Bank Stress Tests: The crazy Grandmother is still in the attic

It was abundantly clear long before the results of the so called “stress tests” report card, the object was not to see which banks where too weak to survive. The object was always to see how much money it will take to make them survive. Treasury has made clear that they will not allow any of the big banks to fail. It doesn’t matter how much money it takes. This is the new economy, where the government picks the winners and losers by decree.

The test contains two economic scenarios for the next several years, a baseline scenario and an adverse scenario. As Andrew Leonard points out in his May 7 Salon.com article, The biggest economists of the day, at least the biggest ones not being paid by someone to issue “happy talk” forecasts, Paul Krugman, Joseph Stiglitz, Simon Johnson, are all convinced that the biggest US banks are insolvent. According to them, the “adverse” scenario has already become the baseline, and it could get much worse.

That view is backed up by Elizabeth Warren, head of the Congressional Oversight Committee: “It looks disturbingly close to where we are now.”

The results indicate the banks in need of a further 75 billion immediately and perhaps 600 billion over the next several years. Nothing that investors don’t already know. But now they know the government will backstop the losses no matter how large they get. Whether that will instill confidence in the markets is an open question. Bank stocks have rallied in the last six weeks, so now investors will get to grade the report card itself. It will be interesting when that grade is handed down, which will be indicated by what happens to the banks’ share prices in the next few weeks.

Risk, more than any single factor, is what caused the meltdown, as in, inability to judge how much risk is prudent. So it seems like a good idea to introduce some risk controls, at least to protect capitalism from itself. Here’s the problem: Backstopping the risk by government fiat may backfire. Look at Fannie and Freddie, the two quasi government mortgage companies whose risk was backstopped by the government. That went well, didn’t it? They required the largest single bailout ever, because it was never their own butts on the line. Sebastian Mallaby of the Washington Post suggests the government’s unending bailout will transform all of Wall Street into Fannie and Freddie, and they will charge ahead, oblivious to risk.

I realize that Obama’s message here is that it can all be fixed, some banks are not weak and the ones that are weak can be strengthened. In this perfect world, at some point, when the banks are strong enough, the fantasy economy would be replaced by the real economy. I wish I believed that could work. But the economy can’t be tinkered with as if it’s a Swiss watch. It’s more ethereal than that. It’s all about uncontrollable things like trust, risk, belief and confidence, stuff that slips through your fingers.

Jaidev Iyer, a former chief of risk management at Citigroup, says taxpayers will ultimately be on the hook. “If there is no appetite to let losers fail, then the real losers are the market at large, the government, and the taxpayers.”

I continue to be perplexed by the lack of accountability for the meltdown. Consider the airline industry. When they have a crash, It is picked apart in excruciating detail, sometimes for years, then a report is issued. The airline industry has an incredible safety record. The economy, well that’s a whole different matter. In our dysfunctional economic model, the crash is the crazy grandmother in the attic; it will not be spoken of. Somehow we are going to build a new economy without really ever doing any detailed thinking about what went wrong with the old one.

Doug Friesen
5/08/09