Stress Tests: The Questions Continue

From Felix Salmon:

Why did Treasury switch from TCE to the even-more-obscure common capital metric? Quite possibly to help Bank of America and Citigroup get the amount of capital they needed to raise down to a number within the realms of possibility. After all, these tests were designed so that they couldn’t be flunked. And that might have seemed a real possibility back when Treasury was still using TCE.

By James Kwak

27 responses to “Stress Tests: The Questions Continue

  1. silly things

    What is your first priority?

    At the root of my disagreement with Simon Johnson and James Kwak is a question of priority. I think the #1 priority is to turn around the economy as quickly as possible. Cleaning up our banks is “not necessary (or actually sufficient) for a rapid economic recovery”[Simon Johnson] (See note 1). In my view, we should turn around the economy first. The reworking of our financial system and the financial regulations is the second priority. If a house is on fire, put out the fire first and than worry about changes to the fire code and the code’s implementation!

    I am not suggesting we wait until the economy has fully recovered before we address the regulatory shortcomings and structural issues of the financial system. If the current improvement in the economy continues for another quarter, I’ll likely start supporting these efforts!

    Some people worry that we’ll forget and lose the will to affect change as things get better. Most people have suffered huge financial lost during this crisis. Employment recovery will also be long and gradual. Therefore, for many the pain is deep and the hardship will be long. It is very unlikely that people will forget this experience in a few years. I think we have time to do things right. More importantly, I feel very strongly that we should _take the time_ to do things right.

    Some people prefer exacting punishments on the banks and their shareholders. I think human suffering trumps vengeance any day.

    Some people worried about all the bailouts the banks get. Well, just take look at the total cost of this crisis in terms of reduced GDP, lost wages, wealth destruction and etc. We shouldn’t be penny wise and pound foolish.

    What is wrong with the efforts of Simon Johnson and James Kwak?

    We had Lehman failure in mid Sept 08. As a result of the Lehman shock, we’ve been in the deepest recession since the Great Depression. Since I started reading baselinescenario in mid Jan 09, SJ and JK has been pushing for preprivatization of banks, wiping out the investors, forcing bondholders to take losts, breaking the big banks apart, and generally threatening the banks’ survival. SJ and JK were pushing strongly to have these actions take place immediately. SJ and JK were very critical of Geithner for not following their suggestion.

    Do we really think the world can take another Lehman like shock any time in the last 6 months?

    Well here is one of many data points to consider. Larry Summer mentioned around March that the stock market, after correcting for inflation, has dropped to 1970s level! Or put it another way, people are predicting with their money that the world economy is heading toward the deepest and darkest abyss of our collective living memory! Should we shock the economy one more time just to make sure we do deep dive into the abyss?

    What really annoyed me about SJ and JK was given the huge potential negative consequence of their proposal; there was absolutely no serious analysis! It was all blind faith! It was just like Paulson’s handling of Lehman!

    Let’s also look at the impracticality of the efforts being pushed by SJ and JK. The hurdle faced by SJ and JK on their various proposals are:

    1. Legal limits
    2. Political limits
    3. Pro-cyclical proposals which exacerbate the crisis
    4. Higher total cost to society due to deeper recession and longer recovery
    5. Undermining the confidence of investors and the business community
    6. Undermining the public confidence of those working hard to turn the economy around (Treasury, Fed, and FDIC)
    7. Inconsistency with historical experience of financial crisis in US

    The evidences are overwhelming that nothing will get resolve quickly or efficiently with SJ and JK’s proposals. What would happen to the economy if the world had to deal with all these additional fear, uncertainty and doubt?

    Now let’s take a look at whose lives are SJ and JK messing around with. Who are the biggest shareholders in Citibank, BA, etc? The biggest investors are the ordinary folks with their retirement accounts and pension plans. Had we nationalized these banks, then these ordinary folks would have ride down with the market crash but will not get to ride back up during the recovery. This is when real serious wealth transfer happens! Also, should we really wag our righteous finger at the retiree whose retirement fund invested in some index fund that happens to include the financial sector? Please see note 2 further below for how pre-privatization can potentially play out. The article will give those seeking vengeance a hard smack on the head instead!

    At the root of my disagreement with SJ and JK is a question of priority. SJ and JK’s effort to rework our financial regulations and financial structure at the darkest hour of the crisis is about as productive as yelling at the firefighters about fire codes while the house fire is raging out of control. SJ and JK’s priority was completely whacked.

