Stress tests under stress

By Felix Salmon
April 16, 2009

David Wessel has an interesting idea today: while the bank stress tests were a good idea at the time they were announced, in February, a lot has changed since then, and none of it in a good way. Most obviously, the tests’ worst-case scenario is now looking more like a base-case scenario, making the tests less credible. What’s more, the very announcement of the stress tests’ existence caused all manner of confusion and second-guessing in the markets, none of which was helpful. And most profoundly, Congress passed executive-compensation rules which mean that no banks have any interest in accepting government funds should they be found to have insufficient capital.

For me, the fact that all these things managed to happen so quickly after the stress tests were announced is an indication that the stress tests probably weren’t such a good idea in February after all. But never mind that: as Wessel says, “Treasury has to deal with the world as it is, not as it hoped it would be”. And that means being extremely transparent about both the tests themselves and their results.

Near the beginning of the crisis, in the early months of 2008, it was still possible for Treasury to attempt a “trust us, we know what we’re doing” approach to bank regulation. That won’t fly any more. Treasury has to internalize the show-don’t-tell rule which is commonly hammered into journalists. Because no, we don’t trust them to know what they’re doing. Especially when the official org chart still looks like this.

Comments
6 comments so far

Yep, why trust anyone who tries to hide important information?

Posted by YR | Report as abusive

What if “toxic assets” aren’t really that hard to value? Imagine for a moment that valuing MBS is actually crystal clear and that once the depth of the housing crisis became apparent it was obvious to the banks that they’d lost, say, 70% on these investments. They immediately realized they were bankrupt by normal rules. Not wanting to admit this, they spread this idea that MBS are “impossible” to value and that no one could know what they were really worth until years hence. This would be perfectly consistent with their attempts to obfuscate their accounting in general. Reporters should look into this claim that these assets are impossible to value.

For example, before the crisis no one had trouble valuing MBS. There was a thriving market for them. Everyone used a standard software package to value them. The values spit out by that software turned out to be wrong because they relied on assumptions about delinquencies and rising home values that turned out to be wrong. But if we just used that software with the correct assumptions it would give us a valuation. Not impossible to value after all… Now, the software might still give incorrect values, but it would be an important data point. And it’s important to note that all securities are of fundamentally uncertain value. Look what’s happened to stocks over the past year! No one is suggesting stocks are “toxic” and need to be taken off people’s hands at inflated values.

Posted by DCreader | Report as abusive

In the unfolding of this crisis, we’ve reinvented the wheel so many times that we could start a tire store. Everything keeps returning to late September and early October. This change of optics with the “stress test” is a rerun of the change of optics with the “stigma problem”.

The stigma problem was originally solved by a plan to hide, shelter, if you will, the banks needing help from TARP, by forcing healthy banks to participate with the unhealthy banks. A kind of “What’s My Line ( Solvency )? show.

Then, when TARP looked to be a pretty good deal for banks, the stigma became attached to the banks that didn’t join, since, reasonably enough, only banks that couldn’t meet the criteria for joining TARP ( now a badge of honor )would not want some of this government largess.

The stigma problem also came up with the IMF’s CCL program.

In the case of the stigma problem, one could argue that the problem was caused by a change in the plan known as TARP. Maybe changing the name, then, would have been a wise move and averted confusion.

With CAP, the change in optics is even stranger. As I read CAP, the set of CAP participants was supposed to be a kind of badge of honor, since participation was to assure the various bank’s solvency, whatever their initial situation was. Case closed. Solvent banks, guaranteed by the US Government.

In my mind, CAP was very easy to understand. If anything, there was less than met the eye. It was mainly a heuristic document. Pure peshat. Somehow, maybe because of the name “stress test”, people seemed to believe that the insolvent banks were going to be named, and a scarlet “I” added to their name (s). Now, this seems to go against the reasoning of CAP. When this new reading became the main reading, the banks that were solvent started trying to demonstrate that, if there was a problem, it didn’t rest on them. Again, this seems to violate the spirit of CAP.

In this case, there was no change of plan by the government. Instead, their plan was changed by popular perception.

There is one big problem for the taxpayer though, and that is that we are shareholders in some of these banks. If we tell investors that they are hurting, won’t that make it harder for these banks to sell assets, thereby hurting our investment? What exactly are our interests in this matter?

The stress test is a joke. The problem is the banks are broke, period. But, the banksters now control our government, including Obama. I don’t care what the market does or what the CEO’s say, history is repeating itself, and this will be worst. Some facts:
http://www.siliconvalleywatcher.com/mt/a rchives/2008/10/the_size_of_der.php

Even without the current mess, we’re still screwed, see at: http://www.truthin08.org/

Posted by Rick | Report as abusive

The big failure of the stress tests, beyond the absurdly lenient assumptions in the “more adverse” test, was that it wasn’t tied explicitly to the other support measures, despite the government’s claims that they were all part of the same package. Given that the government has made clear it will not let any major bank go bankrupt, what it should have done was make the PPIP (or any similar toxic asset removal scheme) compulsory for the banks in the stress tests, within the most vulnerable asset classes, waited to see how the results of that process went, then provided the necessary capital (or capital backstop) for any banks that needed it, while simulataneously publishing full (and I mean full) results of the tests. As it is, the combination of pitiful disclosure and weak stresses make the stress tests useless for investor confidence, and the voluntary nature of the PPIP mean that the dodgiest, hardest to value assets will remain on the banks books where they can cause future capital shortfalls and hindering future capital raising.

Posted by Ginger Yellow | Report as abusive

I am all for your idea of the financial blog being more
accessible for all. It’s time has come.
I appreciate the opinions from other countries where the
whole fiasco is playing out.I will however, be US-centric
here for a moment. Credit Suisse pegs the number of foreclosures at 6.5million by 2011. Run the presses day and night, there is not enough money in the world to soak this spill up. There is still NO floor under the US housing market.
I was boy during the Great Depression.I have many memories of life. This is playing out in a startlingly
similar fashion.No, the Depression was not an overnight
event. It took several years for the destruction of
the way of life we knew.VBe well. Stay strong.

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