The big White House stress test gamble

Sick banks will get six months to raise new capital. Is the Obama administration betting that the recession will end during the summer?

Published May 7, 2009 4:51PM (EDT)

At 5 p.m. EDT, the Treasury will release the official stress test results. Unless the storm of leakage over the last week turns out to be wildly off base, the actual unveiling may be something of an anticlimax. We already know the big picture -- Bank of America, Citigroup, Morgan-Stanley, Wells Fargo, GMAC and a couple of regional banks will need more capital to act as a "buffer" against potentially adverse economic conditions. Goldman Sachs, J. P. Morgan Chase, American Express, Capital One, Bank of New York Mellon and MetLife are receiving get-out-of-stress-tests-free cards. (For a detailed analysis of the past week of leaks that is near-Kremlinological in its clue-parsing, see Noam Scheiber.)

For the financial community, the details of the stress tests -- exactly how much regulators expect the banks to lose on exactly which portfolios -- will be important. If enough detail is provided that outside observers can run the numbers and come up with similar results, then confidence in the government, and presumably, the banking system, will be boosted. As an editorial in the Financial Times notes, the entire process represents unprecedented transparency (something, by the way, that President Obama campaigned on).

By the end of Thursday, the U.S. will have revealed a great deal more about its banks than any other country. Even if investors are not convinced, applying a single standard to all banks and publishing detailed results will provide the market with useful information.

As usual, Simon Johnson and James Kwak are contributing the most airtight analysis of how we got here and what it all means and why it is not good.

In rejecting "nationalization" (regulatory takeover and conservatorship), the government has not ensured a private, properly functioning banking system. Instead, it has muddled into a broken-down, undercapitalized system that is nominally in private hands, but is able to tap the state for apparently limitless support. And to date, that support has flowed on one-sided terms, with the taxpayer accepting downside risk but limited upside potential. No wonder bank shareholders are comfortable with this outcome.

If you want Treasury Secretary Timothy Geithner's state-of-the-art point of view, you can find it here, in a New York Times Op-Ed piece. If you want to mull over the official announcement from the Treasury, Federal Reserve, and FDIC preparing the ground for the official results, you can read that here. The one passage that has everyone muttering is understated, but could be interpreted as an ominous warning to banking executives:

In addition, as part of the 30-day planning process, firms will need to review their existing management and Board in order to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment and maintain balance sheet capacity sufficient to continue prudent lending to meet the credit needs of the economy.

Are you listening, Vikram Pandit and Ken Lewis?

Now that we are finally at the point where the first step of the Obama administration's plan to fix the banking system is just about accomplished, it might be worth taking a look at the next step. The banks get six months in which they have an opportunity to raise the capital the government thinks they need to be safe under conditions in which the economy gets considerably worse.

But there is increasing evidence, albeit tentative and mixed, that the economy may, right now, be poised for some kind of recovery. No one is predicting a strong recovery. That moment when the economy is actually creating jobs, rather than shedding them by half a million or more a month, still seems far off. But the housing bust may be bottoming out, the unemployment situation may be deteriorating at a slower rate, and consumer confidence is ticking up.

All kinds of things can still go wrong. Oil prices are rising, and any real, sustained economic recovery could send them straight back to the stratosphere, and immediately choke off growth once again. Even if the unemployment picture is improving slightly, continued job losses could depress consumer spending in the long run and further straitjacket a feeble recovery. But whatever happens, we'll get a pretty good picture of what's likely over the next six months. If the administration was gambling that they could postpone immediate resolution of the banking crisis while giving the economy a chance to catch its breath, that's a gamble that might pay off.

In the long run, it's hard to argue with Johnson and Kwak. Muddling through the crisis with a quasi-nationalization that doesn't resolve the too-big-to-fail problem means that we are all still at the mercy of the big banks and their tendency to make bad bets and engage in lousy risk management. But there is a silver lining. Escaping from the threat of complete meltdown, while stabilizing the banking system, gives the Obama administration room to address its other priorities -- healthcare, energy and education. That's not necessarily a bad trade-off.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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