What Will the Stress Tests Mean?

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Wouldn’t you like to know just how sick U.S. banks really are? So would Tim Geithner. That’s the point of the somewhat mysterious “stress test” exercise going on now. Unfortunately, it’s probably going to stay mysterious to us ordinary people.

Geithner is starting from the assumption that the economy is sick because banks aren’t lending. And the biggest banks aren’t lending because their balance sheets are already full of assets that they’ve had to write down, which reduces their capital levels.

So, if you could just find a way to recapitalize the banks, they’d start lending again, and consumers would start buying cars and homes and student loans again. Right?

There are so many things wrong with that statement, but let’s stick to stress tests. The Treasury has two choices: they can nationalize the banks altogether (as Sweden did in the early Nineties), and then force them to either find new capital or go out of business. Or they can “encourage” private investors to step up and put some new capital into the banks, without an explicit nationalization.

I’m an investor. If someone asked me to put new capital into most of the large zombie banks, I’d probably ask him if I look like I have rocks in my head. There are so many reasons for a sane investor to avoid this, but Geithner is focusing on only one of them: ”How do I know I’m not throwing my money down a rat hole?”

That’s the whole idea behind the stress tests. If you can show that a given bank will have no problems weathering the worst economic storm you can reasonably imagine, then you can also say that the bank’s existing equity actually is worth more than zero. And that would provide a rationale (and a baseline price) for a private investor to buy in.

For complex reasons I won’t trouble you with, it’s almost never rational to buy equity in a bank that may fail. The bottom line is that if you do so, you’re not actually acquiring value in full measure to your investment. Rather, you’re transferring value to the bank’s existing bondholders, who of course are thrilled to see you do that.

That’s the calculus that Geithner wants to modify. He figures that if a stress test can show that banks are healthy, they won’t have trouble attracting private capital. This is a great potential outcome for him, because it allows him to avoid doing what no one seems happy about, which is a full nationalization. (For the record: nationalization doesn’t scare me, and it shouldn’t scare you either, but that’s another story.)

Here’s where it gets messy: the stress tests are likely to show that many of the largest banks are in very deep trouble. On top of that, the economic assumptions being made in the stress tests themselves are said to be not all that dire, so the results could well be understating the potential problems. (Remember, this is the Administration that, ridiculously, is counting on a 4% economic recovery next year.)

If the stress testing has come up clean, then we’ll have a great big press conference with grins and TV cameras, and a big relief rally in the stock-market. But what if it doesn’t?

Now, if you’re Geithner, you’ve got a big problem, and it’s hard to imagine he didn’t see this coming. Let’s say the stress testing has turned up major problems across the universe of very large banks. (Small and regional banks are a totally different situation, and I’ll get to them in a moment.)

Now what does he do? If he suppresses or candy-coats the results, everyone will smell a rat. For one thing, he’ll totally cement that case that private capital should avoid large banks like the plague, which wipes out the whole point of the exercise. Far worse, he’ll also create so much brand-new uncertainty that financial markets will take another dive, and the economy will also suffer.

What if he comes totally clean, exposing the raw data, the methodology, and the interpretations?

If that happens, you’ll see a whole blizzard of blog posts from people like me, taking issue with everything about the results. You’ll also see an instantaneous sorting of the large banks, in order from the best to the worst. The handful at the top will be the winners. It will be assumed that all the non-winners are roadkill. And if you were watching the last weeks of the lives of Bear Stearns and Lehman Brothers, you know that when a financial institution is even rumored to be in trouble, the end comes swiftly.

In my opinion, that’s exactly what Geithner should do. The resulting bloodbath would eliminate a large amount of overcapacity in the banking system, and make room for some new players to come up, which will happen rapidly.

Why don’t I think the cataclysm would be fatal for the economy? Because the large zombie banks aren’t contributing anything to the economy now. Let Citigroup and a handful of others go away, and let the good parts of their businesses pass into other hands. Geithner is wrong if he thinks that he can return these companies to the way they used to do businesses.

But what is Geither likely to do? He’s not likely to let a whole raft of B players face the meat grinder. He’ll have no choice but to nationalize them. After all this talk of avoiding the “N” word, that’s going to make him look like a fool.

Now, what about the regional and community banks? Based on my information, these are generally a whole lot healthier than the large, wholesale banks with heavy exposure to leveraged mortgage securities.

The problem is that smaller banks tend to regulated by the mid and low level apparatchiks at the Fed and the FDIC. And those people are so incredibly risk-averse right now, that they’re overdiscounting perfectly good capital and underrating perfectly sound assets. It’s gotten to the point that even solidly run, well-capitalized smaller banks with clean operating histories can’t expand lending activities even if they wanted to. Which in many cases, they do.

That’s a story you’re not going to hear on the evening news. This whole crisis still has a long way to go, no matter what Geithner does.

Francis Cianfrocca is a Senior Editor of The New Ledger.
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