    Fortunately, the economy is improving thanks to the tour de force effort of the Fed, the Treasury, and the FDIC. In time, probably by September if the improvement continues, I will begin to switch focus to the regulation and structure of our financial system. Also, credit to the Obama team, they’ve already started preparing the groundwork for this effort.

    A few posts ago, Simon asked, “Is Everyone Confused yet?” I am not confused because my priority is crystal clear.

    What is your first priority?

    Note 1: Here is some reference information for those interested in why cleaning up our banks is not necessary or sufficient to economic recovery.

    http://krugman.blogs.nytimes.com/2009/04/02/japans-recovery/

    http://www.iie.com/events/event_detail.cfm?EventID=109

    http://www.petersoninstitute.org/publications/pp/20090309johnsoncline.cfm

    Note 2: Here is one potential way pre-privatization can play out. Guess who has all the downside and who has all the upside in the end? Look at the description of IndyMac in middle of this article.

    http://www.nytimes.com/2009/05/06/business/06equity.html?_r=1&hp=&pagewanted=all

  2. silly things, I can’t tell the difference between your post and the sort of prepackaged spin paid for by the bankers’ lobby. Also, your post reminds me of those full-page advertorials from a few decades ago, which claimed that smoking Camel cigarettes was good for your health.

    It is a virtually axiomatic truth that anyone who is allowed to amass too much power will abuse it. All those pages of arguments that noone will read cannot outweigh that axiom, because you are trying to tell us that its really okay to allow a small elite to amass enormous financial and political power. Even after history has shown, time and again, that it always ends badly for everyone else who is not “in on the game”. In this case, the average taxpayer.

  3. When I first heard about how they were allowing the banks to negotiate their test scores I pictured all the usual “subjective” fudging. Disgusting, but business as usual in this cesspool.

    But I admit I’m mildly surprised that they were so brazen as to simply change the objective criteria for what was to be emphasized right there in midstream.

  4. I don’t want to put words in the mouths of the people like Johnson and Krugman who you cite, but I think one could argue that stregthening the banking system is a necessary condition but not a sufficient condition for economic recovery.

    Without a strong banking system, the money creation mechansim is broken, increasing deflatinary risks. In addition, the multiplier impact of fiscal stimulus measures is dampened.

    I don’t know why a smart guy like Larry Summers thinks we can engineer an economic recovery without fixing the banking system first, but he’s going to give it a try. I only hope he’s right.

  5. From what I understand the most important financial reforms that came out of the great depression, and kept us reasonably stable for good long while, arrived after committees and prosecutors started taking names and pointing out practices that the general population would not stand for. Then as now the industry claimed we just had to get through it without looking too closely.
    I have no problem with the money we’ve spent as taxpayers if that keeps the economy from tanking through the floor. But I don’t believe for a minute any individual or group of managers is so important to the economy that they shouldn’t be held accountable.
    Fine – the world can’t afford to have a major institution default – no problem. But the people in charge of the institution that should have defaulted must be held accountable, not rewarded, for receiving government assistance.

  6. The financial situation and the governments response and the stress test seem to be deliberately infinitely opaque.
    Perhaps someone could tell us exactly what constitutes Tier1 common as compared with TCE. The description in the WSJ really doesn’t help. Is goodwill included in Tier1 common? The WSJ seems to infer that it is.
    Can someone point us to a definitive description of what constitutes Tier1 common – ditto TCE?
    I thought I understood what common capital was but I’m lost here.

  7. silly things

    Hi g. powell,

    I think we can both agree that how to fix the troubled banks is a very complex issue. SJ and JK have presented a one sided view. For a very complex issue, it would be mistake to listen to only one side’s opinion. The following are additional viewpoints on this subject from the Peterson Institutes (Simon Johnson is a senior fellow there). Here are 2 debates between Simon and his economist colleagues at Peterson Inst.

    http://www.iie.com/events/event_detail.cfm?EventID=109

    http://www.petersoninstitute.org/publications/pp/20090309johnsoncline.cfm

    These two are excellent debates and fully address your concern about troubled banks’ affect on the recovery. There are a lot of interesting and relevant information in these two debates.

    Anyway, let me know what you think of this complex issue after you had chance to hear what Simons’ colleagues have to say.

