The Other Stress Test (For Bankers)

There is nothing you can teach Wall Street titans regarding the timing of news flow.  Stephen Friedman, the former head of Goldman Sachs, resigned last night as chair of the New York Fed’s board, after committing essentially a rookie error.  In December/January, he traded the stock of a company (Goldman) overseen by the NY Fed, while helping to pick a new head of the Fed (formerly from Goldman), and presumably being aware of other potentially nonpublic information regarding bank rescues (benefiting Goldman both directly and indirectly).  The real error, given the Federal Reserve System’s incredibly lax rules on potential conflicts of interest at this level, was failing to disclose this information to the NY Fed – they learned it from WSJ reporters and that cannot have been a good moment. 

If you have to resign, pick your time of day carefully, and Friedman is obviously advised by the best people in the business.  I’m looking at the hard copies of four newspapers.  The news of his departure does not make the front page of the NYT (not even the small stuff at the bottom) or the front page of their Business Day section.  There is nothing on the front page of the FT or Washington Post.  Even the WSJ only manages three paragraphs on the front page, before sending you to look for p.A10.  (It was on from 5:55pm last night, together with his resignation letter.)

I haven’t checked who first broke the news, but Friedman’s resignation was of course the major development of yesterday.  The bank stress test results were hard-baked a long time ago, and almost all the icing on that cake had already been leaked.  But the stress test for bankers is still underway.

The idea of a stress test, of course, is to see what goes wrong under pressure.  We do this for banks with hypothetical scenarios, but when you go to see the cardiologist you need to step on a treadmill and actually get your heart rate up.  The stress test for bankers is very relevant for thinking about our future financial system in three ways:

  1. We are now seeing how they behaved during a boom, both in terms of compensation system and insider-type transactions.
  2. We can see what happened during a crash and attempted recovery; part of which is about massive taxpayer provided subsidies (do the bankers even have the manners to say thank you?) and much of which is about tilting the playing field towards pre-provision earnings (for which Jan Hatzius of Goldman has the most eloquent exposition).
  3. Most interesting, of course, is how bankers think.  They regard themselves as entitled to outsized compensation that encourages excessive risk taking.  They think that insider trading rules apply to other people.  And they are convinced that only they – and their friends – are capable of running government in boom or bust (or in ways that boom leads to bust, at which time you buy low and then recover through large implicit support from the government.)

Really what we have seen over the past two years (a great Freudian slip from the Comptroller of the Currency on NPR last night) is a stress test of our bankers.  If you think they basically did fine, then we can go about our business with essentially the same financial system that has developed in the last couple of decades.

If you have concerns about how they behaved and the potential consequences of such behavior down the road, then we need to talk further.  The banks passed their stress tests, in part because these were designed by bankers and people friendly to bankers (we could also think about how our regulators have done over the past two years).  But are the bankers passing their stress tests?

By Simon Johnson

50 thoughts on “The Other Stress Test (For Bankers)

  1. what is an “insider-type transaction”? is it the same as an insider transaction, which is illegal and which would get you sent to jail and/or barred from employment in the securities business? or is it a fuzzy blanket category designed by our host here meant to capture anyone that does what looks in the least bit suspicious?

    what friedman did — even just not disclosing the trades — would have got him fired for cause at any bank. if there were a real case for insider trading — and there may have been in this case if friedman had nonpublic information about goldman sachs — it would have been a felony offense. in the real world, people go to jail and permanently lose their employment for this. it actually works this way. look it up.

  2. I love the headline up here in Canada: “10 of 19 US Banks Fail Stress Tests, but Regulators Confident”

    Nice of the regulators to be confident…

  3. You learn a good captain when he can also sail a ship in gale conditions… Too many fairweather captains at the helms of the big financial clippers…

    The Titanic was driven into abyss by blind ambition.

  4. Please keep plugging away at all this, and thanks for your work.

    I like the new edge in your tone. Be careful you don’t get too hysterically populist, though.

  5. Simon – Keep plugging away with the same lay explanations and common sense approach to issues like this. If we, as a country, don’t call these crooks out to the public, they will merely continue stealing more with their briefcases than armed robbers do with their weapons.

