William Black: "There Are No Real Stress Tests Going On"

By way of background, William Black is a former senior bank regulator, best known for his thwarted but later vindicated efforts to prosecute S&L crisis fraudster Charles Keating. He is currently an Associate Professor of Economics and Law at the University of Missouri – Kansas City.

More germane for the purpose of this post, Black held a variety of senior regulatory positions during the S&L crisis.He managed investigations with teams of examiners reporting to him, redesigned how exams were conducted, and trained examiners.

Via e-mail, he has confirmed our suspicions about the bank stress tests announced by Treasury Secretary Timothy Geithner: they simply cannot be adequate, given the number and experience of the staff, and perhaps as important, their relationship with the banks (see detailed comments below).

I also asked him about the fact that bank examiners examine banks (duh) and would not have much (any?) experience in the capital markets operations or sophisticated products that the big investment bank, now banks, participated in. Goldman and Morgan Stanley ought to be subject to these exams; Citi, JP Morgan, and Bank of America have large capital markets operations. These firms are where the biggest risks and exposures lie. Do the examiners what to look for in a even the low-risk operations, like repo desks, much the less derivatives and proprietary trading books? He agreed (as presented below) that it was a near certainty that this was beyond their skill level.

Now this begs the question: why has the Treasury Secretary set in motion an obviously bogus process? It suggests the result is pre-ordained.

One possibility is that even a very quick and dirty look at many of the big banks’ books will reveal them to be in very bad shape. In fact, the inadequate staffing could be part of the private conversation: “You know we didn’t send in enough bodies to do this right, and even using your numbers, which we can assume in some cases will be flattering, you look like a goner.”

But all of Geithner’s actions to date are inconsistent with him taking a tough stand. Having a lot of people party to a process that finds that some of the big banks are in trouble would be hard to keep secret (to my knowledge, none of these people have high level security clearances. Government employees and contractors in those cohorts do keep their mouths shut). So I think it is more likely that the banks will get scorecards that show them to be in various stages of peril, but none will be found to be terminal. (They can’t be given a clean bill of health, that would call the whole rationale of the TARP and its various injections into question, and also would put Geithner at considerable risk if any bank declared OK fell over in less than 12 months).

But even the designation of “sick but not ready to be hospitalized” carries with it risk to the Administration. If the banks get sicker than anticipated, how can they explain it? They can’t say, “oh, things got worse than we contemplated”. The whole point of a stress test is to anticipate worst case scenarios. And it is pretty certain a fair number of the big banks will be on such large-scale life support by year end that it will be hard to make a case not to put them in receivership.

Whatever statement Geithner puts out about the results of the stress test is likely to come back to haunt him, as did Colin Powell’s “there are WMD in Iraq” speech before the UN did. And Powell had a better reputation going into Iraq than Geithner has in prosecuting his war.

From William Black:

There are no real stress tests going on.

1) If you did a real stress test, as Geithner explained them, you wouldn’t just have a $2 trillion hole — you’d impose regulatory capital requirements of 50%. (FYI, the regulators have the power to set HIGHER individual capital requirements based on unusually large risks at a particular bank.)

Yves here. By implication, the results of anything approaching a true stress test, plus reasonable regulatory responses, would dictate radical action. We have not seen any corresponding groundwork laid for that sort of thing. Back to Black:

2) You can’t conduct a meaningful stress test without reviewing (sampling) the underlying loan files and it seems likely that the purchasers of securitized instruments (not just mortgages) do not even have the loan file data. Moreover, loss ratios vary enormously depending on the issuer, so even a bank that originates (or has purchased a bank that originates) similar product cannot simply take its own loss rate and extrapolate it to the measure the risk on the value of securitized credit instruments.

3) The regulators are overwhelmed because of personnel cuts (particularly heavy among their best, most experienced examiners that had worked banks that had engaged in sophisticated frauds. Buyouts were common, because more experienced examiners appear more expensive. This isn’t true when you consider effecitiveness and productivity, but management didn’t care about that. Treat what I write after the colon as hearing from me at my most serious and thoughtful: it is vastly more difficult to examine a bank that is engaged in accounting control fraud. You can’t rely on the bank’s books and records. It doesn’t simply take more, far more, FTEs — it takes examiners with experience, care, courage, and investigative instincts and abilities. Very few folks earning $60K are willing to get in the face of the CEO and CFO making $25 million annually and tell them that they are running a fraudulent bank and they are liars. FYI, this is one of the reasons why having “resident examiners” never works. The examiners don’t even get to marry the natives. They get to worship God’s annoited. Effective examination is good for you, but it is very unpleasant, ala a doctor’s finger up your rectum. It requires total independence.

So, the examination force doesn’t have remotely the numbers or the relevant experience and mindset to examine the largest banks with the greatest problems.

Yves here. Black is not using the fraud word lightly. He believe that we have Enron-level accounting fraud happening, now, in the financial services industry. And we have asked repeatedly, why has there been no investigation of fraud at Lehman? There was a $100 billion plus hole in its balance sheet, meaning a substantial negative net worth, when its financial statements presented a completely different picture. Back to Black:

4) As Geithner describes the process, NO ONE can conduct reliable “stress testing.” It inherently requires testing everything in every way any and all aspects of everything could conceivably interact. It also doesn’t provide any meaningful output that can be operationalized (unless you want to force an enormous rise in minimum regulatory capital requirements, which he obviously doesn’t want to do).

5) Examiners certainly can’t A) do the stress testing that Geithner describes or B) evaluate the reliability of a large bank’s proprietary stress test. If they were serious about constructing reliable stress tests, which they aren’t, you’d require their analytics to be made public. You’d have the industry fund independent investigations by rocket scientists chosen by a committee selected by the regulators of the soundness of the analytics. You’d also have the industry fund competitions to rip them apart (a bit like we hire legit hackers to test security by trying to defeat it) and show where they produce absurd results. The geeks would have a field day (that would probably last a decade). There are probably zero examiners that have the modeling skills required to evaluate the most sophisticated stress test models. The concept that there are 100 examiners with these skills, suddenly freed up from all other duties, assigned to CONDUCT stress tests is a lie.

