The Curtain Comes Down on Bank Stress Tests

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A bicyclist rides by a Wells Fargo branch in San Francisco

The most exciting day of the financial year should have been today because the government releases the results of its multi-month bank "stress test" program which includes thorough vetting of the health of America's 19 largest banks. That part of the drama is over. Someone leaked almost all of the information on the banks that failed the tests and how much money they will be asked to bring in as new capital. Citigroup (C), Wells Fargo (WFC), and Bank of America (BAC) are troubled, as the government sees it, and will have to improve their balance sheets by a combined total of almost $60 billion. JP Morgan (JPM) and Goldman Sachs (GS) passed the tests and are free from any additional obligations. The stock market has been voting on which banks are in trouble. The price of the shares in each of the banks indicates that traders already knew which firms had problems.

No one seems to be troubled about the leaking of sensitive government data on the banks. It is unlikely that anyone will be punished for passing along information which the public should never have seen before the pre-announced release date. The information caused movement in the stocks of a number of the banks. Disclosure regulations probably prohibit sharing what the government knew about the firms. In the fury of activity to prepare the findings and present them so that Wall St would not panic, the process of safe guarding the data was neglected. If several of the banks were found to be insolvent, the issue of the public discovering the findings in the press was probably not a priority. Government officials should have assumed that the confidentiality of the data was safe. How would the press ever get its hands on such sensitive information? The same way that it has gotten other classified information — obsessive digging and good contracts inside the Administration. (See pictures of the global financial crisis.)

The excitement over the bank tests was an important replacement for the thrill of Bernie Madoff's weird and exotic life. He was remarkably clever and had great skill in robbing otherwise intelligent people blind. A careful analysis of Madoff's actions has not uncovered much that was not clear in the first few weeks of the investigation other than the fact that the people who gave him money were not intelligent at all. Madoff was such an improbable monster that the public followed the story with untiring fascination week-after-week. Once Madoff went to prison, the magic wore off. The stress tests became a perfect replacement.

The primary reason that news organizations gave the bank story so much space was that the public knew the tests were a fraud. Warren Buffett said so, along with a number of other financial analysts. Bank balance sheets are so complex that applying one set of measures for all of them is irresponsible reductionism, these analysts argued. The second part of the fraud was much more elaborate. The government, led by Henry Paulson, forced large banks to take TARP money that they did not need. He made sure that the taxpayers received preferred shares in the firms in exchange for the capital. After Paulson retired the new administration began testing the banks, knowing that, based on the criteria they had set, many of the firms would fail. The credit markets are harsh. The troubled banks would find it nearly impossible to raise capital from private equity sources. They would turn to the government. The government would convert its preferred shares to common shares to buttress the bank balance sheets. Suddenly, the taxpayers would own controlling interests in many of the largest financial firms in the world.

This conspiracy theory always had one weakness. There is no reason taxpayers would want to own troubled banks. The stocks in the companies would have to keep moving up and stay up for there to be a reasonable return. The Administration, on the other hand, might like to have the ability to force decisions on the private banking system as it moves through instating its mortgage assistance and financial stimulus packages.

The belief that the whole process of testing banks and getting large stakes in them was pre-planned is nearly as preposterous as Eisenhower's military-industrial complex.

The debate over whether the process was fair and whether the criteria were intelligently chosen will go on for years and will eventually become an important part of the history of American capitalism and the banking system. In the meantime, the public has loved watching the tension of big companies pitted against big government. Rich and famous bankers have been ridiculed in public. Some have lost their jobs. Hank Paulson, a well-built former Dartmouth football player and former head of Goldman Sachs and mild-mannered Ben Bernanke have been accused of manipulating a major decision by a public company, Bank of America's (BAC) decision about whether it should by Merrill Lynch, overriding the normal and legal corporate governance system. Put more simply, they broke a law in the name of saving the national financial system.

The rest of the year in finance will probably be dull. Investors know that banks will lose more money. The government claims, probably correctly, that the stress test results and recommendations for banks to add new capital has guarded against an undercapitalization of the system which could cause another crisis.

There is always hope for more bad news and battles between the government and large banks that would bring the issues back to the front pages of the press. The losses from credit cards, commercial real estate, corporate loans, and derivatives may be substantially greater than the government could have ever imagined. Banks could face hundreds of billions of dollars in additional write-offs. The government and bankers did not see the crisis that is just passing coming. They almost certainly won't see the next one.

Douglas A. McIntyre

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