    For additional insight into this and other financial matters, please see

  6. “…after committing essentially a rookie error”
    I presume that is tongue-in-cheek. This is a high government official who was paid by the guys he was supposed to regulate and who stole 1.7 million through insider trading.

    Let’s see… what did they put Martha in jail for…?

    The corruption in the US government today is absolutely off the charts unbelievable. They don’t even try to hide it. Cheat on your taxes, pay out billions – BILLIONS – to old pals, fiddle the balance sheets, lie about assets… what the hell, right?

  7. Check over to the right in Playlist, scroll down to Interview: Stress Tests …

  8. “And they are convinced that only they – and their friends – are capable of running government in boom or bust (or in ways that boom leads to bust, at which time you buy low and then recover through large implicit support from the government.)”

    I have been interested to continue hearing you talk about “implicit” support from the government. The support is in fact explicit. This may seem like quibbling over words, but I don’t think so. When the treasury secretary says publicly (in fact insists) that no large bank will be allowed to fail, that is a very different thing than having people thinking that is what he is going to do. The market is reacting to the categorical and completely explicit nature of the bank guarantees the government has given.

    Thank you very much for this site. You guys are providing a great forum.

  9. This is from the NY Fed’s website @

    Stephen Friedman

    Stephen Friedman is retired chairman of The Goldman Sachs Group and currently serves as chairman of Stone Point Capital, LLC.

    He joined Goldman, Sachs & Co. in 1966 and became a partner in 1973. He was vice chairman and co-chief operating officer from 1987 to November 1990, and co-chairman or chairman from 1990 to 1994.

    Mr. Friedman is chairman of the President’s Foreign Intelligence Advisory Board and of the Intelligence Oversight Board. From December 2002 to December 2004, he served as assistant to President George W. Bush for Economic Policy and director of the National Economic Council.

    Mr. Friedman received his B.A. from Cornell University and law degree from Columbia University Law School. He is currently a board member of The Goldman Sachs Group, Memorial Sloan-Kettering Cancer Center, The Aspen Institute and the Council on Foreign Relations.


    I figured it’d be good to post it while it was still available. The Fed’s post is dated Jan 2009. I doubt it’ll be around much longer.

    Here are Stone Point Capital, LLC’s investments:

    And here is their “team”

    This is a beautiful example of completely infiltrating the federal apparatus and using it as an element in executing a business plan. Oh, here’s a good picture of Mr. Friedman … he’s midway down … a couple of slots below the ceo and coo of GS.

    I wonder who pushed hardest to get GS’s charter switched over to commercial bank last year? Did it help to have your own guys on the inside pushing for you? To help answer that question, here’s the NY Fed’s org chart:

    Click on the President’s box, the one on the upper left with William C. Dudley in it.

    My my my.

  10. I have been a defender of this regulatory system b/c I believe that with tweeks, it could work as we need for it to. But this Friedman thing just destroys credibility in the system and for me, it causes me to take another look at Geithner’s tax issues and makes me much less forgiving.

  11. Simon, James, Peter:

    Your thoughts are now more important than ever about how the “baked-in”, banking-as-usual course we’re now on will play out over the next few years:

    1. We know that “going Japanese” means meager lending, but what other signs of distress will be exhibited by a financial system dominated by under-capitalized, under-supervised, too-big-to-fail banks?

    2. Foreign borrowers adjusted since the 90’s by hoarding cash and creating a savings glut. Somebody suggested subprime is the new Thailand. If, as a result of suffering 4 trillion in losses worldwide through 2010, the consumer or other sectors strongly change their behavior, what should we look for?

    3. How do governments and central banks held captive by bank oligarchs go about managing ballooning public and foreign debt denominated in the world’s reserve currency, and does Britain’s experience in the 20’s or the 60’s tell us anything?

  12. I hope Brendan’s “Populist” remark is tongue-in-cheek. If history has shown us anything it’s that the US benefits from Populism. Populist movements, although often having a dark side, have been the precursors of significant Progressive gains.
    Currently public opinion opposes further bailouts, however “bailout” has not been personalized beyond “why them and not me?” Even those opposed to paying higher taxes to support the current banking system don’t truly realize what’s happening. Just as the oligarchs have ruled the developing world (with the help of the IMF), this system and its dominance of the political structure will produce an ever greater disparity between rich and poor, and taxes, rather than providing a better quality of life for all, will be directed to the coffers of the financiers. This is a recipe for disaster. This system is fundamentally anti-democratic, and if it continues it will create ever-greater divisions in society.
    Those who understand this and have the ability to be heard must speak out in terms the public can understand.