6) It is, however, possible to use even the less experienced examiners to conduct a far more useful examination of the quality and value of nonprime loans. My nightmare scenario which I fear is often true is that A) because the biggest originators of nonprime loans were mortgage bankers, B) because every large mortgage banker that specialized in nonprime loans went bankrups, C) because many of them went into Chapter 7 liquidations and even those that went into Chapter 11’s had little incentive to hang on to files on mortgage loans they had sold to other entities — the loan files on many nonprime loans may no longer exist. (My fervent prayer is that the loan servicers have tapes with copies of the underlying loan files, but I fear that this prayer will not be answered.) Under this nightmare scenario it will be extraordinarily hard to determine loan quality and losses and very hard to foreclose against borrowers that can afford attorneys (admittedly a minority) and that claim fraud in the inducement.

Yves again. Remember, aside from the discussion of the bank’s risk models, he is still framing the stress test in terms of more or less traditional banking activities, that is, that most of the assets that need examining are loans. I asked for how he thought the examiners would fare with more complicated products, like CDOs, CDS, and derivatives. His comments:

Yes, few examiners understand more exotic products. In my experience, nobody understands all the products. I certainly don’t, and if I did I’m sure my knowledge would be out of date within weeks.

The problem is compounded by the fact that understanding how the product is actually used (CDS is a good example) v. how its proponents picture it as being used is essential. Understanding its sensitivity to credit and interest rate risk is well beyond the ken. Understanding the liquidity risks and interaction effects is out of the question.

Examiners rarely know that financial risks are not normally distributed, but have far fatter tails. (Nor do they understand why this makes truncating the VAR a recipe for disaster.) Examiners rarely understand that any econometric analysis undertaken during the expansion phase of a bubble will invariably find the strongest positive correlation with the worst possible business practices (because those practices maximize accounting fraud).

We were, 15 years ago, able to get some strong capital markets people and give them advance training. We sent them out on exams, they impressed the industry — and they were promptly hired away from us at substantial raises

Some countries have found ways around this problem, but they don’t translate well to America. In Japan, the most prestigious jobs are in the top ministries, so they get and hang on to good people. In Singapore, Lee Kwan Yew felt he had to depart from the typical corrupt Asian government norm for Singapore to prosper. Top government bureaucrats are paid like top private sector professionals (think law firm partners). They are well enough paid (or have the prospects of being well enough paid) so as to have an incentive not to screw it up (tough internal audits also help).

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  1. David

    Is this making it all a little too complicated? Why not start with the simple stuff, mortgage loans, commercial loans, auto loans, credit cards, leveraged loans etc. See for example.

    If you really assumed a stressed environment (that is worse than most forecasters think, say 11% unemployment) you can almost certainly wipe out out the equity at C, BAC and probably JPM, WFC with just these traditional products. You don’t even need to ask them what is in the drawer labeled “Structured Products”.

    I don’t think it takes that much work to do the stress test on those products. That is just traditional bank regulation. Heck, Chris Whelan of IRA has done most of the job from the outside. Surely the Fed has a very good idea of what “stress” means for these banks.

    If the banks are really lying, they are probably lying about the complicated structured deals and not how many Option ARMs they have.

  2. Yves Smith


    Have you ever worked in or for a bank or securities firm and seen its MIS and operating level financials. With all due respect, if you haven’t, you don’t know what you don’t know here.

    I have done a wee bit of this sort of thing in my life as a consultant, and I can tell you, mapping the internal financials onto any kind of operating data as well as published financials involves a ton of artwork. And that means is it ripe for abuse.

    And Black points out, you HAVE to check against the underlying documentation. The process otherwise is a garbage-in, garbage out exercise. And that chart you pointed to does not pass muster as an analysis.

    Black supervised examiners. He knows what he is doing. Would you presume to tell a heart surgeon how to conduct an operation? If you aren’t an examiner or financial firm auditor, you have no sound basis for second-guessing Black.

    I correspond with Whalen, who believes in bank regulation, and I can just about guarantee he will side with Black on this one (only perhaps reducing the time span of the risk model slugathons to a year).

  3. Steve

    1) It’s a planned whitewash, or a dilatory tactic, or the first step in a game to scare Congress into ponying up more dough. I vote for #3: “gee, everybody’s in such bad shape we need a new TARP–can’t close ’em all, you know! Wouldn’t be fair to close just one or two if everybody else is just as bad!”
    Nobody gets nationalized; everybody gets more money.

    2) I strongly suspect that the regulators already have a clear picture of the condition of the big commercial banks. The problem isn’t what the regulators know or don’t know, it’s what the politicians intend to do about it.

  4. Swedish Lex


    Further to your comment to David, a question. What would, in the U.S., the role/responsibility be of the auditors?

    On this side of the pond, when a company risks becoming insolvent, auditors have a statutory obligation in many cases to take a more pro-active approach that often will include digging into the underlying documentation, do stress scenarios, etc.

    In the reporting from the U.S. that I see, auditors seem to be absent from the debate.

  5. bg

    I think David asked a fair question given that most (all) of us have no qualification to ask any questions at all.

    If we accepted the premise that we have Enron-esque balance sheet fraud, and also that the books were impenetrable. Then we would be forced to your conclusion that no bank could be stress tested with even a hint of accuracy.

    However if we also accepted one of your other premises that the banks should be nationalized, and the industry made smaller, then the government must chose who is worth supporting.

    And in any scenario, the sense I get is that patience is wearing out in Washington with incrementalism. So decisions will be made with some information somewhere.

    I found that the amount of Level 3 assets held 18 months ago was an tremendous leading indicator of balance sheet degradation. Which leads me to ask a variant of Davids question. If you *must* hurry, why not simplify the models?

    Forget systemic risk and fat tails. You may underestimate risk by a factor of 2 or 10, but you will know the relative health of each player. Look at the 35 biggest borrowers that show up in 50% of CDO’s to model the CDOs. Look for fraud in only the biggest fattest off balance sheet entities (where the action was at Enron.)

    Nobody would want an escalated stress test. But it is better than a non existant one.

    And thanks Yves, for sharing this correspondence. It is fabulous, as always.

