New Stress Trial Balloon Floated

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.

Originally published at Naked Capitalism and reproduced here with the author’s permission