  13. I think we all know the system needs major revision. The power of the bankers needs to be curbed.

    The real question is: How do we go about making it happen? Is it even possible?

    Voting won’t change anything. Democrats and Republicans alike will bend over backwards to serve the financial elite. It was Bill Clinton who signed the repeal of the Glass Steagall Act. Obama suspiciously looks like Clinton 2. Most of his staff are old Clinton hands, the most important of which is Larry Summers, the guy who pushed the Commodity Futures Modernization Act.

    The French revolution happened because the aristocracy would not negotiate any curbing of their power. Had they be more flexible France would probably have undergone an English style revolution. That’s what the bourgeois really wanted. They only unleashed the peasants as a last resort (and they duly crushed them afterward).

    Bob Reich seems to think a French style revolution can never happen in the US. That’s probably for the best. It was not a success. The high bourgeoisie merely replaced the aristocracy (one set of crooks for another). French society today is as elitist as it used to be before the revolution.

    Is there any example in history of a peaceful and successful transfer of power from the rich to the majority?

  14. I am not a lawyer (Stephen Friedman IS a lawyer per the WSJ) so I cannot comment on the legality of Friedman’s actions. I do agree with you his actions do not pass the smell test. However, ethics are as important as laws and regulations. It wasn’t illegal for Ford managers to give the green light to the production of the Pinto because their cost-benefit analysis indicated it was cheaper to bear the cost of 180 immolated human beings and another 180 serious burned humans rather than spend $11.00 per vehicle to redesign Pinto’s fuel tanks. (In truth, thousands died and 10x that number were burned before the Department of Transportation acted.) I noticed that when Friedman joined the Bush administration for 2 years he sold all of his Goldman shares. This indicates one of two things to me: either Friedman needs someone looking over his shoulder to insist he do the right thing or he is a sneaky legal mind who knows how to find the loopholes in the law and doesn’t give a tinker’s dam about ethics. I think we do ourselves a disservice when we write off this type of behavior as owing to “incredibly lax rules.”

  15. You know what – I actually find the resignation of Stephen Friedman to be some of the best news yet in a week chock full of optimism!

    That an ex-Goldman Sachs guy felt compelled to resign from the NY Federal Reserve over the “appearance” of improper conduct is a nod to the fact that there is a sense of what proper conduct is all about.

    And a recognition at least by some in the biz that buying up shares of a company you are to regulate at a time when that same company is getting fed billions of federal dollars is wrong.

    Here’s to hoping that the Justice Department is eager to examine the whole issue of insider trading done by the Wall Street execs as the crisis unfolded.

  16. Cheers Anne! Its funny how two different lenses can view the same piece of news and come up with different conclusions. Populists view this as further proof that bankers are corrupt criminals. Capitalits view this as a positive development because it shows how an individual has realized his error, and dutifully bowed out of his position of power because of it.

  17. Simon,

    I applaud your efforts at trying to bring light to corruption and “anti-capitalist” practices by our banking sector over the last few years. I agree, this isn’t a left vs. right debate, and capitalists have just as much to feel pissed off about as financial industry consolidation and the tax-payer subsidized macro-economic “put” has left our system a very, very, un-free market.

    However, when you continually mention the personal failings of bankers’ greed, and continual lust for power, I’m very worried that you might actually think that its possible to legislate morality into the system, and that this should form the basis for our solution. Lambasting the greed of bankers seems useless in a society where everyone is greedy, and we in fact use that greed to be productive. To me, all it does is fuel the populist anger that’s been welling up over the recent events such that our sheep-like law-makers expend time and energy on useless regulation (90% tax on bonuses, “buy america” clauses in stimulus packages, etc.), who’s unforseen negative consequences far outweigh whatever positives they are supposed to have.