  6. M.G.

    I wonder where external and internal auditors are during these stress tests…maybe distressing. I think it would be easier to ask banks to declare and disclose themselves to the real “best of their knowledge” (which listening Mr. Fould of Lehman was pretty low…). We need some outing plus whistle blowing…It’s time to tell us the truth although I contend that may not really even know themselves…Stress test is at this stage just for some financial engineers who contributed to the mess.

  7. doc berzerk holiday

    Essentially what I see here is the same mentality that Bush and staff had for Iraq, and the same hard-headed arrogant and stubborn stupidity to not tell the truth and do as they please, then push an agenda and feed egos.

    I have alluded to Lincoln and his problems with George Brinton McClellan and continue to see correlations between these parallel political failures, i.e, there seems to be an inherent genetic trait within these types of people, who gain position through nepotism, then use and abuse their position to flaunt their artificial and superficial pedantic intelligence — and then, screw up everything they do. These people like Warsh, Paulson, Bernanke, Geithner, et al, etc, represent the fall and decline of America. It is the FEMA Brown's and all the people that are supposed to be things that they are not, like bank examiners, auditors, cops, FBI agents, DOJ employees, SEC staff, Treasury staff, FASB rule makers, FDIC examiners, state bank examiners and of course all the crooks on wall street dressed up as CEO's, board members and all the fine people that had a hand in our current Greater Depression …

    Ooops, this kind of goes round and round and repeats every night doesn't it? Oh well (sorry) the simple point here tonight, is that yes, there is no stress test, and The Fed and The Treasury, and The Bogus Army Of Auditors are all a bunch of fools, who are as naked as they can be — and they are just making this crap up as they go — and instead of being truthful, or responding to people calling them liars and fools, they will continue to screw up daily …. and just as we saw with Iraq, this entire Obama charade of change will be a complete play-by-play replay of The Bush Years and a string of lies, lies, lies and retarded politics as usual — and the only thing to look forward to will be a change of president (which will take friggn forever) — and when that glorified halleluja time comes — the change which will take shape before us (in that halleluja moment) will be to make choices between retarded idiots like Palin & Warsh, or re-packaged Obama/Clinton jokes that will all be backed and paid for by lobbies and mobsters and CEO's that will push rule making agencies like FASB to change accounting rules around for the people that want law to be engineered as they see fit. What The F do we need auditors for at this point, when the entire system is in ashes?

    God Bless America, because it’s a living hell now, and we need more than change, we need honesty and justice!

    Also See: A phoenix is a mythical bird with a tail of beautiful gold and red plumage (or purple and blue, by some sources. It has a 500 to 1,000 year life-cycle, near the end of which it builds itself a nest of myrrh twigs that it then ignites; both nest and bird burn fiercely and are reduced to ashes, from which a new, young phoenix or phoenix egg arises, reborn anew to live again.

  8. Charles Monneron


    for the stuff that is securitized, there is always a bond trustee that computes the waterfall. As every bond has its peculiarities, I would not be surprised that for most of them, cashflow are simply modelled using an Excel spreadsheet. Having such spreadsheet put in the public domain (after removing data that should be kept private for privacy purposes), together with the trust deed would be of great help to bring transparency in the market. A bit of open sources valuation effort could be of some help here.

  9. Don

    My recollection of the S & L Crisis was that a lot of fraud wasn't prosecuted because it was claimed that it mirrored stupidity. In any case, I would have liked his opinion on how well we investigated and prosecuted crimes associated with the S & L Crisis. I see a direct link from that crisis to this crisis, in that these investment crimes tend to be passed over. There are usually a few big name prosecutions, with the emphasis on few.

    Felix Salmon has been talking about blogs and papers investigating iffy investments, what about the FBI, SEC, and DOJ? Subprime loans would be a natural place to begin.

    We all now that these agencies need resources to deal with these crimes. Is there any hope that they'll get them? The idea that the industry being investigated hires them away is truly dreadful, but makes sense given our system.

    If we don't investigate and prosecute Fraud, Negligence, Collusion, and Fiduciary Mismanagement, what good will threats of regulation do?

    Don the libertarian Democrat

  10. cap vandal

    Good post. You are covering a LOT of material here. I think the critical thing is the distinction between investment banks and traditional banks. Unfortunately, there has been what I now believe to be an active policy of trying to blur the distinction between the two and the inherently different problems that they have. You pretty much laid it out in a post the other day. The Geithner quote about the quantity of lending that occurred via securitization. As far as most mortgages go, this has been picked up through the nationalization of the GSE’s. However, there is still a big hole, since there was a lot of lending via securitization on things other then conforming or quasi/neo conforming mortgages. Home equity loans, second mortgages, credit cards, auto loans, etc. Some of it can be picked up by traditional banks, but traditional banks were disintermediated to the extent that they can’t reverse this trend quickly.

    If we move back to traditional banking, I think that the regulators have a reasonably good idea (or good enough idea) of how they are doing. The biggest issue has to do with general economic assumptions. As long as the regulators know the relative strength of the banks, it is simply a matter of where to draw the line. Right now, the price to book value for the common stock is about .2 for Citi and BAC up to 2.0 for Northern Trust. You see a clustering at the bottom, and the markets at least think they are likely going to be wiped out or heavily diluted. JPM is at 0.7 and WFC is at 1.0. You see the same sort of thing in the regionals.

    If we are really talking triage, then the traditional banks — especially the larger ones, aren’t far from it. Indy Mac closed by FDIC. WaMu force merged with JPM. WB wiped out most of the equity and paired with WFC. WB took $60 billion in writedowns as part of the purchase accounting adjustments plus planned 09 writedowns. Based on deposits, these banks are 20% of the 50 largest and 11% of all US banks (including National City).

    BAC and C make up about 15% of deposits. Since both of them have gotten significant additional TARP money and guarantees, I don’t see how they can get more without either wiping out or heavily diluting the stock and preferred. The major point is that the idea that regulators have been just sitting on their hands isn’t accurate. I am referring to the media that keeps saying to “just get on with it.”

