Should we believe the US Treasury’s stress tests?

The results of the US Treasury’s stress tests of America’s 19 biggest banks yesterday were less bad than many were expecting. Nine of the banks, including JPMorgan, American Express and  Goldman Sachs, were given the all-clear by the Treasury – they weren’t likely to need any more state support.

And the other ten banks, including Citigroup,Wells Fargo, Bank of America and GMAC, only needed $75 billion in fresh capital. That’s alot, but it’s alot less than the $480 billion that Nouriel Roubini, or ‘Dr Doom’ as the economist has come to be known, suggested the sector needed in February.

That means that, if the stress tests are correct, the government’s ongoing presence in the banking sector is likely to be limited, and we are unlikely to see the sort of mass nationalisation of the sector that many, including Roubini (and myself) thought we would eventually see.

Geithner declared that the results marked the end of a long period of uncertainty, and ushered in a new stage of transparency in the crisis.Markets, on the whole, seemed inclined to believe him, with equity futures up in the US.

Now, the debate has shifted quickly from a discussion of mass nationalisation to the question of letting banks fail. If only two or three banks need large amounts of capital – Bank of America, Citigroup and GMAC, for example – then perhaps there is less systemic risk in letting them fail, and the government should look to carry out an orderly winding up of these institutions in a way that protects depositors without bailing out private lenders.

That much was suggested by Roubini in the FT yesterday, who was quick to re-position himself after his original apocalyptic estimate was shown to be apparently wrong.

But are the stress tests really a step forward for market transparency, or instead a confidence trick?

None of us are privy to how these stress tests were conducted, or what kind of economic scenarios were used. We do know, though, that they only looked two years ahead, while the economic recession could well last longer than that.Paul Krugman points out at the New York Times:

The regulators didn’t have the resources to make a really careful assessment of the banks’ assets, and in any case they allowed the banks to bargain over what the results would say. A rigorous audit it wasn’t.

The tests were as much about PR as they were about real fundamental analysis of the banks. As one hedge fund manager, Alan Schram, puts it on the Huffington Post:

These stress tests were probably designed to come up with a dollar figure below the $110 billion left in the TARP and already approved by Congress. Secretary Geithner does not want to repeat the PR disaster of last October. He wants to be able to declare that big bailouts for the banks are over.

The tests notably allowed banks to estimate their capital position without marking to market their loan books. In other words, their loans are worth very little now, but the government allowed the banks to assume that the loans would be worth more in the future – in effect taking a big bet on economic recovery.

Schram writes:

Most banks can probably survive without further capital as long as they are not forced to mark their loan portfolios to market. If forced to mark loans to their current distressed prices, almost all banks would prove to have no equity left. With their loss reserves insufficient to absorb the losses, they will be essentially insolvent. However, those losses happen over time, and so if they allowed not to mark-to-market, they will be able to build back their equity capital. After all, with low interest rates business is booming, and most banks are now perhaps more profitable than they have ever been.

Fortunately, the markets seem to believe the stress tests. If the economic data continues to be positive, this may prove to be a brilliant move by the Treasury. But if the data gets worse, and if you examine the housing market doldrums you might be tempted to believe it will get worse, then we will have to go back to square one on the banks bailout.

For the banks, it means they can go back to business as usual, and the possibility of genuine reform of a system that almost broke the global economy is rapidly receding. Krugman writes:

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street éminence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.” Hey, that little thing about causing the worst global slump since the Great Depression? Never mind.

Those are frightening words. They suggest that while the Federal Reserve and the Obama administration continue to insist that they’re committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they’ll soon be able to go back to playing the same games as before.

As I suggest in the new issue of emeafinance, the banks appear to have got away with it again.