Bank Stress Tests Now Officially a Garbage In, Garbage Out Exercise

We’ve had plenty of company in voicing doubts about the Treasury’s so-called stress tests of the 19 biggest banks. To quickly recap the main issues:

The bank will run the tests themselves, using the same risk models that caused the mess. With only ten examiners on average per bank, and most of the banks having very diverse businesses (mortgages, complex structured credits, credit cards, consumer loans, commercial real estate, large corporate loans, small business lending, foreign operations, credit default swaps, other derivatives exposures, foreign lending and FX exposures), their ability to probe the results, from a skill and manpower basis, is dubious, particularly in the capital markets exposures

For the simpler products, there will be no verification of the loans versus the underlying files.

The so called “adverse” scenario, at the time the tests were announced, was far more optimistic than the typical trajectory of a financial crisis. As the IMF noted in its newly released economic outlook, the current mess is likely to prove worse, due to it being an international, synchronized credit crisis (past outbreaks have been at worst regional).

As the economy has only deteriorated since the tests were announced, even more optimistic mainstream economists are coming to the view that the supposed downside case is likely to approximate the middle of the road case, meaning the “stress” in the tests is insufficient.

The Administration has acknowledged this problem with one of its typically Orwellian responses, by saying it will interpret the results more harshly. But how can anyone do that in a realistic way given the inadequate knowledge of the operations, resulting from sending in only enough examiners to have pleasant conversations over tea about the numbers as they came out? Without digging into operational level data and seeing how it is adjusted to produce bank wide results, any understanding is woefully superficial. Even among the big banks, you can’t apply the same sort of adjustment to a largely retail bank like Wells versus a bank with incredible product and geographic diversity like Citi. or ones with very substantial trading operations and complex derivatives exposures (JP Morgan, Goldman, Morgan Stanley, as well as Ciit). Pray tell, how do they decide what adjustment to make to banks with very distinct business profiles? And even for ones with largely similar profiles (Goldman and Morgan Stanley), there are very important differences between.

Answer: they haven’t done the spadework to make these subjective adjustments. So the whole exercise, which was dubious from the start, is now patently a PR stunt, with the Treasury also having indicated that it wants to have the exercise be seen as having teeth. That means the Treasury has decided on a forced curve, that on their relative ranking, the somones on the bottom will need to raise more equity (either from the public or failing that, the TARP).

The one thing that may change (we stress may, to paraphrase T.S. Eliot, this Administration cannot take very much reality), is that the line on the relative ranking of who is deemed to need more equity or not may be pushed higher. That’s the noise being made to reassure the great unwashed public. But whether there is any real difference in outcome is unknowable. All that is certain is a show will be made as to how the process was toughened up.

A relative ranking is a “price of everything, value of nothing” process, definitive yet singularly unhelpful. An absolute measure, of who needs dough and who doesn’t, is vital. In fact, we have said repeatedly that that should have been the Treasury’s and SEC’s top priority after Bear failed. But the procedures were never in place to do that adequately.

From the Financial Times:

Rising unemployment is prompting US authorities to consider taking a tougher stance in judging the results of bank stress tests…

When the stress tests were revealed two months ago, the authorities defined the adverse scenario as one in which unemployment rose gradually to peak at 10.4 per cent in late 2010.

But, since the announcement was made, unemployment has risen much more quickly than was expected, even under the “adverse scenario”…

The authorities believe it is too late to revisit the assumptions underpinning the stress tests. However, it is not too late for them to decide to interpret the implications for capital more stringently. The Treasury declined to comment.

Making such an adjustment would help arguments against claims by critics such as Nouriel Roubini, chairman of RGE Monitor, who wrote on his blog: “The stress test results are meaningless as actual data are already running worse than the worst case scenario.”

The authorities have not yet made a final decision on changing the way the tests will be interpreted. Even if officials do lean in this direction, it may never be visible because they did not specify in advance any precise formula relating stress test outcomes to required bank capital. Moreover, signs of economic recovery could persuade policymakers to disregard the rapid recent rise in unemployment on the grounds that it might revert to the less alarming trajectory they originally expected.

Policymakers also believe that other assumptions in the test still reflect a worse-than-expected outcome.

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  1. Russ

    Unfortunately all of these are reality-based criticisms.

    But as Yves pointed out from the start, the stress tests were never meant to reflect reality, but were rather a Rove-style marketing campaign, and were only supposed to function according to that fabricated alternative reality.

    It seems that here and in the aptly called “potemkin profits” of the previous post we have two examples of what looks more and more like a coordinated marketing blitz, more or less coordinated by the administration and FIRE sector, with the tacit support of the MSM, to represent the economy as looking up.

    I don’t know to what extent they really believe this, to what extent they hope perception can generate new reality, or to what extent it’s simply an attempt to gain more political time for the looting operation.

    At any rate, it looks alot like the runup to war in 2002.

