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Stress Tests: The Same Clever Financial Engineering That Led To The Crisis In The First Place?

First Posted: 06/01/09 06:12 AM ET Updated: 05/25/11 02:20 PM ET


Disclosures that at least six of the 19 big banks undergoing stress testing have been ordered to acquire more capital has not assuaged critics who contend that the tests are dangerously mild.

"This stress test is the equivalent of testing the Brooklyn Bridge by running a single heavy truck on it," Nassim Nicholas Taleb, a scholar of risk and chance at Polytechnic Institute of New York University, told the Huffington Post. "Bring engineers for this stress test, not the economists who failed us."

"The fact that six banks failed the stress test is more indicative of the weakness of the banks than the strength of the stress test. Most analysts thought the stress test was pretty wimpy," said Henry Blodget, president of Cherry Hill Research and CEO/Editor in Chief of Silicon Alley Insider. "If a good number of banks hadn't failed, people would have dismissed the stress tests as propaganda. So from the government's perspective, I'd say they were about right (if any more banks had failed under those wimpy assumptions, people might have been terrified.)"

Two of the institutions told by federal regulators to expand capital in order to be able to absorb additional losses are Citigroup Inc. and Bank of America Corp. The other four have not been publicly identified.

The testing was first announced February 10. The departments and agencies involved in the testing include the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board.

On February 23, the Treasury announced that bank testing would begin two days later to ascertain whether the nation's 19 biggest banks had enough capital to weather "a more challenging economic environment." If not, the "institutions will have an opportunity to turn first to private sources of capital. Otherwise, the temporary capital buffer will be made available from the government," according to the Treasury announcement. Federal officials sought to soften the stigma associated with finding that a bank required a "capital buffer" from the government, noting that "this additional capital does not imply a new capital standard and it is not expected to be maintained on an ongoing basis. Instead, it is available to provide a cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers."

The results of the tests will be released next Thursday.

Critics of the stress tests argued almost from the moment they were announced that federal regulators had set standards too low, and that the regulatory staff was not equipped to deal with the complexities of these massive, multi-national institutions.

"This is a garbage in, garbage out activity to placate the public and perhaps reassure investors. It would probably be fine for a strictly US bank which was a traditional retail and commercial lender (think a Washington Mutual). But for the really big banks with capital markets operations, this is a joke," wrote Yves Smithand, on the economics blog Naked Capitalism, on February 12.

In a February 23 story headlined "As Doubts Grow, U.S. Will Judge Banks' Stability," the New York Times reported that "many economists, Wall Street analysts and even some bank executives contend that some of the banks are already effectively insolvent."

Interviews by the Huffington Post and an examination of web-based commentary published by economists and financial analysts shows that these concerns have not quieted in the two months since the tests were announced.

University of Oregon economist Mark Thoma told HuffPost that "the stress tests weren't tough enough" to begin with, "so I interpret this as saying that even with a fairly weak test, problems surface easily. Who knows what we might have found with a tougher test, and how much additional concern that might have caused."

James K. Galbraith, the University of Texas economist, was more detailed in his comments.

My sense is that the tests understate the problems because they emphasized the econometric relationships between economic conditions and assets of an assumed quality, rather than the underlying loan quality. The main procedure as I understand it was to ask the banks to simulate their own portfolios under various economic scenarios, meaning that the banks' own view of loan quality was largely accepted. Loan quality is the big problem, because if the sub-prime securities are as bad as I think, they should not be treated as securities but as intrinsically-defective instruments for which no market is likely to revive. Nor should it. Unless there was an actual audit or decent sample of the loan tapes behind the mortgages, we won't know for sure. I will continue to suspect that Treasury is resisting this step because it doesn't want to know what the evidence would show.

As the deadline for releasing the findings of the tests approaches, not only are the tests themselves under assault, but so are the mechanisms which federal officials are suggesting banks use in order to meet capital requirements.

Barry Ritholtz, writing at The Big Picture, argues that "the cure for inadequate capital is not more capital, but an accounting trick -- converting preferred stock to common.... US banks are suffering a solvency problem, and what they need is more capital, not an accounting sleight of hand. Yet that is precisely what they are getting -- the same clever financial engineering that led to the crisis in the first place. All Treasury needs is more leverage and a few derivatives and the transformation into the financial Borg will be complete."