    The above is still primarily about traditional banking. As far as stress testing, the traditional portfolios are whole loans and aren’t marked to market. Therefore it is possible to make reasonable estimates of needed loss provisions over the next year. There is no point in doing a stress test where you assume the worst, although getting a sense of sensitivity realistically bad conditions is warranted.

    As far as government actions — once again, traditional banking, if you take a bank like the new WFC, IF significant action is needed, the only issue how much equity and debt gets wiped out and how far down the chain of command you want to fire management. They have 23 million customers (families) — thousands of branches, etc. The same is true with BAC’s traditional business. These are important issues, but most Americans won’t care for more then a week about the details of the fate of debt vs equity and whether they fire the top 10 people or the top 100. Most people don’t know or care that the GSE’s were taken over, management fired, etc. However, the unintended consequences of wiping out a lot of bank assets with the GSE takeover added to the overall bank problems.

    The investment banking part of the problem is much more difficult. However, my guess is that a determination of whether Citi and BAC will need significant more capital within a year under realistic economic scenarios will be attempted. I don’t think it will be a tough diagnosis. Citi has already proposed its own split into a quasi good bank/bad bank. If either of them will need significant more capital then they have to punish management, equity and a decent chunk of the debt.

    I don’t see how anything significant can be done with GS and MS. I also think that the capital markets stuff is inherently too hard to regulate via examination. Since the Treasury will be the only market for the next generation of asset backed securities, they can set the bar where ever they want, and can change things like required capital ratios, reign in the credit derivative market, etc.

  11. mmckinl

    We know the Wall Street banks are insolvent.

    Otherwise why have they pushed FASBy so hard on the valuation models for level 3 assets and their panic at putting their QSPEs on the balance sheets?

    FASBy reluctantly agreed to push back the drop dead date for QSPE balance sheet recognition to I believe September this tear from Jan 1. I believe the banks were hoping against hope that the economy would have turned around by September.

    The on-going battle between the Wall Street Banks and FSABy will be a telltale sign of where and how many bodies are buried.

  12. cap vandal

    As far as Lehman, consider this.

    “There has been widespread speculation that Lehman was contemplating a sale of Neuberger Berman, whose value is estimated by analysts to vary from less than $7 billion to as high as $13 billion “


    But then….

    “NEW YORK (AP) — A bankruptcy judge on Monday approved the sale of Lehman Brothers Holdings Inc.’s prized investment management unit to a group of managers and employees.
    The sale was worth $922 million to the Lehman bankruptcy estate, a Lehman lawyer said. It includes the Neuberger Berman money management business.”


    There is about $10 billion — although I don’t know what it was booked at.

    I also think they could have gotten their price a year earlier.

    They also had to essentially give away their Japanese and European units. The same ones they were trying to sell for billions pre BK.

  13. M.G.

    Lehman was forced into bankruptcy in September. Neuberger Berman was the last big asset to be sold off in the bankruptcy.

    That means that we have buyers for some assets of bad banks. So simply get them into bankruptcy procedures and start breaking up the largest banks and selling off individual operations to the public sector (non-state ownership). At the same time just set up the GOOD BANKS!

  14. fresno dan

    teach a man only to hammer, and everything needs hammering. What I get out of the article is Buiter’s thought of “regulatory capture.” That is, the idea of Geithner is that the most important thing to do to save the country is to save the banks. Japan II.

  15. Ginger Yellow

    I find it hard to disagree with what Black says, apart from that in certain asset classes such as CMBS, loan tapes will be much more available than he implies. But his comments raise the question of what the hell bank examiners are for, if they’re not remotely capable of assessing the risks a bank is taking on and if they’re making absurd ahistorical assumptions like standard distributions of returns.

    Charles: “for the stuff that is securitized, there is always a bond trustee that computes the waterfall.”

    Technically the calculation agents compute the waterfall, not the trustee, but often it’s the same small group of companies doing it (especially BoNY Mellon and DB Trust).

  16. John Galt

    I used to have a similar job to Mr. Black in the US, but was hired away into the private sector. I’d agree 100% with Mr. Black’s comments.

  17. Anonymous

    I really think everyone is expecting way too much from these stress tests. William Black is talking about performing a full examination of banks assets and quite rightly points out there is not a body equipped to perform that. This just confirms that accountants, ratings agencies, the SEC and the FED have not really been on the ball and internal audits achieved very little.

    I rather suspect what they will do is perform something similar to what the UK FSA is performing. Here they took the published balance sheets and applied the kind of losses incurred during the worst period in the 1990’s. This was good enough for Lloyds/HBOS in the UK to declare a further 12billion loss. I doubt whether this will do much about confidence because there will still be questions not least because things may be worse than during that period and a proper stress test will have to ensue once it becomes obvious this one did not go deep enough.

  18. Lune

    Allow one more non-bank examiner to critique Mr. Black’s explanations: while I don’t doubt the accuracy of his statements, I think he’s missing the forest for the trees.

    Mr. Black is assuming that Geithner’s call for “stress testing” banks is some sort of accounting / financial review. It’s not. It’s a political “stress testing” i.e. what labels do we attach to which firms to be able to justify and pass the policies and interventions that we (i.e. Geithner and Summers) wish to pass. This includes political decisions about which firms need saving and and which firms can be tossed (or fed to the favored lions), to political decisions about which sectors / products / asset classes of the financial industry need to be saved. This has nothing to do with economics or finance (except perhaps in the self-rationalizing minds of Geithner et al).

    The government is now so enmeshed in the financial sector that valuations of financial assets (e.g. bonds, stocks, etc.) are now based not on assessment of intrinsic economic value, but on the value that will be imputed by the government as it works its way through its trillion(s) dollar bailout schemes.

    And since Geithner et al already “know” what’s good for the industry, they merely need the appropriate studies to back them up when pesky congresspeople or (gasp) reporters have the temerity to ask them why they need the next trillion dollars to bail out the banks that were supposed to have been saved by TARP / TALF / TSLF / GSE bailout / BSC bailout / AIG bailout / Citi bailout.

    Your analogy to the Iraq War build-up is apt. Bush never needed a real weapons inspector (every “real” weapons inspector, including our own, was telling Bush there were no WMDs). He needed someone who could work the political process to produce the end result he desired. Sounds exactly like what Geithner is attempting to do now.

