If You Can't Handle the Stress Test...

Are the Democrats tired of being the bear in the china closet?

What would your finances look like if nationwide unemployment rose to 10.3 percent? How about if average real estate values in the United States fall another 22 percent?

You may have trouble coming up with an answer. The unemployment rate might not affect you at all; on the other hand, you might end up unemployed. You might live in a relatively bust-resistant neighborhood, or your house value might fall even faster than the average.

These are among the questions the country's 19 largest banks have been subjected to [pdf] (for what feels like years but is actually just since February) under the Federal Reserve's "stress test" or "SCAP." The Fed, the Department of the Treasury, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation, after weeks of strife and foment, released the results of the stress test [pdf] last night. If you had trouble answering the above questions about yourself, you can understand why banks had such a hard time with the stress test.

That is, the problem with the stress test is the same limitation on any kind of standardized test. By trying to map a diverse collection of institutions, many of them regional banks whose dynamics differ widely from those of international banks, the stress test produced a range of interesting yet inconclusive statistics. "The idea of using some level of unemployment to say whether Citigroup is not as strong as JP Morgan to me is laughable," longtime investor Mike Holland told MSNBC recently.

This is not to second-guess Treasury Secretary Tim Geithner. As bully pulpit exercises go, the stress test was one of the more necessary, and certainly the most justifiable. The Department of the Treasury is on the hook for hundreds of millions of dollars—hemmed in, ironically, by the free-handed methods of Geithner's predecessor Henry Paulson, who in 2008 successfully lobbied spooked congresspersons and an unprincipled president into approving more than a trillion dollars in support for financial institutions. Promises made last year, and subsequent promises made this year, have effectively told all players at the table that the government will stay in the game until the sucker has been identified.

In this context, it's difficult for an honest person to condemn the government's doing a census of the market. The stress test was both reasonable and reasonably applied. That's why it demonstrates, even better than a screwup would have, the grotesquery of government action.

Predictions of the stress test results have been widely distributed ahead of the actual release. The final score tracks so closely to the preliminary spread that it's evident the government has been very carefully managing expectations. As a result, a new stupid-like-a-fox reputation has descended upon Geithner.

That reputation may be deserved. With all due respect to conspiracy theories about market makers, large buyers and sellers try very hard not to make the market. This was—or was claimed to be—the great challenge facing Fidelity Magellan Fund managers back in Magellan's heyday: how to get into or out of a large position in a given security as quickly and as quietly as possible, before the market reacted?

Geithner faced the same challenge, but with none of the silence, exile, or cunning available to a fund manager. All the major public and private players in the stress test would have preferred to keep the entire exercise a secret (speaking of which, why wasn't the Air Force involved?), and it took considerable wrangling just to get a partial disclosure of the results. In the end, even Geithner could not cancel centuries of law and consensus regarding secrecy in public spending. So he took pains to make sure the results would be absorbed ahead of time.

It's tempting to say the Obama administration has played its unlucky hand superbly. (And since I'm told we're all in this together, let's throw Federal Reserve Chairman Ben Bernanke in with the administration.)

But a closer look at how bank stocks fared in the market this week makes that harder to believe. To take two examples, Bank of America (BoA), which was predicted to be undercapitalized by a cool $34 billion, surged ahead of the stress test results. The final tally was off by only $100,000,000, with BoA's "SCAP buffer" coming in at $33.9 billion. But Wells Fargo, which was expected to be light by only $15 billion and may be better positioned to survive, saw its stock pummeled. And Wells Fargo's SCAP buffer turned out to be more than a billion dollars lower than predicted, at $13.7 billion. Results like these must be why Wells Fargo chairman Dick Kovacevich swaggers like a eunuch, raging against the conditions attached to the money he chose to take.

However, this week generated another piece of evidence of the administration's skill: the trial balloon proposal to allow banks to pay back their Troubled Asset Relief Program funds—subject, of course, to means testing. Coming back to back with the government's inanely sunny comments about the stress test, this suggests that President Obama may be telling the truth when he says he'd like to have less on his plate: The Democrats recognize that bailouts are a political loser. They want out of the bank business.

This desire, though, gives rise to some inflated hopes. The Democrats are still sure that the good old American machine will start producing again one of these days. They seem to think that having ended this particular Bush intervention, they will share in the bounty of the free market, without having to pay it any respect. Some economists believe the Democrats are supported in that hope. Others do not. Bernanke splits the difference.

But there's a moral reason to hope that the Democrats won't be able to exit the economic quagmire. It offends the conscience to consider that Citigroup, Wells Fargo, or Bank of America may survive. It is insulting to think that they may not only survive but be allowed to withdraw back into the private sector after the downturn is over, that in a few years their CEOs will again be the de facto spokespeople for the free market.

This is why I propose that the Treasury immediately seize all four institutions that scored a bigger-than-five-billion-dollar SCAP buffer. That would be: Bank of America, Wells Fargo (my bank at this time for all lending and borrowing), Citigroup, and GMAC (or wait, has that last one already happened?).