    No, we will always have greedy bankers, and I’m appalled at your seeming naivete in believing otherwise. We should be focusing efforts on preventing the greed of bankers (or airline execs, politicians, used car salesmen, troubled youths, or anyone else in our great society) from bringing down the rest of our system. The greed of bankers and investors is good when they make profitable capital allocation decisions, and spur our economy forward. It is bad when they hold our politicians hostage because of the size of their institutions, forcing taxpayers to shell out money to subsidize their losses (and the cash bonuses that they’ve paid themselves). We need to focus on the structural causes of this crisis such as TBTF, excessive de-regulation, and the like, and not waste our time trying to construct a utopian society of 300 million do-gooders.

    Otherwise, if we focus the debate too much on greed and personality faults, we risk 1) diverting our attention away from the necessary reforms, and 2) implicitly sponsoring counterproductive legislation that will bite us in the A$$ later.

    The defense of capitalism is now more important than ever, and I would implore the authors to acknowledge it. One has to only scroll through the comments section of this blog to see why…

  18. Simon,
    I can’t tell you how glad I am that I have found this site. This information and explanation is invaluable – your tone is spot on. Your civility is admirable. I find myself feeling betrayed at the theft that has happened (by wall steet) and dismayed there has been no change of leadership of these companies. Somehow your research makes me feel that there may be hope for the truth to affect change in this country.

  19. I have a question that no one has been able to answer: who is making money right now? I hear plenty of news about various institutions, financial and otherwise, losing billions of dollars everyday. Unless they are playing with monopoly money at NYSE someone has to be making money, right? Or is this money simply dissappearing?

  20. that’s a great question, and most critics of derivatives fail to realize that unlike the other asset markets (stocks, real estate, etc.), it is truly a zero sum game where someone wins as someone loses. Many smart investors (hedge funds, GS, etc.) have been raking it in by getting the right side of the markets. And while the hurdle to invest in a hedge fund is high on an individual level, rest assured that your pension plans are investing in them, and cushioning the blow of the crash in stocks…

  21. Coffee Boy,

    I don’t actually know any capitalists who are as naive as you claim to be. I worked in banking over the course of several decades; I am a capitalist, and I know my share.

    Further, I don’t think there is a distinction between capitalists and populists. I have helped fund small business people who are capitalists – but they are also disgusted by the grotesque advantages financial institutions like mine are receiving. Which makes them populists.

    Please look into the historical roots of both words. Beyond the Latin, back to the Greek. That may help you to understand. Populist, populus, polis.

    Polis, the people, the individual units of democracy. Nothing anti-capitalist about democracy, never was. What is inherent in democracy is anti-tyrannical. Goldman Sachs and B of A aren’t capitalistic, but tyrannical. And that’s why REAL capitalists and REAL free market people oppose them.

    I recommend you read Adam Smith on this point.

  22. I don’t disagree with you – in fact i completely concur with everything you said. My only point is that it should be viewed as a positive that one by one, people such as Madoff, Friedman, and the like are being taken to justice and stepping down.

    My logic is this: if someone catches a criminal, I’m happy that he was caught, not angered at the fact that criminals exist. I’ve already resigned myself to the fact that criminals exist, and I’ve adjusted my behavior accordingly. However, I am pleased when they are caught. To me, its useless to use the catching of a criminal as an excuse to try and justify the complete extermination of criminals, because trying to create a criminal-free world is an exercise in futility. We cannot eradicate 100% of crime. We can however, set up a system where the small amounts of crime that occur, are not enough to disrupt society. Take this metaphor and apply it to bankers, and insider dealing, and regulatory capture and all the rest, and you will understand my point.

  23. insider trading?….. **** NEWS FLASH **** Wait, do I really even need to SAY IT???? ………..

    Wake up and smell the roses…. We already have annual audits by Big 8 CPA Firms,…. we have Sarbanes Oxley, we have the SEC and the FBI. Guess what? ….. Look at the put option history the week before Lehman Bros. filed…. look at the equity trading history for ANY of those big news events over the last six months. Here’s a clue….. IT SPIKES…. OFF THE CHARTS…. Why aren’t you in there getting some lf that greasy money? Too proud, too ethical, too lazy,….. NO – just too scared. Well, there are 10’s of thousands who aren’t too scared…. Friedman was one. He says, free money?, sure, I’ll take it.