    If Geithner was attempting to really investigate the soundness of the banking sector, then Mr. Black is correct: the current staff is woefully inadequate. But Geithner doesn’t need such trifling data as the accurate balance sheets of the banks upon which he proposes to lavish a trillion dollars, nor the true nature of the financial instruments that are consuming those dollars faster than black holes swallow light. He already knows which banks he wishes to save, which financial products are “essential” for the economy, and which sectors need to be preserved at all cost.

    All he needs is someone willing to support his pre-ordained answers, and for that, overwhelmed and poorly skilled regulators are the perfect staff to have. While Bush and Rumsfeld had to create such a staff de novo within the Defense Dept to get away from the annoyingly competent and skilled analysts at the State Dept and the CIA, thanks to the War on Financial Regulation that has been waged since Reagan, Geithner has an embarrassment of riches within our current atrophied regulatory infrastructure from which to choose.

  19. Kafka

    Obfuscation, the Governments best friend, make something simple seem complicated and define everything in undefined terms such that nothing can be measured. It aint that hard, plenty have figured it out and made a fortune shorting these insolvent institutions just by reviewing their 10ks and looking for all the lies (which are all self evident). Americans love lying to themselves and continuously put the same people in charge who have purveyed and profited from their own failed polices.

  20. tracy

    “Yves, we have our best men on it..”

    Ah, yea, but who? I mean, I am the best…

    “Yves, the very best men on it…”

    Excuse me, who?….Mr Geitner…which men…? Mr Geitner?

  21. David

    I don’t know why you need to respond with “the experts know what they are doing. You don’t” type answer. Obviously they didn’t know what they were doing and that is partly why we are in this mess. Plenty of people like myself and yourself saw that things were a mess while regulators were asleep at the switch.

    I am not arguing with with either you or Black. I am saying that even back of the envelope calculations show that the banks are insolvent. You don’t need 1000 auditors to tell you that. If BAC wants to make the case that their mortgages are special then that will be their burden to prove. Otherwise, we should assume that they will suffer 10% losses on 10X leverage which wipe them out.

    Investors don’t get to look at the inside of banks. They need to make decisions from what they can see on the outside. That is how stock prices are set. That is also how Whelan comes up with his estimates. He doesn’t get to crawl through the loan book. He use public information. Obviously public information is not all the information but it is all you get and you need to make decisions on the information you have. Investors add a risk premium to make up for the uncertainty which in times lie these is quite significant.

  22. JP

    The stress tests will prove to be political theater. They will say out of all the banks we tested only one really needs to be difibrillated by the government, and all the other banks are right as rain. This will be a wimpy attempt to affirm confidence in the financial system. With so much hope in the markets, the wimpy attempt will work. Then, we will revisit how they stress tested when the latest deleveraging downleg hits, and more banks will finally acknowledge this isn’t about our common equity shareholders, this is about our debt bond stakeholders.

  23. patrick

    So what’s the end result likely to be? Insolvent zombie mega banks with fictional/fraudulent accounting reports.

    That’s not sustainable without continuous injections of vast sums of taxpayers money. And there is a limit to what Geithner can get from Congress.

    Once the bailout funds stop flowing, the banks will implode. When they implode, the financial system will seize up again like it did when Lehman failed, only much much worse.

    Good times.

  24. Anonymous

    To date it looks like Geithner will be ‘the guy’ who drags down the Obama administration right from the opening gun.

  25. Stephen

    Your analogy to WMD is appropriate. Things are hidden, suspected to exist and there is likely a scheme to hide true purpose.

    The pool of experts is small. I would suggest that the regulator draw resources from a friendly country that has a stable system to assist in the review. Think Spain, think Canada…not sure about Australia’s status for the moment.

    It is a real problem, the core of it. The sooner the size of the problem is known then everyone can figure out the speed with which the writedowns can take place. My biggest fear is the Banks hang on to these things hoping to “gow out of them”

  26. Anonymous

    Yves, you rock!

    For those who think that this is matter of just starting “with the simple stuff”, like “mortgage loans”, you need to start here with the “lost or destroyed” notes.

    The below is an excerpt from one of Naked Capitalism’s, “Links 2/17/09”, entitled, “Legitimate Issues: Where is the Note?” Read it for a good look and feel for the tip of the corruption iceberg, and especially to gain a feel for the intentional fueling of the energy dissipating perpetual conflict fire …


    “Unfortunately, unless you represent borrowers, the vast flow of notes into the maw of the securitization industry meant that a lot of mistakes were made. When the borrower defaults, the party seeking to enforce the obligation and foreclose on the underlying collateral sometimes cannot find the note. A lawyer sophisticated in this area has speculated to one of the authors that perhaps a third of the notes “securitized” have been lost or destroyed. The cases we are going to look at reflect the stark fact that the unnamed source’s speculation may be well-founded.

    UCC SECTION 3-309

    If the issue were as simple as a missing note, UCC §3-309 would provide a simple solution. A person entitled to enforce an instrument which has been lost, destroyed or stolen may enforce the instrument. If the court is concerned that some third party may show up and attempt to enforce the instrument against the payee, it may order adequate protection. But, and however, a person seeking to enforce a missing instrument must be a person entitled to enforce the instrument, and that person must prove the instrument’s terms and that person’s right to enforce the instrument. §3-309 (a)(1) & (b).


    Enforcement of a note always requires that the person seeking to collect show that it is the holder. A holder is an entity that has acquired the note either as the original payor or transfer by endorsement of order paper or physical possession of bearer paper. These requirements are set out in Article 3 of the Uniform Commercial Code, which has been adopted in every state, including Louisiana, and in the District of Columbia. Even in bankruptcy proceedings, State substantive law controls the rights of note and lien holders, as the Supreme Court pointed out almost forty (40) years ago in United States v. Butner, 440 U.S. 48, 54-55 (1979).

    However, as Judge Bufford has recently illustrated, in one of the cases discussed below, in the bankruptcy and other federal courts, procedure is governed by the Federal Rules of Bankruptcy and Civil Procedure. And, procedure may just have an impact on the issue of “who,” because, if the holder is unknown, pleading and standing issues arise.”


