New Stress Trial Balloon Floated

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I am coming to realize there might be method in the seeming madness of changing dates and shifting sneak previews via favored members of the press as to what the stress tests might entail.

Tire out the critics, numb the casual followers, and leave the boosters in firm control of share of mind.

Let’s face it, the fact that the authorities are allowing banks to negotiate the findings is a very very bad sign. It says either they don’t trust the results themselves, or they lack the guts to act like they are in charge. But regulators are always in charge (well until fifteen plus years of criticism in the media and Congressional budget cuts left them undernourished and fearful). And now they also have the power of the purse on their side too. BreakingViews had a few choice words:

…the behind-the-scenes tug of war between banks and the government over the results of their recent stress tests strains the already tenuous credibility of the exercise. It also shows that banks have become too powerful….

So it’s curious that regulators have put so much stock in the tests they announced in February…

But like the banks’ earlier and insufficiently stressful stress tests, the government’s worst-case outlooks aren’t all that far-fetched. They also use banks’ own estimates, meaning unscrupulous managers could tweak them to get a better grade. And bankers say they’ll produce very little information that regulators don’t already have.

Because of this, bank risk managers (not the most credible group these days) tend to view these tests as a public relations stunt that regulators will use to force their institutions to toe Uncle Sam’s line. That, in itself, is worrying. Regulators shouldn’t have to invent justifications for regulating properly. The right response by a bank when its overseer says jump is, “How high?”

There is another way the stress tests fall short. As was revealed earlier, the tests are focusing on bank loan exposures. Ahem. The real risk to the system is not in not-too-difficult to value (and sell) loans, but in the complex dreck and derivatives exposures at the big capital markets players, namely Citi and Bank of America. Even if a bank as big as Wells Fargo, a very big bank but in traditional retail and wholesale businesses, were to prove terminally impaired, it might be costly to resolve, but procedurally it would not be pathbreaking.

It’s the capital markets firms that pose the real systemic risk. The powers that be still have yet to develop procedures for an orderly resolution. The reason being that their large trading books depend on ongoing credit from counterparties; if a firm is put into receivership or bankruptcy, a counterparty can’t continue to trade with it (otherwise, it gets downgraded. So when a big trading firm gets into trouble, counterparties are fast to shut off credit, putting the firm, a la Bear, into a death spiral. Indeed, we’ve been saying since the Bear collapse that the first orders of business should have been an intrusive and thorough assessment of the big credit intermediaries and the creation of a special resolution regime should anyone go asunder. How many months have passed? And tell me, how much progress have we made?

The other reason to focus on the securities and derivatives exposures rather than loans is many of them are much more sensitive to a deterioration in economic conditions than loans. While loan losses tend to rise in a linear fashion, the values of complex instruments can drop precipitously when cash flows on the underlying asset pool drop below certain trigger levels.

Yet the new spin is “not to worry, Team Obama has everything under control.” From the New York Times:

The results of the bank stress tests to be released by the Obama administration this week are expected to include more detailed information about individual banks — assessing specific parts of their loan portfolios — than many analysts have been expecting.

Yves here. As we said, the loan books, while interesting, are not where the most treacherous risks lie. But analysts are being given extra detail in the hopes that they won’t call attention to the failure to provide disclosure on all the exposures. Back to the article:

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.

Yves here. The Administration should never have gotten itself in the position that it has to persuade the public of bank safety. Indeed, as Wolfgang Munchau, reminds us, efforts at reassurance become hollow over time:

Adam Posen, deputy director of the Peterson Institute in Washington, made the following observation in a book* he published in 2000 about the parallels between Japan’s lost decade and US policy during the savings and loan crisis. He wrote: “Bank regulators issued a litany of announcements meant to be reassuring about the extent of the bad loan problem and the adequacy of Japanese banks’ capital, each of which was correctly disbelieved by other financial firms, foreign banks, and by Japanese savers as understating the problem.”

In a loud and continued vote of no confidence, Thomas Hoenig of the Kansas City Fed argues that big banks need to fail, and propping up “too big to fail” institutions leads to economic distortions. By implication, that means he sees the stress tests at best as a way to legitimate a fundamentally flawed process:

….the current policy raises a host of issues:

● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. Capitalism is a process of failure and renewal, and a “too big to fail” policy undermines this renewal and makes the financial system and our economy less efficient.

● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

● The US government has poured billions of dollars into these firms without a defined resolution process, adding to our national debt. While there will be some repayment, there also will be losses. The longer resolution is postponed, the greater the losses and the larger the debt burden.

● As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.