    Bottom line:

    Nobody up there really cares, either regulator, banker, exec, trader….. They don’t care, unless you have a political aspiration agenda like Spitzer, and then, watch your back, you will either turn up missing, or turn up in bed with a princess- who is not your wife. That is: unless you are obvious, as Friedman was…. and then, the bulls will kick you under the bus…. as you deserve.

  24. Brendan, Too late. All of this is already too populist and, at times, a bit hysterical as well.

  25. And we’d better see some of these bankers/captains leave their respective board rooms. (and Fed posts) Even though government has helped many of these management teams/officials survive, it is time to take a close look at bankers who “don’t need no TARP,” to survive. Let’s reward those second tier bank management teams who have played it “straight up” for as long as they can remember…

  26. Coffee Boy,

    I agree with your overall points, but once again, you’re decrying “populist” as if it’s somehow anti-capitalist, as in your statement:

    “all it does is fuel the populist anger that’s been welling up over the recent events”

    Populist anger is not anti-capitalist. Populist anger has often fueled the necessary reforms that protect free markets.

    And I would suggest, again, that we show more respect for the etymology of the word “populist” (as I wrote earlier today.) Ask a 5th century BC Athenian what the polis was – he might say “hoi polloi” but back then, hoi polloi was an honorific.)

    Please consider showing more respect for the term.


  27. Probably not. But I guess that might depend on how you define the terms,






    transfer of power.

    The “American” revolution wasn’t peaceful, but it did accomplish some useful aims. Also, the quiet, post-WWII U.S. redistribution of wealth/growth of the middle class was peaceful, but that was made possible in part because we’d deafeningly bombed our competition to pieces. But higher taxes on the rich, and subsidies to veterans so they could move into the middle class played an important role.

  28. This may be a dumb question but is there a reason for any sort of risk premium now on TBTF bank bonds? I guess maybe a little for political risk in that future administrations may act/think differently than the current? But it seems to me like the precedence has been set…especially if a recovery takes hold. And so then, might the premium for smaller (or more expendable) banks actually go up? If so, will they be able to remain competitive? Have we guaranteed ourselves a future with only a few TBTF banks?

  29. CB, these folks are not to be counted among the “Many smart investors (hedge funds, GS, etc.) have been raking it in by getting the right side of the markets.” They’re rigging the game, as most everyone who’s in the markets realizes, such that they cannot fail. The basic idea is to use AIG as a conduit to funnel taxpayer $$ to the banks and HFs. Read this:

    When the welfare system has been sucked dry, these guys are going to have to find another sucker to play the game. So far their customer have been torched and the federal govt’s getting tired of being the patsy (Congress is becoming increasingly restive in approving more tunneling, … er … funneling, … er … what exactly would this be called? It’s certainly not capitalism.

  30. That’s what I hear. Shared a taxi last night with a good friend who’s at JPMorgan Chase. He says the firm is having a banner year (to date) in credit derivatives–and that they’d prefer to keep this quiet. So all of you Baseliners just keep that to yourselves.

  31. You misunderstand my point. If bailout money to AIG went in one door and out the other, the question is where did it go? Sure, some went to big banks like Goldman, but unless you trace the extremely interconnected web of CDS trades, you won’t know if it then went from Goldman elsewhere. What we do know, is that given that AIG was a net seller of protection, the ultimate beneficiary was probably a net buyer of protection (and i-banks like GS and MS were intermediaries between the two). Who was a net buyer of CDS protection? Hedge Funds such as Paulson & Co. Ok fine, John Paulson is rich and I’m not, but I still respect the man for delivering returns to his investors during the toughest market environment in living memory. And guess what? Your pension fund is likely invested in Paulson & Co as well as other similar hedge funds. So when the US govt bailed out AIG, it effectively bailed out the broader investing universe, and that means it bailed out anyone with savings or retirement money that is managed by someone else.

    Of course, i’m painting broad strokes, and there is a very annoying caveat to the story: the middle men between John Paulson and AIG (GS, MS, etc.) still paid themselves bonuses, which they would have been unable to do without the taxpayer support. Even AIG itself paid out bonuses despite its egregious risk management techniques. This is obviously annoying, but I’d rather this, than every end investor who thought they’d hedged themselves against a downturn, be completely screwed.