  8. silly things

    Hi George,

    I agree we need to properly address the systemic risk in our financial system. However, we are also in the midst of the deepest financial crisis since the Great Depression. Therefore, my key point is we must address the different challenges with the right priority.

    I think we can both agree that how to fix the troubled banks is a very complex issue. SJ and JK have presented a one sided view. For a very complex issue, it would be mistake to listen to only one side’s opinion. The following are additional viewpoints on this subject from the Peterson Institutes (Simon Johnson is a senior fellow there). Here are 2 debates between Simon and his economist colleagues at Peterson Inst.

    http://www.iie.com/events/event_detail.cfm?EventID=109

    http://www.petersoninstitute.org/publications/pp/20090309johnsoncline.cfm

    These two are excellent debates and fully address your concern about troubled banks’ affect on the recovery. There are a lot of interesting and relevant information in these two debates.

    Anyway, let me know what you think of this complex issue after you had chance to hear what Simons’ colleagues have to say.

  9. I often see this articulated in defense of Obama admin policy. Look at what happened when Lehman collapsed. Do you want to have 100 Lehmans? No, well, then you’d better support current policy!

    It is as though the only two choices are either: (1) chaotic, uncontrolled bankruptcy; or (2) give the banks everything they want and ask for nothing in return. Can there really be nothing in between those two extremes?

    What about something along the lines of what is happening with Chrystler? Or indeed what happens all the time when the FDIC takes over a bank? Some kind of controlled restructuring where deposits remain insured, and where all parties are asked to share in the pain, while chaos is avoided by reasonable and targeted government guarantees necessary to preserve the financial system as a whole.

  10. Silly Things,

    The trouble I have with your argument (I admit I have yet to go and read up on the back and forth between Simon and his colleagues) is in:

    “5. Undermining the confidence of investors and the business community
    6. Undermining the public confidence of those working hard to turn the economy around (Treasury, Fed, and FDIC)”

    In these bullets you suggest that pre-privatization would cause these effects. You have the cart before the horse here. It’s not as though letting Lehman fail caused the crisis. Lehman failed precisely because confidence in it’s business was already shot. In other words, Lehman was not a cause of the crisis, it was merely the most visible casualty. The argument you are making suggests that Lehman was fine one day, the next it was in the tank, and only after that failure things went bad. Lehman failed because confidence was already shot. That’s why they had a run. A run on them was building before they failed, by definition.

    In order to truly prevent this from happening again is not a matter of preventing these symptomatic “events”, it is about creating the conditions where the pressure would not have built in the first place. Playing by roughly the old rule book while we solve the “greater priority” strikes me as a red herring, and a dangerous delay.

  11. silly things

    I just want to summarize all the villains.

    1. The Greenspan Fed kept interest rate too low for too long. The lead to the housing bubble and it is the most direct cause to the current financial crisis.

    2. The government has gradually relaxed regulations for the last couple of decade.

    3. The US consumer have been spending beyond their means for decades.

    4. Banks’ excessive risk taking in conjunction with the systemic risks of our financial system.

    I have no idea how to even begin to mete out justice. If any one of the above was properly addressed early on, a very strong case can be made that we wouldn’t have today’s crisis.

  12. silly things

    Boris,

    My comment is not about what cause Lehman to fail. I agreed that Lehman failed because confidence in its business was already shot.

    The main point in my previous post is: given Lehman has already failed and we are now deep in this financial crisis, what should we do next? What are our priorities? We have an economy in deep recession that we need to turn around. We also have a financial system that is in trouble. These two can be and should be consider as separate tasks. We can address them independently.

    In my previous post, I pointed out why the efforts of SJ and JK are making the current situation worse. There is already a lot of fear, uncertainty and doubt in the market place. SJ and JK are adding to that fear. They are in essence pouring gasoline on a fire. Anyway, I won’t regurgitate what I’ve already written.

    I completely agree with you that we need to figure out how to prevent this from happening again. However, I will stress that in order to fix our financial system we need to apply steady and deliberate effort. Emotionally rushing in is a recipe for failure.

    Anyway, please listen to the 2 debates Simon had with his colleagues. Let’s talk more when we’ve considered different aspects of this very complex issue.