● Failing effectively to resolve these non-viable firms has long-term consequences. We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Yet back at the Times, we get more of the “everything is for the best in this best of all possible worlds”:

The stress tests are one more example of the extraordinary ways that the government is intervening in the economy, to cushion the blow from the current financial crisis and recession. Having already propped up the credit markets and the automobile industry, officials are now putting the finishing touches on an exercise with no obvious precedent.

On Thursday afternoon, regulators expect to publish an analysis of the banks’ assets, akin to a sprawling research report written by a Wall Street analyst but one that comes with the government’s imprimatur. In effect, Treasury Department and Federal Reserve regulators will be handing over information to investors so that they can decide which banks they want to invest in — and which will ultimately need more bailout money.

The analysis could become a template for future financial regulation.

One way or the other, the stress tests have the potential to be a turning point in the financial crisis. If the tests fail to instill confidence, it will be the clearest sign to date that economists who have criticized the administration may be right that its rescue plan has not been aggressive enough….

Yves here. OK, this is the Times, and Leonhardt is a seasoned reporter, so there have to be a few caveats. Nevertheless, this piece is awfully friendly to the powers that be. This is how it closes:

There are signs, though, that the assumptions will be tough enough to satisfy some skeptics. Jan Hatzius, a Goldman Sachs economist, has a more pessimistic outlook than many forecasters, and he said that he initially thought the stress tests would not take a sufficiently dark view.

“But we are changing our mind about this,” he wrote in a note to clients last week. The tests now seem likely to assume loan-default rates higher than those of the Great Depression. Putting together a plan for the financial system to withstand such losses, Mr. Hatzius wrote, “would be a big step toward a resolution of the crisis.”

Admittedly, Hatzius was early to publish a high credit loss guesstimate based on some simple assumptions that got a fair bit of flack but was directionally well ahead of the pack. But he is also Goldman’s chief economist, not a bank analyst. And comparisons to the Great Depression are misleading. Mortgages then were five year bullets (they were typically refinanced when they matured, which obviously did not happen when credit dried up). But more important, loan to value ratios were only 50%. The issue is thus not merely whether the default rate assumptions are high enough, but also what the loss assumptions are. You need both pieces of the equation to make even a first cut at the reasonableness of the effort.

I’d wait till Meredith Whitney weighs in.

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  1. Jesus

    I think you raise a good point at the beginning, the Obama team has really mastered how the current new cycles work. The old style was denial and then dumb the report at 6pm on Friday. The new style is to front-run the bad news before it happens, so that the media can play the “he said, she said” game with no definitive information. That way when the news does come out, the media is bored with it already and the public never knows which way was correct.

  2. attempter

    This is one of the best short summaries of the general FIRE sector transformation from capitalism to corporatism that I’ve read.

    We also see here the mission creep and the ever more intense propaganda and deception it will require, since it’s not just a few TooBigToFail banks, but the whole exponential debt/growth system, which is unviable relative to the real world productive base.

    It’s not a matter of an acute malady within a fundamentally healthy system, where the system needs to be temporarily enslaved to the interests of a few well-connected entities, but a chronic, terminal illness of the system itself, which is now the one big zombie.

    But the admin and the MSM are treating it as the former, and will go as far as they can with the corresponding policy and propaganda.

    So the corporatist transformation itself is delusional and is a gulag built on sand. It’s not physically and therefore economically viable; rather, to continue to prop it up will require more and more aggressive political and geopolitical policies, which will become more overtly for the benefit of the ever-shrinking few.

    What may have seemed cloudy over the last 35 years should be crystal-clear by now.

  3. Independent Accountant

    I read the NYT piece this morning. Bravo on your dissection.

  4. Luke Lea

    Isn’t the bottom line issue here who wins, who loses, and who is made whole? And how much money are we talking about?

    I have a general impression (perhaps misinformed) that Citi’s losses here are, when all is revealed, on the order of a couple of hundred billion dollars, and that a lot of these losses are irretrievable (ie, the winners are long gone). So the question is who is going to be left holding the bag: will it be the shareholders and bondholders or taxpayers?

    But then there is also the question of whether current management will keep its jobs (and reputations)going forward? How that weighs in the scales is not at all clear, but it would seem its interests are tied to those of the shareholders and bondholders.

  5. Neal

    There is much talk about the Swedish model for getting out of this crisis.

    There is an excellent paper by the Cleveland Fed, "On the Resolution of Financial Crises:The Swedish Experience", June 2007 (on line PDF)

    The 4 characterisitcs that are said to have made the Swedish actions successful were:

    1) Transparency

    2)Management by a politically and finacially independent agency with the decisions to close a bank or business being done on a purely economic basis.

    3)Maintain market discipline, offer no blanket guarantees.

    4)Repair the credit worthiness of the damaged components of the "real" economy.

    First, as I see it, the current problem has not been addressed in the US with any of the 4 characteristics listed above.