The Treasury should seize all four of these institutions, formally and immediately. This would be a form of blight removal during a period when the credit markets are clearly overbuilt. In this way, the market can teach Ho Chi Minh's lesson to a new generation of Democrats.

Contributing Editor Tim Cavanaugh writes from Los Angeles.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • ||

    Also don't forget the results of the stress tests were supposed to be released all at once so that no one could capitalize on the good or bad news in the market. Instead they have been dipped out one at a time. Almost makes you think that the Administration is selectively leaking news to benefit friends on wall street. President McHopey? Really? I am shocked.

  • T||

    the stress test produced a range of interesting yet ultimately inconclusive statistics.

    Inconclusive to you, maybe. To the ignuts in DC, the numbers conclusively demonstrate a need for more government intervention.

  • slutmonkey||

    "The Democrats are still sure that the good old American machine will start producing again one of these days. They seem to think that having ended this particular Bush intervention, they will share in the bounty of the free market, without having to pay it any respect."

    uh... this doesn't make sense. How can they be hoping to share in the bounty of the free market when they don't believe in the free market to begin with??

    If Christians destroyed implemented Sharia law in an Islamic country because they realized that implementing biblical law would get them removed from power, they still wouldn't expect Allah to bless them for it...

  • slutmonkey||

    er my bad--remove "destroyed" from the above post.

  • ||

    The Democrats are still sure that the good old American machine will start producing again one of these days. They seem to think that having ended this particular Bush intervention, they will share in the bounty of the free market crony capitalism, without having to pay it the free market any respect.

    I think that's more like it.

  • ||

    This bailout debacle reminds me of someone who need to vomit, but keeps trying to hold it in and swallow. It's eventually going to spew everywhere.

  • Tim Cavanaugh||

    I know it's paradoxical slutmonkey -- may I call you slutmonkey? (Actually...maybe you could, you know, call me slutmonkey sometime?)

    But that is the gamble the democrats are making. They might not call it the free market -- maybe "the American dream" or "the hard work and honesty of the American people," or if they're trying to be sophisticated, "the well managed economy under which Americans experienced unprecedented prosperity from the end of World War II until Ronnie Raygun tore it all up." But they are banking (npi) that the American economy will again start sprouting green shouts and growing trees full of money, just because crimony, it always did that in the past!

  • ||

    Is it just me or is Cavanaugh kind of a weirdo?

  • ||

    Is it just me or is Cavanaugh kind of a weirdo?>>

    =======
    While reading the article I had to double check that this website was Reason.com.

    That article read like somthing that one would find on the Daily Dos or Politico.

  • alan||

    Nick | May 8, 2009, 3:01pm | #
    Is it just me or is Cavanaugh kind of a weirdo?


    Well, no comment on the personality of the person who wrote it, I don't really have enough of a feel for TC for that, but the article had a random quality to it. Maybe something was edited out that would have more cohesively tied the strains together.

  • alan||

    As for the content portion of the program, I don't share Cavanaugh's optimism about the current line up of Democrats that their sense of political self preservation may moderate their overarching authoritarian tendencies. They are not lead by Bill Clinton who had an admirable instinct for political calculus, but by an inflexible ideologue this time around.

    Tim Geithner may be the most likable guy you could possibly to ever be be at the center of the managerial elite universe. Even I think he is an improvement on Paulson, but ultimately he answers to a political clique that is hostile to anything they cannot contain or restrain. They are willing to do a great deal of nihilistic damage before anything resembling sense is considered as we have seen just last week when Obama leaned on Chrysler's secured creditors to go along with his haphazard industrial policy.

  • alan||

    bleh, strike out, 'could possibly' from the preceding remarks.

  • ||

    Nick,

    I agree with your ultimate conclusion about banks that need to be placed in receivership. But please don't give any credit to T. Geithner or compliment the stress tests. These tests are so ineffectual that they are widely regarded as a joke among the independent financial media. Some of the main problems:

    1) The stress test numbers are all based on self-reporting by the banks themselves, all of whom have conflicts of interest and many of whom have well-documented reputations for less-than-honest accounting. The methodologies for coming up with the numbers haven't been disclosed, and the Fed hasn't seen any independent data;

    2) The Fed started the stress tests with the premise that no one could fail the stress tests, which means that they weren't really stress tests at all;

    3) The banks were allowed to re-negotiate the results of the tests behind closed doors to make them appear more favorable, which lessens their credibility further;

    4) And finally the main problem: the economy is already approaching the worst case scenario envisioned by the stress tests and is getting worse. The "results" of the stress test reflect economic conditions that are better than economic conditions currently, and it is a virtual certainty that conditions will become worse than the worst case scenario contemplated by the stress tests.

    Overall, the stress tests are a complete sideshow; a scam and a joke. The problems with the tests have been covered in the following blogs (among others):

    http://market-ticker.denninger.net
    http://www.nakedcapitalism.com/
    http://www.globaleconomicanalysis.blogspot.com/

  • Tim Cavanaugh||

    This bailout debacle reminds me of someone who need to vomit, but keeps trying to hold it in and swallow. It's eventually going to spew everywhere.

    This is really the most perfect metaphor for the bailout anybody has come up with.

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