Geithner: jusqu’ici tout va bien

You remember those stress tests the government conducted at the largest too-big-to-fail financial institutions. They have long since been forgotten. But, they are a relevant topic of conversation because some of the policy makers’ thinking in administering them of has come to light in the Atlantic’s recent exposé of Treasury Secretary Geithner. I suggest you read it because it highlights Geithner’s view that the elites’ need to take “deeply unpopular, deeply hard to understand” measures was the only way forward.

How I see the stress tests

Before we get to the Treasury Secretary’s comments, let me remind you of how Credit Writedowns characterized the stress tests last year. Here are a few quotes.

• Meredith Whitney: Regardless of stress tests, banks will still need more capital, 21 Apr 2009 

  The Bloomberg video below makes it seem that Whitney believes the stress tests are a sham. She says the tests are a theoretical exercise whereby banks ask: “what will our earnings power be in two years after we sell off these ‘toxic’ assets?” She goes on to suggest that the answer to this question will be a self-serving, upbeat response not wholly reflective of the real dangers lurking.

  In reality, much more capital is still going to be required.  Some of this will happen via asset sales, as she suggests.  However, one should anticipate a real need for yet more capital still.

• Reinhart: Not everybody can be above-average in stress tests, 22 Apr 2009

  Irrespective of whether one thinks the stress tests used to test the U.S. banking system is a sham (10% unemployment is not a worst-case scenario), the fact of the matter is these tests MUST show some differentiation in order to be credible.  Vincent Reinhart, a former Fed official now at the AEI, makes this case in the video below with Bloomberg News.

  Most of us have fixed on whether the stress tests will be credible or not.  In order to be credible, there will have to be stress test winners and losers. Now, mind you, the government has to be very careful about the stress exercise hurting some institutions, so it will tread carefully. This is very much a political exercise. So, having heard Reinhart voice his view, my question is whether the winners and losers will be picked based on real financial differentiation or based on other more political factors.

• Stress tests reveal Citi and BofA need more capital, but you knew that already, 28 Apr 2009

  It sounds a lot like a test where the student banks who just failed go to the teacher regulator with mommy and daddy bank lobbyists in tow to see if they can get their grades changed higher. See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem.

  According to MIT Professor and former IMF Chief Economist Simon Johnson, this is very nearly what Larry Summers said in a Feb 24th speech at the Inter-American Development Bank…

  Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

• What the stress tests reveal about Obama’s thinking on banks, 23 May 2009

  The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to beregarding nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution.  Notice that bondholders did not lose any money here…

  My conclusion from all of this building from March on was that bank shares would pop and I said so in April.  Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital.  However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again.  Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

  I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention.  This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

If I had to summarize these thoughts I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

How Timothy Geithner sees the stress tests

I think you’ll find my characterization very much in line with Tim Geithner’s.

Geithner thought the best plan would align three cannons. The first was monetary policy: the Federal Reserve would lower borrowing costs to nearly nothing. The second was fiscal policy, through which massive government outlays—a stimulus—would help fill the gap in private spending. The third was the recapitalization of the financial sector, which meant getting money into banks to help them absorb losses and continue lending…

All of this was textbook crisis response. The daring break from form—really, the plan’s defining feature—lay in where the bulk of the money would come from. History said the answer was government. But there was, theoretically, another option. “The distinction in strategy that we adopted when we came in,” Geithner says, “was to try and maximize the chance that capital needs could be met privately, not publicly”—that investors, rather than taxpayers, could supply the money banks needed. If the plan worked, it could save taxpayers a great deal… The danger, if the plan failed, was that the crisis—and the cost—would escalate, and that the government’s credibility would be shot. It’s a barometer of how uneasy some administration officials were about the plan that they referred to it in the press as the Geithner Plan. If it failed, there’d be no doubting who would get the blame.

The first challenge was to persuade panicked investors, amid what amounted to a run on every bank, to buy shares in any of them. The infamous “stress tests” were designed to accomplish this…

Geithner says he settled on stress tests as the centerpiece of the economic response in December, while sitting on a beach in Mexico. The plan was to force banks to submit to an appraisal of how they’d fare if conditions worsened, and then make a judgment about how much additional capital they’d need. They’d have a chance to raise that money privately. But if they couldn’t, the government would supply it—with all the strings that implied. The gambit was that injecting this new measure of uncertainty would ultimately be helpful. Good results would halt the panic and might lure back investors; bad ones would at least clarify the severity of the crisis. “The basic strategy,” Geithner says, “was to dispel the cloud of uncertainty.” Initially, that didn’t happen. Many people assumed the tests were a pretext for allowing the government to seize weak banks. Others complained that the tests were too mild, and suspected that the whole thing was an excuse to let banks try to grow their way out of trouble—to reprise what Japan did.

To just about everybody’s surprise, though, the plan has appeared to work.

So far! And yes – this was a ruse to let the banks grow their way out of the crisis like Japan, albeit after they had already received huge capital injections from the private sector. That’s why big banks are earning gobs of money with interest rates at zero percent. If it weren’t for all the hidden losses, we’d be home free. But, notice the word “appeared” in the last sentence of the quote. The only difference between what Geithner says and what I have been saying has to do with the hidden losses and their likely impact. Therefore, the article’s most important sentence was this one:

The danger, if the plan failed, was that the crisis—and the cost—would escalate, and that the government’s credibility would be shot.

The whole thing has been a gamble – a roll of the dice. This demonstrates the clear need for keeping up appearances, doesn’t it?

Much more below.

Source

Timothy Geithner: Inside Man – Joshua Greene, The Atlantic

Also see the more Administration-friendly spin in No Credit by John Cassidy of the New Yorker.

Jusqu’ici tu va bien!