    We need to pop the gullibility bubble. The ‘rule of law’ is a corrupt scam that needs a reset.

    Deception is the strongest political force on the planet.

    i on the ball patriot

  27. Anonymous

    There are plenty of people who can do this work: every poor sap who got fired for talking sense at the peak the boom. 60K + Revenge is a dream package.

  28. Independent Accountant

    These stress tests are nonsense. Where were the Big 87654 firms which supposedly audited these megabanks? What were they paid for? Among other things, CPAs should look at underlying loan documentation in the course of an audit. Could Geithner’s goofballs find anything? Suppose they did? It would call into question the entire rationale for: audits, the SEC and the OCC. I expect nothing of substance to come from this.

  29. Donlast

    Many here bemoan Washington seeming incapacity to deal with the bank bailout. But what of the general public? Yves CNN interview illustrates the problem: how easily the public can be led by the nose. The CNN interviewer showed a disdain for Yves views that made me grind my teeth. Her abrupt…Well this is the plan, and Geithner is the Treasury Secretary..he’s got a tough job and I am glad I’m not Treasury Sec as I am sure you are too. Bottom line: who are you to say his plan is a fiasco.

  30. Anonymous

    You gotta start somewhere after years of neglect, so it doesn’t surprise me that initially the effort falls short of what’s needed. I think more important is watching how far this administration goes in building up regulatory muscle. There’s certainly a big pool of unemployed ex-financial wizards to tap into.

  31. Anonymous

    Have Paulson’s rights to be above the law and all that -and no investigating into his activities that just incidentally includes the entire banking system, been transferred through Treasury to Geithner and the new administration?

    Do citizens have any rights in all this?

    Apparently securitized mortgage holders now have no legal standing?

    Otherwise, mortgagees could simply demand note holders show up in court with the paper or default.


    Obviously I’m not a lawyer. Maybe this is something I should ask in an email.


  32. Anonymous

    I don’t think the people venting on this here and elsewhere have any idea of the opacity of financial instruments born in the bowels of computers and based on faulty assumptions that mistake uncertainty for risk. Suppose one finds a risk spread modeled on a standard gaussian distribution of outcomes. What exactly does one do to “stress test” this model? Fatten the tails? By how much? On what basis? It’s one thing to model molecules banging around in a glass bottle and quite another to model risk for a rancid soup of grubby human greed. The complicated truth is that there is no modeling for reflexive systems as George Soros has been saying for years. As soon as the members of the system become aware of the model they attempt to game the outcome for personal gain. This changes the behaviour of the system and the model breaks. It’s a problem of recursion that isn’t fixable.

    I understand that some of you all are suggesting that some attempt to analyze the mess is better than none at all. I disagree. This is a Potemkin Village solution which has only one purpose – to give the appearance of action when the outcome has been predetermined. A kangaroo court where the culprits will be found not guilty.

    We need Obama to grow a pair of organs Harry Truman had in spades and drop a neutron bomb on Wall Street banks. With Tiny Tim(id) and Bankie Ben the chances of this happening are slim to none.

  33. early withdrawal

    yet another excellent detailed article. as others have observed this is all theater. there is no possible way a reasonable audit can be done in a timely way off all the major institutions simultaneously. besides this govt is running on no credit, they have yet to make the right move so there is no rreason to trust them. which is why i find krugman’s repeated wishfull thinking so damn exhuasting. id love to get that guy to play some three card monty on broadway, would clean him out fast.

  34. Anonymous

    early withdrawl @ 11:23 AM:

    which is why i find krugman’s repeated wishfull thinking so damn exhuasting. id love to get that guy to play some three card monty on broadway, would clean him out fast.


    Krugman is part of the plutocratic machine, as much as the rest. His role is that of apologist or rationalizer or let’s-wait-and-see hopemonger, but in the end he’s culpable.

    Every time I read Krugman, I think to myself “10 million SEK buys a lot of complicitness.”

    (10,000,000 SEK = $1,187,584.08 USD at today’s rates)

    – StewPDX

  35. Markel

    Yves, you may have noted that CR thinks that Geithner expects the banks to perform their own stress tests using parameters set by the government. If this is the case, the concerns about fraud make things even more dicey.

  36. Yes I Can Find Trouble

    In a different (nonmortgage) context, I have found billions of dollars in errors. Once in a while they were deliberate, but mostly they were sloppy work by people who didn’t really understand the rules, or who were overworked. The funny thing is I located all of them from publicly available data.

    After you’ve been through enough of any particular type of report, you can find problems pretty quickly.

    I encourage Mr Geithner to use data which is already public or already in the possession of regulators. Start by asking regulators and former industry people about red flags and areas where a decent chunk of people screw up materially. Then pursue those indicators.

    Stress tests are much different than detecting fraud. Stress tests are good if you think you have roughly comparable quality data from multiple entities.

    Many types of fraud can be spotted without looking at the overall financial condition of an entity. If someone deliberately told shareholders the wrong default rate for a portfolio, or made up a nutty way of calculating it, put the cuffs on them and make an example of them.

    The message should be clear. The fastest way to jail and receivership is fraudulent reporting.

  37. Anonymous

    The models, especially for Level 3 assets, should be tested, not just the data going into them. All these entities including investment banks have a model review functions that evaluate the models. In turn, this model review activity is examined by the institution’s primary regulator.

    At a minimum, the investigators should read and understand those model reviews, because these may identify weaknesses. One persistent question should be whether the effects of credit contagion are being adequately accounted for, or accounted for at all.

  38. Martin

    As to the possibility of the U.S. government setting the parameters for the stress test: over here (the Netherlands) the central bank, in its capacity of pension funds regulator, has a thing called the “FTK event”. (FTK is shorthand for something like “financial regulatory framework”.) Is works like this: assume that all your equities drop by x%, assume the yield curve that is relevant to your fixed income portfolio rises by y basis points, assume that all non-euro currencies drop by z%. What will be the drop in the value of your portfolio? Needless to say, there has been a lot of bickering about those parameters, and every now and the DNB does tweak them. I understand it works fairly well, but -and that is where I have reservations about across-the-board parameters- I fear this only works for fairly plain-vanilla assets. Whether this helps to get a grip on really slippery stuff… And, of course, it requires common sense, and the ability to smell when somebody is beating around the bush. I wish the ladies and gentlemen who have to do this stress testing all the best of luck. They will need it.