    Secondly, the specific actions taken during the Swedish experience are not necessarily applicable in the US problem. The scale is different. The mechanism of how we got here is only superficially similar. There are key differences-most critically, the multifarious new versions of "financial innovation" being held by the US institutions.

    In the end, the Swedish model had more relations to the S&L crisis in the US when there were actual, tangible asssets that had some essential value that much of the current "innovations" do not seem to have.

    Read it, its a good paper to know about when people start talking Swedish to you.

  6. Moopheus

    “OK, this is the Times, and Leonhardt is a seasoned reporter, so there have to be a few caveats”

    Though Leonhardt has generally taken a soft, don’t worry, be happy attitude when reporting on the credit/housing bubble, and was even generally in favor of the TARP bailout. I find it hard to take him seriously on this issue.

  7. Joe Costello

    The NYT is the official publication of the court. Remember Judith Miller? Great suspicion should be placed on anything they write when there is a direct conflict between rulers and subjects.

  8. Rellag

    >>well until fifteen plus years of criticism in the media and Congressional budget cuts left them undernourished and fearful


    Here's the actual SEC historical budget
    SEC Budget 1995-2009

    Its tripled over the period you reference.

    Here are the FRB budgets from 2000-2009. 74% increase

    FRB budgetsDon’t have OTS numbers. I assume they’re similar. In any event, they self fund and are not subject to congressional appropriation.

    So what exactly are you referring to regarding budget cuts at the regulators?

    Do you have any evidence for this assertion?

  9. undercat

    Subject: Functioning of this website. (note to webmaster)

    For about 4-5 days now, I’ve been experiencing very slow page loading at and/or a total cut off of loading about halfway through the load. At first, I wondered if there was some technical change that made the page incompatible with my Opera browser but it does the same thing with Internet Explorer. is the only webpage I’m having any problems loading.

  10. profnickd

    In a loud and continued vote of no confidence, Thomas Hoenig of the Kansas City Fed argues that big banks need to fail, and propping up “too big to fail” institutions leads to economic distortions.

    Today I will light a candle for Thomas Hoening a whsiper a small prayer of thanksgiving.

  11. george

    I Love your analysis of all but the causes of regulatory inhibitions.

    Regulations do not exist so how can regulators, well, regulate?

    Your first paragraph says it all so why then do you find it necessary to look for some cause for the regulatory failures. These are not regulatory “failures” but CORRUPTION and MANIULATION and good old-fashioned Dog and Pony shows.

    KEEP UP THE GOOD WORKS, but don’t try to find a rationale for human corruption. It just is and we are knee deep in it…

  12. Lockstep

    I agree. I think this is just an excercise of buying time. The foreclosure moratorium that lasted six months and the stress tests that are lasting at least 4 months have been designed to delay the inevitable and make you think the government is now in control.

    I also wait for Mike May, Meredith Whitney, and Bove to give the truth about bank stress, not this fake “stress test”.

  13. Hugh

    The stress tests were always kabuki. Make them no-fail. Let the banks overvalue assets and undervalue debt. Let them use their own models. Look at all the simple stuff and not look at the off balance sheet exposure. And even with all this some banks will still look awful.

    From there we go to the joke process of having precisely the most dubious banks go out to try to raise private funds (like that is going to happen) before coming back for more government handouts.

    And who looks to have done best in the stress tests? The two BINOs: Goldman and Morgan Stanley. (BINO: bank in name only)

    As for Leonhardt at the NYT, he is an idiot. What we are seeing here is the creation and validation of what Wall Street and Washington (Wall Street on the Potomac) are putting forth as the official narrative. The stress tests are legitimate. They show problems but the problems are manageable. So we should all trust them and go back to sleep. We should all forget that if the banks were solvent they wouldn’t need trillions, and that they need trillions means they aren’t solvent. Reality has been superseded. Happy talk remains the dominant economic philosophy. The math when properly massaged proves this conclusively. And besides, depression is a state of mind.

    We are so screwed.


    One test isn’t the answer.

    While there is utility in estimating how adverse macroenconomic trends will affect loan quality and in testing capital adequacy in a forward looking scenario, one also needs a measurement in the instant “spot of time” that separates the knowable from the guestimate.

    The acid test is the extent to which a bank’s liquid assets cover the liabilities that have been insured or guaranteed by the FDIC.

    By liquid assets, I mean cash, marketable securities at market and collectible performing loans. The definition would include derivates and swaps that can be unwound at market.

    Just what is the value of assets that are not marked down, written down, impaired, valued using estimates and artistry, and not watchlisted or adversely classified (to use bank regulatory language)?

    Net, in order immediately to pay off deposits and guarantied bonds in a bank seizure, would the FDIC have to make payments out of its insurance fund?

