No Stress? No Sweat!

The flood of leaks related to the bank stress tests due to be released this week has me thinking: why? Why, that is, are we getting treated to an almost daily series of ‘off the record’ and ‘unofficial’ flow of information about them? It makes no sense. Unless the administration wants to dull our faculties so much that we ignore all the flaws.

In which case it might be working.

The New York Times has an article written by the normally sober David Leonhardt that is positively breathless in its optimism. Reading it is like being handed the administration’s sugar coated version of the truth. Leonhardt argues that ‘using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear’.

“Using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear.”

My that makes me feel so much better.

It trivializes the amount of capital shortfall there seems to be in the system. A “few banks may need additional money”. OK then. Move along. Nothing to see here. Come on: move along.

So all this fuss over potentially failing banks was just a little storm over nothing. Apparently. Or so the administration now wants us to believe.

It gets worse. Now we hear that weaker banks, those very few who need just a little cash. Very few remember. Well they get six months to raise fresh capital before they’d be forced to take government money. Six months. Half a year before we fix our banking system. Talk about punting.

The administration’s entire strategy seems to be to talk the crisis down into a manageable little blip that is nothing more than a nuisance. The banks are just fine. One official is quoted by Leonhardt as saying none of them are insolvent and that “these losses are manageable”.

Presumably that’s why the market has discounted the stocks of Citi and Bank of America to a historically low level. It was all a silly misunderstanding.

I suppose I wouldn’t be as annoyed about all this were it not for the fact that the tests were rigged in the first place. Not only did the banks provide all the information, but the tests only applied to loan portfolios. Think about that for a moment. What’s missing? Derivatives. that’s what.

Yes. These stress tests avoided taking into account the very asset class that brought down AIG, and which has been sending shudders of fear through Wall Street since the crisis arose last year. The tests treated our major banks as if none of them had big capital markets positions that could implode at any moment. Of the biggest banks only Wells Fargo fits that description. All the others have huge derivative overhangs. And it is the tangled world of the capital markets that the real monsters lurk.

Were a ‘normal’ bank like Wells to hit the rocks it would be relatively easy to clean up. Yes it’s huge, but it isn’t as riddled with counter-party entanglements as its peers. The standard FDIC reorganization playbook would work just fine for Wells. No one has a playbook for a banking version of AIG. In fact the only people who would know how to unwind the mess at a Citi or a B. of A. are the morons who created the mess. It’s a bit like hiring a gang of fraternity brothers to clean up your house just after they trashed it. Except these idiots get paid by the million. We’d probably get treated to more of those ‘retention’ bonuses that so angered us all over at AIG.

So derivatives traders have been able to instill so much fear in the administration that no one wanted to admit there may be a lingering problem in bank portfolios laden with capital markets systemic risks. We simply ignored them. Presumably hoping that the monsters would all go away of their own accord.

Which means the stress tests weren’t that stressful.

What a shock.

So the combination of incessant leaks and weak tests has rendered the whole process a farce. We will learn that a few banks need to raise capital. But we will also be told that they’re jolly good people giving it that old college try. The others will presumably pass with flying colors. The banking crisis will end forthwith.

There are instances in the past where banks were thought to be on the brink and managed to come back to life without major government intervention: the Latin American loan crisis is one such instance. Leonhardt manages to make a reference to it. Frankly I don’t think it’s a very good analogy at all. The systemic risks are now far greater; the derivatives business has skyrocketed in size since then; fewer banks were involved, which meant that many banks were perfectly healthy all along; the economy was not contracting on all fronts as it is now; and the losses were concentrated in one sector, unlike now when we haven’t even entered the usual loan loss period brought one by deteriorating commercial real estate and credit card portfolios. In other words the Latin American loan crisis is a very bad analogy.

Which is another cause for concern.

The administration’s apologists are scrambling to clutter the argument with misdirection and poor analogies.

The fact remains that we have several large banks that are weak. No matter how you cut it they are inadequately capitalized. Usual sources of private capital are unavailable for the very banks who need it the most precisely because the stress tests look rigged. The obvious fudging that the administration is doing is counter productive. It prevents private investors being able to distinguish clearly which banks are safe investments. Yes the tests will appear to give the right information. But can we really trust it?

Especially when we hear the banks have been ‘negotiating’ the results.

But that’s another story.