    All I’m saying is that before people criticize CDS and other derivatives, they should try and figure out the entire picture. A CDS can be a very dangerous instrument because its a “contingent liability,” ie, for the seller it can result in losses far greater than the premium earned. But we’ve had contingent liability type derivatives for decades….they are called options. The options market is very liquid, transparent, and well-functioning, and thats primarily because of the elimination of counterparty risk. The CDS market isn’t dangerous because of the “contingent liability” aspect – its dangerous because the market hasn’t dealt with margin and counterparty-processes correctly. In the options market everyone, dealers and investors alike, have to post margin to a clearinghouse. This limits the implicit leverage in the system. In the credit markets, margin was only posted “one-way,” as in hedge funds posted margin to dealers, but not the other way around. So the implicit leverage in investment-banking credit desks was much higher than for hedge funds. As well, the entire market could be screwed by the collapse of a single counterparty (AIG). But if the options market operated in the same way, it would be just as dangerous. Some wise guy at an insurance company would have realized that he could sell some 1100 puts on the S&P and boost his division’s revenue by a tidy amount. September comes around and he’s driven his firm bankrupt.

    If CDS moves to a clearinghouse, and there’s two way margin-posting, I argue that it becomes just as useful and necessary an instrument as a stock option.

  32. Coffee Boy writes:

    “Of course, i’m painting broad strokes, and there is a very annoying caveat to the story: the middle men between John Paulson and AIG (GS, MS, etc.) still paid themselves bonuses, which they would have been unable to do without the taxpayer support. Even AIG itself paid out bonuses despite its egregious risk management techniques. This is obviously annoying, but I’d rather this, than every end investor who thought they’d hedged themselves against a downturn, be completely screwed.”

    I’m sorry, but that’s a less-than-cogent argument for NOT letting the middleman go down. (As Joey Heller wrote somewhat tongue-in-cheek in “Catch-22”, why not eliminate the middleman?)

    If, in fact, we are funneling money to pension funds, wouldn’t it be more transparent, democratic, and efficient to give the money to them DIRECTLY and have let Goldman Sachs, AIG, et cetera to die as the free market mandated they should?

  33. Forget the regulators. The banks went bust because their management structure doesn’t work. How else can anyone explain a big bank failing to make a health profit on 12x leverage while paying depositors just 5% and charging borrowers 7%. It beggars belief. In fact the leverage was way over 12. It’s not just the top management who were incompetent. From top to bottom the structure took a wrong turn. Experienced shopfloor were ignored then distrusted. Their authority ripped away and with it went the quality control. Their input replaced with surveys, tick boxs and target management. It didn’t work and no amount of regualtion will make it work.
    Propping them up with ridiculously low rates of interest on deposits (they should be over 25% with ease) and govt handouts and guarentees that are going to cost us a fortune is a total waste of time.
    Watch the UK. The govt there will change next year and the conservatives have made clear they are going to break up the banks, let the insolvent ones fail and encourage new entrants.

  34. I think you must realize by now that it’s time to collect whatever marbles you have left and head home.

    It’s game-over. The bankers have won.

    And you’re gonna just love the new economy they’ve spun from the mess they made. Millions of useless private and public sector jobs will be created to keep them safe from you and well-fed from the blood and sweat of your toil.

    And all of these millions of useless jobs will merely serve to amplify the dysfunction and rot that is so pervasive in our greatest institutions.

    So get back to work you slackers, you’ve got a lot of useless work to do, and generations of debt that you owe to these bankers.

  35. Sometimes I think anything short of a beret and an AK-47 will not even get their attention.. Good thing I got Jesus.. Where is Che Guevara? Wait CIA popped a cap in his ass.

  36. My bad, Che may have been a bad example. How about Robin Hood. I could get behind that guy. Nothing on earth would give me more pleasure than just taking money from these arrogant asses and building free homes for the homeless with it.

  37. One thing I’m doing, and urging friends to do, is to write to my Congressmen and tell them that if this madness doesn’t stop, I will find someone else to vote for.

    It also can’t hurt to remind them that the taxpayers pay their salaries, pensions, and healthcare benefits, while the bankers only pay for their campaigns.

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