It’s Stress Test Eve … Oh Fun

I can hardly wait. After what seems like months of talk, leaks, and rumor we have finally arrived at what should have been a decisive moment in our economic crisis. Tomorrow is the day that the administration is going to release the results of its now infamous stress tests on our major banks. I say ‘should have been’ because there doesn’t appear to be much mystery left, and the leaks and rumors have taken the sting from any news the Treasury Department will convey to us.

As you know I think all those leaks were designed exactly to distract us. They were a series of trial balloons floated by the administration to determine what the stock market thought was a reasonable outcome. Too much of a shortfall for the weak banks and a panicked sell-off may have been triggered. Too little and the market would simply have laughed at the evidently rigged results.

The problem the government had, and still has, is that the tests have no real credibility. Since we all knew that they couldn’t afford to go back to Congress for more money the tests had to end up with only small amounts of capital being required. On the other hand the test had to look as if they were serious, so there had to be some relative ‘failures’. Then again those failures could not be so big that the test results precipitated a run on the banks in question, something that would have then meant the government had to step in actively.

So, having committed to doing the tests, which it did to demonstrate its determination to solve the banking crisis, the government had to ensure they were useless.

Which it has done admirably.

Such is the effectiveness of the confusion spread throughout the market and the media by the incessant leaking of tidbits of information that no one is quite sure what to make of the real news when it arrives tomorrow.

All we know is that there are no failures in these tests.

Which is shocking given the awful state that some of the banks are in.

The entire administration strategy has been constructed around the belief that if the banks are given enough time they will heal themselves without the need for any serious intervention from the government. By intervention I mean forced re-organization in the way the FDIC has already cured the problems of thirty-six small banks across the country so far in 2009.

The effort the administration has made to protect the banks from the results of their own mistakes is enormous. They have shifted the regulatory emphasis from Tier 1 capital ratios to Tangible Common Equity [‘TCE’], which all the leaks refer to as the ‘better’ gauge of bank strength despite years of official focus on Tier 1. Why the shift of focus? Because you can fix TCE simply by converting preferred stock, which doesn’t count as TCE, into common equity, which does. So by changing the regulatory focus the government made it much easier to fix any problems it may then have identified in the tests. And, just by chance no doubt, the most troubled banks are those with tons of government preferred stock sitting just waiting to be converted.

How convenient.

The hope is that as the economy recovers later this year and with the yield curvesharply sloping upward[the difference between short term and long term rates is called the ‘yield curve’], thanks to the aggressive activity of the Federal Reserve Board, bank earnings will grow sufficiently to restore capital to decent levels.

Presumably this assumes that the banks will not be lending too much since that would have the effect of using the capital to support growth rather than to re-establish acceptable ratios against the old book of business.

Larry Summers keeps beating the drum that all the banks need is time. The stress tests were set up to distract us from the real ailments of the banks, and to consume time. They have succeeded brilliantly.

But our banking problems remain.

Just to demonstrate my point here are a couple of articles, both of which tow the party line.

First the Financial Times. Here’s the giveaway statement:

• “People close to the situation expect Citi to have to raise less than $10bn in extra capital, and possibly as little as $6bn, through the expansion of its planned conversion of preferred shares.”

This comes after the initial paragraph lets us know that Citi is deemed to be $50 billion short – a figure that looks about right given the mess its in. So a $50 billion shortfall becomes an easily manageable $10 billion. How? the conversion sleight of hand and the new focus on TCE. Were we still in the old days of Tier 1, e.g. as recently as January, then that $50 billion would still be $50 billion and Citi would be sucking wind.

The second comes from this article in today’s New York Times. In reference to Bank of America’s expected $33.9 billion shortfall the article says this:

• “It could satisfy regulators‰Ûª demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock.”

Cased closed.

Both papers commit the error of thinking that conversions of preferred stock into common equity fix capital problems.

Obviously the government has won the propaganda war. It has no intention of dealing with our weak banks, other than to try to buy them time.

This does not bode well for a strong recovery.

But, hey: it’s Stress Test Eve! Have fun everyone.