  2. Richard Kline

    The stress test is a shining example of political theater with an untrained assistant thrust into the director’s seat. The banks needed more money pronto in January; the public hated it, and Congress said “Ahh-um.” Some kind of test had to be devised, but is was predetermined by Summers and Geitner that no friend of theirs could be found defective. So real, honest-to-gods bank examinations were out. Henceforth, a theatrical exercise was announced, a ‘test.’ With no details, and farcically few staff. Well, that didn’t go over well. So the tests had to actually be held, but we were then told that the banks would do them and the government would send lackeys to the podium to announce the results. Well that didn’t go well. So we were told that the testers would acutally, y’know, look over the shoulders of the banks as this was done so that, y’know no funny business was performed, and that the tests would be ‘tough;’ so tough that the results wouldn’t be announced, as a matter of “fairness.” Well, _that_ didn’t go over well. So we are now told that ‘some’ results will be announced, and that ‘some banks’ might be found deficient and gently urged to make their numbers look better by any means necessary. Does anyone thinkg that THAT is going to go over well?

    Spot the trend here, m’friends? The Bo Prez Administration has been to this point marginally slicker than the one it replaced but there is no excess of evidence that it is any more competent. And that is sad, given the exceedingly low level of competence of The Last Guy and his self-important motley. The only things being tested by stress here are the credibility of the Obama Administration and the patience of the public. No wait, the former has already collapsed structurally at its base; it just hasn’t toppled over yet.

  3. Independent Accountant

    I agree. The stress tests were just a propaganda ploy. I never took them seriously.

  4. VG Chicago

    I was wondering what others thought about my yesterday’s post, where I suggested that once/if hyperinflation hits Dollarland, banks would return to the government, hat-in-hand, for new handouts, this time to prop up their rapidly devaluing mortgages and other loans.

    Now that we finally managed to get the banksters addicted to taxpayer (a.k.a. chump) money, does anybody see this as a possibility?

    Curious what others thought about this scenario.

    Vinny GOLDberg

  5. DownSouth

    There’s a very insightful lecture by Beatrice Golomb, Associate Professor of Medicine at UC San Diego, about a similar phenomenon, and that is how the medical academy and the medical publishing industry have become totally captive to the big drug companies:

    This is really scary stuff, and goes to show how big business has infiltrated and corrupted practically every aspect of our lives.

    The question that keeps haunting me is: “Are we already beyond the point of no return?”

    To try to help answer that question, I began reading Reinhold Niebuhr’s Moral Man & Immoral Society last night, first published in 1932. This from the introduction:

    Complete rational objectivity in a social situation is impossible… Since reason is always, to some degree, the servant of interest in a social situation, social injustice cannot be resolved by moral and rational suasion alone, as the education and social scientist usually believes. Conflict is ineviable, and in this confict power must be challenged by power. That fact is not recognized by most of the educators, and only very grudgingly admitted by most of the social scientists…

    They do not recognize that when collective power, whether in the form of imperialism or class domination, exploits weakness, it can never be dislodged unless power is raised against it.We have now reached a point where many, if not most, of those in the scientific, medical and economics professions have become compromised by interest and/or passion. Granted, there are still a handful of “candles in the dark” like Golomb (and I would also add Yves to this category) who are not afraid to speak truth to power. But are there enough? And in the end, will truth prevail, or propaganda?

  6. calmo

    A PR stunt to be sure, but which segment of the public? Clearly, not those that are dismissing it out of hand as an empty PR stunt. Is it for the nervous nellies that need to be reassured that the regulators are now regulating and that things will return to normal May 4…end of May at the latest…absolutely end of summer once all the smoke has cleared?

    PR is all the ammunition these people have…wasn’t that the 60 Min message?

    So the Great Consolidation has been indefinitely postponed while we witness another episode of ‘united we stand, divided we fall’.

  7. Anonymous Jones

    Niebuhr’s comment is appropriate here and in most every other aspect of human relations. It’s almost all about power dynamics. What sort of world do other people inhabit, I wonder? A world where those in power voluntarily cede it to help *you* out? I don’t think so.

    I felt like a lone man on the tracks this last decade, trying to tell the oncoming train to slow down. It’s mostly too late now. If you allow this kind of concentration of power, it’s almost impossible to counteract it until it simply consumes itself. It’s now a runaway train, and we just have to brace for impact. Resistance is futile.

  8. Don

    “Will applications filed by QFIs or the names of applying QFIs be released publicly?
    No. Treasury will not release the names of QFIs who apply for the CAP or those which
    are not approved. Treasury will publish electronic reports detailing any completed
    transactions, including the name of the QFI and the amount of the investment, as required
    by the Emergency Economic Stabilization Act of 2008, within 48 hours of the


    “What if a QFI needs capital in excess of the investment limit referred to above?
    An institution that needs capital in excess of the investment limit referred to above is
    deemed as needing “exceptional assistance.” In consultation with the appropriate Federal
    banking agency, Treasury will determine whether an institution qualifies for “exceptional
    assistance” on a case-by-case basis.
    What will be the terms of transactions involving QFIs in need of exceptional
    QFIs falling under the “exceptional assistance” standard may have bank-specific
    negotiated agreements with the Treasury Department.”

