks also means that other banks that did business with them could be severely hurt. Loans made to failed banks that would have once counted as assets would be worthless, the contracts on credit default swaps that other banks may have bought to insure them against risk of mortgage backed securities would be void- all of which could result in the weakening of many banks, and setting off a chain effect of bank failures and a massive sell off of bank stocks (the gov would also wipe out Warren Buffet whose Berkshire Hathaway has a substantial stake in Wells Fargo). To overcome these problems, I suppose the government could take over the 3 or 4 biggest banks they think are insolvent, without investors knowing (like over the weekend and assuming there are no leaks prior), and basically guarantee all the banks’ creditors. While I understand that propping up failing banks, buying their assets to get it off their balance sheets, replenishing them with capital so they can continue business, presents a moral hazard, is very costly and not the most efficient, the alternative of a government intervention does not seem feasible given the risk of a domino effect of bank failures. But maybe it won’t play out like this or the government can structure the takeover and unwind assets in an orderly manner. I understand that the nationalization plan is gaining traction among economists and is strongly advocated by Simon Johnson, Paul Krugman and the “Austrian School” of economists and Sweden successfully executed the process years ago, so there is a good chance there is something I’m not considering. I’m not sure how we could essentially force the collapse of some of the largest banks in the world and not suffer the repercussions. I’m also unsure shareholders would sit quietly by the sidelines. Belgian shareholders of Fortis certainly didn’t yesterday. Thanks for reading and I appreciate your comments.

  4. Closing anyone of the “too-big-to-fail-banks” would have to protect the uninsured depositors. In contrast to IndyMac and other large thrifts, such depositors in commercial banks hold the largest proportion of all deposits.A threat to those holdings could cause a run on the other very very large banks and thus threaten a contraction of bank credit similar to what we have witnessed recently. Parceling out the uninsured deposits would be very difficult, should not sell them to the other large banks, but not necessarily impossible. Then there are the bondholders in the holding companies that own the banks. The ability of existing large banks to raise capital could disappear, unless some means is at hand to comfort those bonholders. We have to wonder if the current set of government regulators is up to the task. Nationalization maybe the only game they know how to play. They say that is not an option. Is it any wonder they are paralyzed?

  5. I saw the TV show, and while it was well persented, I saw no mention of the fact that Lehman was closed, Bear Stearns wnet to JP Morgan, Merrill went to BOA, Thain is gone, etc. That doesn’t show that those bankers had any clout with the politicians, so why believe that the remaining big banks do, or that there is an oligarchy? It seems more reasonable to presume that the U.S. needs the remaining banks to handle treasury auctions and maintain orderly markets, as the remaining big banks have thousands of brokers who service institutional investors – a labor force of their own, and contact with all world markets for the orderly buy/sell of sovereign bonds.

  6. It looks like the stress test will not be applied to the sacred 8 (9 if you include Merrill) BB’s that were given the first 350Billion TARP in October. This is a smooth move…set the stress test police out in the field to uncover as many regional banks in trouble as possible so that then their stock prices will be run down farther, leaving them to be scooped up by the sacred BB’s of the original TARP allowance. By the time June comes, we will have a front that looks like an oligarchy of 8 banks but really it will be one big monopoly! With possibly over 60 TRILLION dollars of credit default swaps out on mortgage backed securities, and dividing that by the number of institutions including AIG and we might have a very empty feeling when we find that the numerator is too large to be divided by the 40X leverage that is currently allowed by banks….this is a monster, and how is it sensible or safe, our country depend on the makers of the monster to bring our system back to health?

  7. The big banks are like vampires, they suck our economic blood. While they are down a stake should be driven through their hearts.

  8. Such poor management of the 1st TARP handout so poisoned the well it probably would be a good idea to rename it i.e. the Stimulus Bill became ARRA. Under new management and with the American citizens on high alert demanding accountability only a fool would not handle this more responsibly.

    FDIC should be the lead agency directing the breakup of traditional banks,investment houses, hedge fund operators under the same roof into more manageable parts. There should never ever be Too Big To Fail banks dictating the economic health of our country. How many of these firms became banks to qualify for funds to pad their books to cover losses anyway? Dishonest from the get go.

    I would love feedback as to these comments from fellow commenters.

    Once again, thanks for such a well planned platform we can all feel free to voice our opinions in a less heated political forum.

  9. I had the same thought as Sophie Major:

    The ‘Stress Test’ is subterfuge for picking the winners and losers as the finance sector further consolidates down to the few monster banks that will control whatever economy we wind up with.
    ………..
    My first visit, following the Bill Moyers interview.
    ………..
    Chilling new Celente video ties in:
    youtube.com/watch?v=9nJ7LM3iyNg

  10. “I saw no mention of the fact that Lehman was closed”

    Lehman was out of the club when its analyst dissed Fannie and Freddie sometime after the Paulson Bazooka bailout. Perhaps it was a foolish attempt to bare its teeth as they circled for the kill.

    Anyway, I am glad that people are starting to recognize this is a political issue of breaking up a rich crony club that hops from private to public service like they were two divisions of a single corporation.

    Because no amount of economic theory or bailout stimulus action gets us out of this one.

    Only by prying them apart and forcing them to realize their losses and pressing the banking “reset” button can we start building anew.

    Those that hold sway though will fight tooth and nail. They will pull every trick in the book, call in every favor, twist every arm. There is good chance there will be blood. Much older forces are now at work, and much is at stake– the control of our nation’s money supply.

  11. Thank you methodman, please do talk more, and spread the word.

  12. I note the wall street group is already making noises about the unfairness of the “stress test”. They realize that once the real information is let out and there are actions to be taken the party is over.
    I think this is a major test of the Obama group to see who is in charge. If they waffle, then it will be business as usual.

  13. Simon,

    Your’s is great blog! I have learnt so much even though I am civil Engineer. Your blog reignited my passion to go to school for economics and get Master’s degree in Economics here’s my two cents on buying up of toxic assets by US government.

    Firstly of all I call TARP as Toxic assests relief program and not Troubled assets relief program.

    If we buy those toxic assests from banks at the price set by the banks. I want those banks to pay back all the money home owner has paid to bank plus 50% of the interest paid (to foreclosed home owner ) Or else we should buy at what the market is willing to pay. Second option would lead to large scale bank insolvency.

    Why don’t we split these Monster banks into small one’s so that they are never too big to fail?
    At the end as a tax payer we will have to pay the price no matter what route we take all we need to make sure that we follow the best strategy so that we keep our losses to minimum and gain if possible in good economic times.

  14. I am not sure we need the stress test anymore, to know what? Will it be reliable? Ok it can be a tool for the assessment of the situation of troubled assets and their counterparts and have some disclosure. Yet, if the final objective is to resume lending and restore proper functioning of the credit markets, then you need new good banks to do it, while getting rid of lemons, and strengthen those that cannot safely lend because lemons are around. The belated stress test may reveal to be neither necessary nor sufficient to get bank to resume lending unless you then start to openly declare which are lemons. And the winners are?

  15. When my doc put me through a stress test I was informed that a heart attack was a pretty clear indication of failure. There was no real consideration as to whether I might be too big for a heart attack.
    So I guess if through stress testing we can more quickly identify and close the weakest banks, regardless of size, that would increase the amount of information available to the market. At least it would create a class of banks that are considered less at risk for fatal heart attacks.