    If the cushion under the FDIC exposure is inadequate, the bank will have to raise new capital in any way it can and it will have to suspend payments of interest and dividends to junior creditors and claimants until it rights itself.

    More and more FDIC guaranteed bonds could be used to restore bank capital from the perspective of trading counterparties. Bankruptcy, conversion of bonds and preferred shares to common may not be necessary or desireable.

  15. mmckinl

    As Yves has famously noted:

    We live in a Potemkin Country with Potemkin Media, Potemkin Government and a Potemkin Financial system …

    We are going Japanese a la 1990 and our economic trajectory will be the same …

    Asking Fiat to take Chrysler was a dead giveaway as to the intent of TPTB. We will be a soft Fascist State … capitalism for the populace and welfare for the corporations and rich … Now Murdoch can take over all our media, just as Berlusconi has in Italy.

  16. marin belge™

    The stress test wording, in itself, conducing to an unfair representation of the situation. It was choosen on purpose by bankers. The issue is not anymore about liquidity, that would imply stress tests. The fed is feeding the banks ad nauseum. Why care about liquidity. The problem is all about losses and plain old solvency.

    These are the word that everyone wants to avoid confronting with. Those should be the words to be used by Treasury. The sooner the better.

  17. Yves Smith


    I suggest you read former SEC chairman Arthur Levitt’s book, Take on the Street, as to how Congress regularly threatened to cut the SEC’s budget repeatedly and forced him to cut enforcement staff and curtail enforcement actions. He was SEC chairman from 1993 to 2001.

    Overall budgets tell you nada about enforcement staffing and policies. Remember, the SEC introduced Edgar during that time period. I have no idea how much of the increase in expense that accounted for, but that alone would have a significant cost and operational impact.

    As for the FRB, again, Greenspan was completely anti-regulation and openly so. The Fed has been criticized before Congress for failing to implement even basic bank reporting requirements under the Home Owner Equity Protection Act, which even bank friendly OCC took seriously. And there was more to HOEPA than reporting….

  18. Jim T

    Below is a response I wrote on November 30th 2007, to an article in the Wall Street Examiner reporting on Hank Paulson's latest attempts to solve the emerging financial problems. Remember the Super SIV solution that never took off?

    My response must have fallen on deaf ears because it seems nothing has changed in the past 18 months!


    I have lived in Australia for the past 8 years, but I’m originally a native San Franciscan and an ex-U.S. Mortgage Banker of some 20 plus years. (What in the Hell is going on back there?)

    It appears from here everybody (and I mean everybody) from Government Officials, Government Regulators, Banking Industry Giants, Wall Street, Investors and the Media have absolutely lost your collective minds.

    Since when has it become a good thing when the watch dog (Government) helps the burgular (Mortgage Industry, Banks, Investment Bankers, Bond Brokers, Bond & Mortgage Insurers, etc…) escape with the loot?

    Someone please stand up and just say, “NO, this has to stop now and everyone accountable needs to take your licks. PERIOD!”


    Hank Paulson! Has that man completely lost his mind? Super SIV? Freeze the Rates? How stupid can one man be and the rest of you act like the “King isn’t naked.” He’s Naked folkes and he doesn’t have a clue! Throw him out of office and get someone with some balls in there that will call a “Spade a Spade” and fix the problem with the sensible solution of holding the guilty accountable.

    No more games, all of the cards on the table now and deal with it!

    My children and grand children still live in the U.S. I need someone to stand up and take control of the mess back there so I can sleep at night knowing my loved ones will be OK.


    Jim T.
    American & Australian Citizen

    Friday, November 30, 2007 at 7:10 pm | Permalink


    The Bush Administration Started it and now the Obama Administration continues the same FAILED POLICIES!


  19. run75441


    I have been critical of your not fully dissecting the issues. These two articles by you are certainly eye opening for this manufacturing/econ person. While I am the bull on the manufacturing floor, I hope someone of purpose reads your words.

    Thank you

  20. john bougearel


    I fell behind on my reading this week and only now am catching up.

    In light of the banks re-negotiating with the regulators more favorable terms for the stress tests, ie. measuring Tier 1 common instead of tangible common equity, Goldman’s Jan Hatzius (whose insights I generally respect because he has earned that) either has to revise his opinion about the stringency and sufficiency of the stress-tests or be dead wrong. Hatzius believed the stress-tests loan default rate assumptions would be set sufficiently high enough to create a plan that could withstand those losses. From my understanding of Tier 1 common, that formula is permitted to strip out goodwill, impairments, and net unrealized losses.

    I suspect he has already restated his opinion to his clients, and agree that we’d be better advised to hear the independent Meredith Whitnew weigh in.

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