    That’s from CAP. In other words, the whole point was to assure that these banks would be carefully examined for problems, and then made whole or solvent. What we were supposed to hear in public was the amount of assistance, which could vary with the size and particular needs of each bank. The program was meant to instill confidence by assuring the necessary backing for solvency.

    Now, just looking at the program as presented, it’s asinine to announce who’s in what shape. That would negate the point of issuing the blanket guarantee of solvency.

    What’s happened is that popular perception has latched onto the idea of “stress tests” being a test for who gets seized or something like that. But, think about it: Even if the govt was going to do that, they wouldn’t tell us beforehand.

    The program was meant to erase a stigma, not produce one. For one thing, we own a lot of Citi, which is trying to sell its assets. It will hardly make selling those assets easier if we announce exactly what they’re getting and why.

    Now, if you don’t want the govt to help these banks, I can understand pissing on this arrangement. But if you do, why would you want to make the banks less able to do business than more?

    Finally, unless we seize the banks in an FDIC sort of way, we are going to be left with a hybrid. In other words, if we simply own stock and have someone manage the bank for us until we sell it, that will still be a hybrid plan because the bank will be a private company with certain fiduciary responsibilities to all its shareholders. It’s probably a better idea than CAP, but it has lots of risks, such as:
    1) It’s one thing for a private company to default, another for a govt to default. If we own it, foreign investors and countries expect us to guarantee it. That’s why it could lose us a lot of money. We could just screw them, but that will have negative consequences.
    2) We will involve ourselves in foreign politics. For example, we needed a retroactive govt law from Mexico to be able to take more than a 10% stake in Citi. That was popular with some people, while not for others. As well, selling Banamex could have currency issues. All of Citi’s foreign holdings will involve a similar problem.
    3) All other hybrid problems, like conflict of interest, will remain. After all, Geithner is not even from Wall Street, and he’s being accused of collusion.

    It is true that we can announce every detail of these tests, and that might be what happens. But it could well end up costing us a lot more money if the market and potential investors or buyers hold out for more money. I thought that we were trying to save money.

    I’m no fan of this plan, but I’m also not a fan of us shooting ourselves in the foot over and over again. We’re in a damnable mess, and there’s no clean or easy way out. We’ve lots of bad choices to choose from. That’s it.

    Don the libertarian Democrat

  9. Yves Smith


    My schedule today forces me to be brief, I may return to this later.

    The issue, as Richard Kline pointed out, is turning this into a PR exercise is what caused the mess.

    Regulators do intrusive inspections all the time. They are not media events, in fact the reverse. I keep invoking the 160 bank examiners that were investigating Citi’s US commercial RE portfolio (Southwest only) as the linchpin to its solvency. That never hit the media, and my impression was it wasn’t known in the investment community either. I heard it from some very well connected in RE who knew senior people at Citi.

    The way to have done this was immediately post Bear, to have had SEC and Treasury go in in a pretty serious was to all the big IBs and bank capital markets player, so Lehman, Merrill, Goldman, Morgan Stanley, JP Morgan, and Citi. Give that you had some perceived to be healthy names on the list, the inspections (to the extent word got out) would not cast a stigma. And if anyone asked, the answer would be, “We do examinations all the time, we want to make sure our information is current, and the results are confidential.”

  10. kackermann

    Harsh interpretation… good for them!

    One of my daughters came home with a B in pre-calculus, and a B in physics.

    I lit into her and said, “why can’t you be more like your sister? She got an A+ in all her special education classes!”

  11. Waldo

    Yves I have a question for you:

    Do you think this year there will be another large injection of capital into these colossal banks by the Fed and or Treasury?

    If so what $ amount do you estimate will be shelled out by the American taxpayers in aggregate before these banks are made whole?

    I have a $ in mind and if your estimate exceeds it I think Obama will change strategies regarding this financial mess (he won’t just facilitate financial haircuts but a bloody scalping for all the American bond holders and foreign bond holders of these toxic assets).

    Thank you for your insights.

  12. Doc Holiday

    Also see: Bank Regulators Clash Over Endgame of U.S. Bank Stress Tests

    Geithner has said he crafted the stress test program in an effort to provide more transparency about the health of banks’ balance sheets. He and Fed Chairman Ben S. Bernanke have also noted that most of the 19 banks are currently well capitalized and that not all of them would need new capital.

    "What we will see is high-level capital ratios that show each bank is a viable institution at current conditions," said Jeffrey Hare, a partner at Alston & Bird LLP in Washington. "Bank regulators don't want to show something that could be misunderstood and create undue panic to the system."

    The Fed and other regulators are expected to publish a paper on their methodologies for the stress test on April 24, according to a banking source…

    >> Methodologies, as in a new improved model — not unlike or to be confused with the models and methodologies used by all the rating agencies and Fannie, Freddie, AIG, Lehman, et al, and Timmy & Ben …

    Please Lord, grant us the power to use lasers on these models and make them vanish before they are seen, because we know in our hearts that this shit is just connected to pathetic and retarded lies which will serve the interests of only crooked bastards.


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