  13. silly things

    Hi Francois,

    First we really cannot compare Chrysler or GM to the entire US financial system. You can get a real sense of the difference if you consider what happened when Lehman file for bankruptcy and what happened when Chrysler file for bankruptcy. The difference is literally the difference between the deepest recession since the Great Depression when Lehman failed and a little blip in the intra-day stock chart when Chrysler went (in fact, I vaguely recall that was an up day).

    I know what I am about to say is not going to be satisfying. The reality is the systemic problem in our financial system was built up over many decades. Furthermore, to be fair, some of the root problems are cause by our own government. Greenspan’s Fed keeping interest rate low for too long is the most direct cause of the housing bubble. Furthermore, for decades, our government has been relaxing the regulations of our financial system. The banks can make a fair and valid point that if the government hasn’t failed to begin with, we wouldn’t have this crisis and the banks wouldn’t have lost most of their market value.

    There is a fourth choice. Focus on turning around the economy and in the mean time let the banks muddle through. Let the banks earn their way out is the least costly. Again, please review the two 2 debates Simon had with his colleagues. Once we get the economy to turn the corner, we can than focus on reworking our financial system.

    It is very important to keep in mind that there is zero chance that our financial system will stay the same after this crisis. The Obama team is already laying the groundwork to fix the structure of our financial system. If fact, I strongly suspect, the government is very likely to over do it. Historically, the regulatory pendulum always swings both ways to the extreme.

  14. silly things

    Hahah, did you check wikipedia?

    http://en.wikipedia.org/wiki/Tangible_Common_Equity

    http://en.wikipedia.org/wiki/Tier_1_capital

    In the reference section of these pages, there are more good articles.

  15. super – thanks

  16. A lot of the stress test results are pretty dubious. To be well-capitalized under US federal bank regulatory agency definitions, a bank holding company must have a leverage ratio of at least 5 per cent. For example, the results show that Citi will only have a leverage ratio of 2.3% according to the WSJ, and it is not clear how they can grow their way out of it through earnings .

  17. silly things

    Francois,

    As you can see from my reply that I think the Obama team’s approach is a distinctly different approach than the 3 suggested in your post. However, I too have wondered if there is a viable and meaningfully better way. The proposals from SJ and JK are simply not viable when examined below the surface (see the list of 7 hurdles in my original posts). I’ve read many other blogs and articles and have pretty much came up empty. Every alternative I read were too simple minded and didn’t properly consider the complexity of the issue and the social and political environment. The only conclusion I came to is there are a lot of armchair quarterbacks!

    Geithner, at a Congressional Oversight Panel hearing, make a very valid point that I’ll paraphrase here. He said something to the effect that there are a lot of criticism of the administration’s effort, however, what do you compare it against?

    Intellectually, I am sincerely curious to know what will work better. I don’t believe there isn’t a better way either.

  18. silly things

    Here is a recent interview at the Peterson Institute regarding the stress test. Simon Johnson is a senior research fellow there. This interview is with William R. Cline who is also a senior fellow at the institute.

    This interview offers an more balanced and well reasoned perspective on the stress test results.

    http://www.petersoninstitute.org/publications/pp/20090510cline.cfm

  19. Okay, I have now read the debates through the Peterson Institute. I am not an economist; I start with that premise. I have a solid education behind me, however, and there are elements I believe are clear even to lay actors like me.

    That said, what strikes me about both debates are the frames of reference being used. Both Mussa and Cline are using more recent (post war) benchmarks for comparison, while Simon is discussing the crisis in terms of events that came before the collection of many of our modern data sets. Cline in particular is comparing quite directly to 1982.

    Given that more than one of our more recently initiated data-sets are creating new extremes for the time periods over which they have been collected, making comparisons within those datasets seems pretty narrow-focused, to say the least. In particular, to think that we can have the government intervene in the debt markets to the unprecedented extent that we have now done and then compare to situations with a (compared to today’s situation) trivial government involvement is wishful thinking.

    In the end, the argument counter to Simon’s is for the government to avoid taking a strong position with regards to the banks, so that the banks can recover (we hope) based on the broader economic recovery rather than on government intervention. I think that debate is over and has been for months. The government is already acting in tandem with the banks, is dictating to the banks, and is being dictated to by the banks. We cannot now go back and “let the banks sort it out themselves”. You talk about “emotionally rushing in”. It already happened — in September — and we cannot change the fact that we are now involved intimately in the running of our largest banks. The idea that we are now free to sort out the economy and the banks separately strikes me as an idea that might have worked in August, but we’re past that point now and have been for a long time.