  39. Anonymous

    YS Said:

    And Black points out, you HAVE to check against the underlying documentation. The process otherwise is a garbage-in, garbage out exercise. And that chart you pointed to does not pass muster as an analysis.

    Actually, you don’t need this information. A sufficienly large sample will provide plenty of information for a rudimentary ‘Stress Test’. Moreover, don’t make the securitzation process sound so exotic. Once you understand the process, building a model to provide a ‘non-robust’ valuation is simple. The Treasury is not looking to slice these things down to the last basis point, simply err to the downside.

    And, I worked on a desk for many years. We all knew these things were a joke by 2006…yes, a PONZI scheme well bigger than anything Madoff could muster. By 2007, three month defualts were 12 deviations higher than predicted. To get left holding the bag when the music stopped shows senior management should be fired forthwith. Everyone on the desk knew….EVERYONE.

  40. Anonymous

    I’m very cynical about this process too but I do think we need to try to get some harder information about how badly off individual banks are before shoveling a few more hundred billion in their general direction. How do you do that? Ideas?

    I think an audit, even if fast and dirty because of the complexity of these damn products, might give you some decent insight, even if it’s say 20, 30 percent off (anyway you cut it, there’s going to be a lot of educated guesswork going into estimates of the securities anyway).

    Also can’t they have the CFO and top company officials sign off on the audit, saying that they verify the information they have provided is correct and if not, are subject to imprisonment or some such language? Put some teeth in it.

    Right now our financial system is in a very very bad way. We need to get some hard intelligence on how badly off individual banks are, and some appreciation of what their asset books look like (what kind of assets, how interlinked are banks, etc.).

    If this so-called stress testing pursues this goal honestly and is not a political fig leaf, I think it’s worthwhile.

  41. Anonymous

    There is just one thing about the “stress testing” plan that I do not understand. What happens if one (or more) of these entities fails the test?
    These banks were judged, in August 2008, as being “too big to fail”. Since then they have all become “larger” – not in a financial sense but in terms of their liabilities. So, are they capable of failing now? If yes, why? If no, what happens to them? I concede that the process of testing them would be very convoluted and time-consuming but to what end if there is no penalty for failure?
    A strategic aim of the banks could be to ensure that the process does take a very long time indeed allowing them to a) attempt to repair their balance sheets and b) milk more bail-out funds from the Treasury. This is a process that could, with active complicity of their allies at Treasury, the Fed and Congress; be kept going until a) they do pass the “stress test” (what a laughable name for an insolvency test) or b) Treasury can sell no more bonds to gullible foreigners to finance this Ponzi operation.

  42. Anonymous

    Yves, while your concern is–no question– valid, I think that there is a difference between what Geithner is proposing to do and a normal audit as, say, with Enron.

    First, the government has a very, very big stick. If companies are not honest, the government can withhold additional money or even withdraw funds already given. Prosecution for fraud would be a certainty. In other words, in a normal fraud, the incentive is to delay discovery until the losses can be recovered or the perpetrator can sneak off the stage. Assuming that the corporation can survive, the employees have an incentive to protect management.

    But here, if the corporation can survive without government money, it has no incentive to lie. If it can’t survive without government money, then the incentive for employees is to come clean about past accounting practices, at least in a limited hangout kind of way. Management…well… I don’t think the management of the investment banks is as self-deluded as Lay and Skilling.

    So, it’s true as you and Mr. Black say that if there is fraud, it requires talented and adequate staff to uncover it. But in this case, the incentives are so different than they were in Enron that even limited staff may serve.

    Yes, I’d prefer to have lots of staff looking at it.

    –Charles of MercuryRising

  43. Yves Smith


    With all due respect, your assumptions are incorrect.

    The government has not withheld funds from any player deemed systemically important. Look at AIG, which not only got additional funds in massive amounts, but got an improvement in terms too.

    The government acts as if it has no negotiating leverage, and after Lehman, it is simply not willing to let one go. You know the saying, if you owe the bank $10,000, it owns you, but if you owe it $100 million, you own it. Same principle.

    In addition, there is not willingness to investigate fraud. As we noted in the post, there was no investigation of Lehman, which looks to be a prima facie case. They do not want the embarrassment of exposing how deficient their procedures are, and exposing that other players might also be frauds, which would do wonders for stock and bond prices.

  44. Anonymous

    Charles, Enron isn’t a comparable. It failed first, was investigated later. Only whistle-blower of sorts. Sherron Watkins, did not go outside company, just raised issues internally. That example actually supports Black’s point, the frauds go undetected even when massive.

  45. Waldo

    "Your analogy to WMD is appropriate. Things are hidden, suspected to exist and there is likely a scheme to hide true purpose"

    This means a "plan" regarding WMD to serve a higher purpose ($).

    The financial obfuscation is the thick outer layer of the onion. The core of the onion is now a darkish brown (cancer) and must be remedied for long term health. That darkness is the oil thugs and their tremendous heist (oil and gas prices). WMD stuff involved our Executive branch, our Treasury wealth, and our military. Think about it.

    Enron, Stanford Financial ($8 billion fraud uncovered by SEC today), Bush I & II are all Houston born and bred.

    This fraud and felony misconduct has reach the institution of the President of the United States. There must be justice. Think.

  46. Anonymous

    Good grief, does anyone on the left know what’s going on in their own party?

    Geithner is a figurehead…HE HAS NO POWER.

    All of this was the work of Summers, and to a degree, Axelrod. And it has proven to be a terrible idea.

    The polls are sinking on the stimulus, because folks with retirement accounts are watching the market go up in smoke…And what are we doing? We’re dropping billions more into GM and Chryler when everyone can plainly see the writing on the wall. Is it any wonder why traders are SELL, SELL, SELLING?

