Monday, May 11, 2009

Stress Tests an Exercise in Calculated Deception

I'm simply awestruck by the insanity. In order to cater to my audience, I try to be as cynical as possible in these pages. I work hard at it, I really do. But ever since I started writing, the ridiculousness of our current economic situation has consistently surpassed even my Orwell-inspired perpetual skepticism.

The recent debacle with the bank "stress tests" is yet another manifestation of this phenomenon. From the outset I dismissed the tests and their legitimacy. But I never dreamed that the Obama Administration, the banking industry and big media would go to such lengths to blatantly deceive investors. Now that the results of the tests are being used to justify further potential interventions, I suppose I need to summarize why the whole exercise is a fraud.

From the outset, there were so many problems with the structure of this plan that it should not have been given any attention as a legitimate exercise in the first place by the major media. By completely ignoring the contradictions that were plain as day in the process of the tests, the media tipped its hand that it would simply regurgitate whatever the administration and banking lobby told them to say. Here is a quick summary of why the tests were not even a worthwhile exercise in the first place:

1) The tests focused only on the loan books of the banks. It made no mention of derivative exposures, which are what really put the "entire financial system at risk." If the credit crisis were as simple as too many loans to people without jobs, this would be sufficient. But it is not.

2) The Treasury hired under 200 people to inspect the balance sheets of 19 banks over the course of approximately 6 weeks. A similar team of lawyers and securities experts spent years trying to untie the knot of Fannie Mae's loan book. They never really finished when Fannie went in to receivership. To think that 200 people could analyze 19 banks in such a short period of time is preposterous.

3) The Treasury officials relied on information given to them by the banks. There was nothing to stop the banks from picking and choosing what information to give. The models and assumptions that went into valuing the assets were not disclosed.

4) The goal of the test was to "restore confidence in the financial system." It was not to discover the truthful health of these institutions. So it was implicit in the very intent that banks should lie and obfuscate in order to achieve the "higher ideal" of confidence.

5) The test's "baseline" and "more adverse" scenarios were laughably optimistic. In some metrics, the baseline scenario's assumptions were already surpassed. Additionally, the scenarios did not factor in any acceleration of the Commercial Real Estate collapse, nor did it account for further deterioration in "Alt-A" loans or "Jumbo Prime" loans that are only now starting to approach their peak reset periods. The "stressful" scenarios flat-out assumed that no new problems would arise.

6) Immediately preceding the tests was the rejection of FASB 157, which allowed the banks to continue to mark their books to whatever they wanted, rather than what they were actually worth. Coincidence? Highly unlikely.

7) The repeal of FASB 157, along with inflated Q1 trading profits and other accounting shenanigans allowed the banks to post record profits for the first quarter. Those profits were used as the basis for future assumed profits in determining the capital ratios banks would require.

8) The banks were permitted to negotiate the results of the tests with the Treasury prior to their release. This alone should be enough to conclude that the whole exercise is a travesty of regulation. If the capital requirements were interpretive enough to be negotiable, they are effectively meaningless. The interpretive nature of such simple guidelines like, "what constitutes capital" makes it blatantly obvious that the results should not be trusted. In one such situation, Citigroup was able to negotiate their capital requirements down to $5 Billion from $50 Billion by claiming that assets that they have "pending for sale" should be considered as tangible equity. I tried to buy groceries this morning with a craigslist ad of furniture that I have for sale. They nearly called the police before I caved and paid cash.

9) Banks were permitted to use "Tier 1 Capital" as opposed to "Tangible Common Equity" as a measurement of their capital. The former massively overstates this capital. An analyst from RBC suggested that using the former would have resulted in an additional $68 Billion shortfall to the $70 Billion that was released. Below is a table from Rolfe Winkler that highlights this clearly:

The tests as they were originally crafted were supposed to be using TCE. But the banks didn't like this so they bitched and moaned until Treasury finally agreed to the less aggressive metric. Just another example of who was really calling the shots.

10) Now that the results are in, the banks have been reassured that the capital requirements may not actually be required if bank earnings continue to improve over the next two quarters. Essentially the Treasury said, "look guys, don't worry about the capital requirements we make public. We will give you ample opportunity to make up the difference by booking profits over the next two quarters. And we'll even turn a blind eye to any accounting tricks you need to make those numbers."

I could probably go on with another ten reasons why this whole process was a charade, but I will spare you the details. It is plain to the bare eye that what we have witnessed is a coordinated attempt by government and the financial industry to do anything possible in order to "restore confidence." If that means falsifying information, so be it. If that means tinkering with definitions, so be it. If that means trampling over decades-long regulatory procedures in order to obfuscate the truth, so be it.

As usual, what I find to be the most appalling factor in this is the mainstream media's total ignorance of the above and outright cheerleading of the results as an "all clear" signal.


Together with the media's compliance, the Obama Administration and the Financial Services industry have staged a massive confidence building charade, which to anybody not in direct benefit comes across as precisely the opposite. The fact that the Administration would go to such lengths to hide the truth behind the bank's insolvency issues, is anything but confidence inspiring.

All of the policy actions of the government over the last 6 months seem to be directed toward giving the "appearance" that the system is still solvent. The powder-puff regulatory treatment. The constant wink-wink, nudge-nudge relationship between regulators and boards of directors. The FASB 157 decision. Q1 earnings. The carefully crafted "scenarios" of the stress tests. The list goes on. It is all a carefully coordinated game of chicken being played with the minds of investors.

I'm not buying it. And I am fairly certain that some nasty details will be revealed of this whole situation as the economy deteriorates beyond the "more adverse" parameters, banks require continued capital infusions from Treasury or from FDIC via the Treasury. There was undoubtably collusion between the regulators and the regulated.

Which of course is one of the most identifiable characteristics of regulation in the first place. Heads are going to roll over this. Perhaps "Regulatory Capture" will become the catch phrase of 2010?

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Matt Stiles said...

I also wanted to mention, but forgot to do so in the process of writing the article, that the constant "leaking" of stress test results was likely not an accident. It appears the Treasury started with what they thought would be an acceptable number to the market without being too generous and without being to invasive to banks. They then sent out trial balloons to see what kind of reaction the market gave. If the market tanked on the news, they would simply deny the "leak" and come up with a new number.

If that isn't government manipulation of the stock market, I don't know what is. Remember when insinuating that the government had a hand in the market got you lumped in with the tinfoil hat conspiracy theorists? Now it's just business as usual.

All in the name of "preserving confidence." Right.

mike.montchalin said...

A steel 'I' beam can be TESTed by adding weight until it buckles.

A car can be crash-TESTed by putting a dummy at the wheel and smashing it into a wall.

An engine can be given a leak-down TEST by introducing air pressure through the spark plug hole and seeing how the air leaks past the valves or rings (or heaven-forbid a hole in the piston!)

A TEST is the application of a physical reality to the item being tested.

In the case of the 'Stress Test,' it seems the closest thing to a physical reality was the leaks; they were directed at the market, not the banks.

To properly test the markets, they could have had increasingly stressful leaks....until the markets physically buckled.

BTW, the most articulate green-shoots argument I've heard is Don Coxe at
For Don Coxe, $BDI is the TEST that confirms his theory.

Thanks for another great post. I gotta go read May 7th again, "What's Behind The Rally?"

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