  20. Coffee Boy

    Not sure if anyone’s paying attention to this post, but here’s a great counterarticle to the TCE vs. Tier 1 debate: http://tinyurl.com/tcetier1

    JK made a point earlier that converting banks prefs into common doesn’t actually add any more cash into banks balance sheets, so isn’t really a recapitalization. I think this is the exact point regarding TCE vs. Tier 1. Ceteris paribus, the difference between TCE and Tier 1 seems to be the “classification” of capital, rather than the amount. A poorly capitalized bank under Tier 1 suddenly becomes well-capitalized under TCE if prefs are converted to common. The government is too scared to become a majority shareholder, so they decided on using the metric which doesn’t force them to convert their shares.

  21. silly things, I am sorry, but you are completely off track with your line of argument, because we are no longer really in control of our immediate economic future. In fact we have entered a period of consequences. They are the consequences of allowing bankers to gain too much political and financial power over the last 20 years, with an orgy of excess credit fueling Ponzi-style “economic growth” which in turn fueled excess credit. We are now surrendering back all of that “growth” and the adjustment is inevitable.

    The solutions to our predicament are clear to me and to anyone else who has half a brain and whose paycheck does not depend on preserving the system we have now. The most obvious point is that we cannot solve a problem by repeating the steps that created the problem in the first place (i.e. creating credit out of thin air – a.k.a. “blowing a bigger bubble” is not the right path out of this mess). Among the deep reforms that have to be made, a key reform is that financial institutions should henceforth be boring, small and resemble utilities in discharging their main function of intermediation between saver and borrower. “Too big to fail” really is “too big to exist”, and anyone who argues otherwise is either misinformed, or on the payroll of someone who belongs in the “too big” category.

    I recommend reading up on Islamic finance. Muhammad must have learnt a thing or two from the Jewish habit of a debt jubilee every 49 years when he put his foot down on usury, on speculation and on several other things that have just blown up in our collective faces.

  22. whether it does or does not represent a recapitalization depends on your point of view.

    if you believe that the bank is required to pay back the principal of the TARP preferreds, then it is certainly recapitalization.

  23. le grain de sable

    The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

    Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests’ “rigor”….

    Citigroup’s capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.

  24. angry_liberal

    Every time I see a capitalist say that market problems are the consequence of a government’s failure to regulate …

    I see a capitalist admitting a failure of the free market paradigm.

  25. angry_liberal

    The thought that any broader economic recovery is in progress is kinda wishful.

    Our nation is on a “service economy” footing, wherein about 70% of GDP is not per se productive activity. Just before this past year, the finance “industry” provided about 41% (?) of GDP.

    A cruder way of expressing the above numbers: for every ten average workers, three are digging a ramp out of this hole, three are sharpening shovels or otherwise being useful to the three who are digging, and four are trying to convince each other to repurchase their interest-option shovel refi packages.

  26. silly things

    Hi Boris,

    Past performance may not be indicative of future results. Indeed, every crisis is unique. Each crisis is the result of a set of extreme imbalances prevailing at the time before the said crisis. However, we can and should use the past as a guide. Who is using more relevant historical data (simon vs. mussa and cline) is a very complex discussion. It is way too lengthy to go into here. However, at minimum, it is a matter of this historical record that this country does have multiple first hand experience with financial crises. Furthermore, cleaning up the banks was not critical to ending those crises. By the way, Simon agrees with this too. The following is a direct quote from Simon.

    Cleaning up our banks is “not necessary (or actually sufficient) for a rapid economic recovery”[Simon Johnson]

    Turning around the economy and stabilizing the financial system have always been parts of a multi-prong approach of the Obama team. No one is suggesting that we should solely focus on the economy and leave the banks alone. However, don’t you agree that “stabilizing the financial system” vs. “rework our financial regulations and financial structure” is vastly different?! SJ and JK’s effort to rework our financial regulations and financial structure at the darkest hour of the crisis is about as productive as yelling at the firefighters about fire codes while the house fire is raging out of control.

    Lastly, it is very important to keep in mind that there is zero chance that our financial system will stay the same after this crisis. The Obama team is already laying the groundwork to fix the structure of our financial system. If fact, I strongly suspect, the government will over do it. Historically, the regulatory pendulum always swings both ways to the extreme.

  27. silly things

    I strongly disagree with unfettered free market.