    What is most amusing in all of this is that the fool Republicans handed all of this to the left…and you guys are about to give it right back.

    I really hope the pay out was worth it, because you may very well not get another chance to run things for a while…or at least until the Republicans screw things up again.

  47. Anonymous

    left … right … Republicans … Democrats … Duh!

    Scamerican terms meant to divide – and dissipate the energies of – the gullible in a perpetual conflict.

    Wake up and smell the deception – the strongest political force on the planet.

  48. Juan

    fresno dan: That is, the idea of Geithner is that the most important thing to do to save the country is to save the banks.

    i agree, but would expand it to say a ruling class captured by financial ‘interests’ likely believes that ‘saving the banks’ is the only way to save capitalism, or at least save the form of capitalism which that class’s real bosses personify.

    somewhat contrary to this though is the whole notion of industrial development centered around ‘green’ technologies, which is really no more than to (again) resurrect the later 1960s-earlier 1970s idea of a corporatist/’post-fordist’ ‘social-industrial complex’. … during that earlier period this idea carried sufficient weight to result in nixon’s white house conference on the industrial world ahead but in most respects faded away under the pressures of too low an avg rate of profit, shift to ‘market knows best’ ‘solution’ and rise of financial capital during the 1970s-earlier 1980s.
    so, neo-lib financialization became the debt financed, progressively more fraudulent, post-fordist structure of accumulation, which, crisis by crisis, bubble by bubble, has been akin to a giant, mostly subterranean, bankruptcy proceeding.

  49. Anonymous

    The government acts as if it has no negotiating leverage, and after Lehman, it is simply not willing to let one go.

    As a taxpayer, I would have loved Treasury to have gotten more favorable terms than what Buffet got. Certainly I think it could have hardballed for them.

    However (and perhaps overly graciously on my part), perhaps Treasury felt it couldn’t completely maximize the upside on the fear that no investor would ever come back to invest in these companies.

  50. dedstam

    It is difficult to meaningfully discuss a “stress test” without defining the details and standards. Failing a stress test is not the same as fraud. The standards of GAAP accounting are not the standards of a stress test. Recall the several years of efforts by the SEC to force banks to reverse loss reserves. If the standard for determining those reserves was the stress of an economic meltdown then the SEC would have never prevailed. It is almost by definition that no bank meeting the standards of GAAP would be able to meet a “severe” stress test scenario even in the best of times.

    Another clarification on the nature of a stress test is that it is not a statistical concept. It is arbitrary and worst case and not expected to occur. It is not a business case that reflects the historical data used to construct statistical distributions used in Risk Management. A stress test is not tail risk. It is the knowable unknowable.

    The “stress test” proposal is an effort by the administration to buy time. Treasury has an idea of the size of funding that is needed but it is not specific enough for the political side, who along with O’Bama have probably choked on the number. The fiction of attracting private capital is what has been latched onto as the way out. A possibility until Dodd’s pay legislation raised the specter that the government will not honor contracts and has a special interest in confiscating private returns after the fact (the reason the administration tried to stop Dodd”s action).

    A stress test that focuses on cash flows is not that hard to do. The models all exist. Nobody has told the analysts to run them under stress assumptions. It is computational grunt work not rocket science.

  51. foesskewered


    It requires total independence.

    there isn’t anything remotely resembling that in the modern business or accounting owrld; no sensible audit and accounting firm wants to upset their existing clients or potential clients, particularly when the clients try to run a revolving door policy re audit firms (the big 4) used.

    not to mention the fact that some very senior accounting/audit execs tend to move on to their former clients as consultants when they leave the audit firm.

    as for Japan; you did hear about the resignation of one minister “drunk” oops, sorry, knocked out (pretty much) by cold medicine and wine(now , where have we heard them). Let’s just say this, the most rigorous of hiring practices and the dangling of a very fat carrot does not preclude peter’s principle and the hiring of idiots, albeit well-connected ones.

    as for stress testing CDOs and CDS and the derivatives gang, is it even possible? The basis for their existence and operation is questiobale right now, can you really test something that is , in effect, not quite in meaningful financial existence?

  52. john bougearel


    Thank you once again,

    Lune and others are right to point out this is political stress-testing, obfuscation, grand-standing “to give the appearance of action when the outcome has been predetermined” as one anonymous points out, and another “wimpy attempt to affirm confidence in the financial system” as put by JP.

    Now, the circus on Capitol Hill is so cringing, it is time for us to just scream “ENOUGH!” We probably need to lead a march into Washington with pitchforks in hand, set up Obamavilles throughout the beltway and if we have to, take over the gov’t, since they are incapable of action beyond obfuscation.

  53. Anonymous

    Yves, I can’t argue with your examples of AIG as improper leniency. However, to be fair, that did occur under the previous administration. Roubini and Richardson’s article in the WSJ today makes it clear they believe that there will be meaningful stress testing and that genuinely insolvent institutions will be exposed.

    So do I.

    Charles of MercuryRising


    There appears to be $30 TRILLION still outstanding in CDS’s which virtually assures a systemic meltdown if the colluding institutions of the Western Banks and the Western Governemnts cease colluding. You guys would feel far better about the future if, like me, you converted to radical socialism. In fact, the worse things get day by day, the better i feel and isn’t that the nut of the problem, how people feel about the future that guides their economic choices?

  55. Lorenzo

    So, we do we start seeing auditors going to gaol? The folk who signed off on “true and accurate records”.

  56. Anonymous

    If only its was 30 trillion.
    BIS December report (page A103) has outstanding CDS’s @ 57 trillion and “Unallocated” (where the MBS and credit card rubbish lives) @nearly 82 trillion. Some runs on volantary (single party) CDS “write-offs” identified 1.1 tillion in both the US and Europe. So atotal of $138 trillion left.
    Say all that is worth 90 cents in the dollar (a wildy optimistic hope, I agree, but..) well that’s only 14 trillion in uncovered debt or 14 months of the last year’s US GDP.
    Another interesting number is the US’s domestic debt securities @ $25.1 trillion – up $3trillion in 2 years! obw $5.5 trillion of this debt matures in 1 year. Tic toc – mazel’tov!

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