Banks Gaming the System, Playing for Time: Publishing Results of Bank Stress Tests Delayed

Publication of the results of the bank stress tests has been delayed this week. Test results were originally supposed to be announced, Monday May 4th. The date has subsequently been pushed back to Thursday, May 7th.

Why should the public care about the delay in announcing the test results? First, bank regulators have traditionally operated in a cloak of secrecy. The justification for such secrecy is that if the public knew the details of banks' balance sheets, the public might panic and pull deposits out, thus destabilizing the entire financial system. Of course, the answer to this secrecy justification is that we have come to the current once-in-a-generation financial disaster, complete with a series of investor panics precisely through use of secrecy that shielded bad decisions from public view.

I fear that the delays are a product of push back by bankers against the inevitability of a new more transparent supervisory regime.

Second, the back-room dealing about future capital levels includes negotiation between Treasury and the 19 tested banks about the valuations for converting the preferred capital, a hybrid debt and equity investment by taxpayers, to common equity shares with voting rights owned by the Treasury Department.

The public should care about whether taxpayers have representation in the board rooms of banks that have received several trillion dollars of taxpayer subsidies because, for the most part, the same CEOs and board members who were in charge before the crisis are still in charge. There is no reason to believe that new, creative and public-regarding decisions will be made by banking executives who have sought every opportunity to game the system.

The gaming has included recent intimations by Bank of America, Citibank, and J.P Morgan Chase that they would participate in the highly favorable Treasury Public-Private Partnership to bid on the very "toxic assets" that they themselves bring to the bidding. Thus, these banks sought to game the system, by using taxpayer guarantees and highly leveraged loans from the Treasury to bid up the price of their own toxic assets, at taxpayers' expense.

Another gaming strategy includes changing the Financial Accounting Standards Board (FASB) mark-to-market rule to permit the banks to use their own discretion, in collaboration with their primary regulator, to value the non-performing loans at prices that are purely fictional, because they are based upon the existence of an "orderly market" that has not existed for nearly two years.

Most people have now forgotten a third gaming strategy. This was the opening game in October 2007 in which the same bad assets being stress tested today were wrapped in a pretty bow in a Paulson- orchestrated "super special investment vehicle" with the mind numbing name, Master Liquidity Enhancement Conduit. In this bit of creative financing, J.P. Morgan Chase, Citibank and Bank of America agreed to pay themselves for providing short term financing for anyone who bought the bad assets. It should come as no surprise that within two months, the Master Liquidity Enhancement Conduit was quietly withdrawn, because there were no takers.

It is widely believed that the delays this week are designed to give the banks more time to negotiate the details of how much information and in what form it will be disclosed, as well as to appeal adverse findings on regulatory capital requirements.

The stress tests administered to nineteen of the most systemically important banks have been widely viewed as the beginning of a focused solution to the problem of identifying which banks are solvent. The tests are designed to determine which banks will need to raise private equity capital, or accept government capital to protect against future adverse conditions in the economy.

The primary dispute about the significance of the test results centers on whether the regulators are applying criteria that are too lenient. For example, the selection of the "worst case scenario" figure for unemployment is barely two points higher than the actual unemployment figures today. Many expect the unemployment figures to far exceed these worst case scenarios, thus making the tests results weak predictors of future solvency.

My biggest concern about the delay is that the longer we wait for disclosure, the more opportunities are available for gaming the taxpayer.