The Long Crisis

Tim Geithner and Ben Bernanke must rue the day that they agreed that a stress test and making public the results of the tests would be just the thing to assure the markets that all is well within the US banking system. Or not.

The problem with the stress tests from the beginning was that it is a lose-lose deal for the government. If the test results as released by Uncle Sam show that all 19 banks tested by the government pass the tests the credibility of the results would be blown away as market analysts and traders know full well that at least a few of the big banks are insolvent.

However, if at least a few banks are deemed to be short of capital and fail the tests the market may well gang up on the weaker banks and immediately punish their share prices, making it all the more difficult for them to raise the capital they need without further dilution to shareholders.

The Fed and the Treasury Department must be having some late night sessions trying to decide how best to spin the results. Yesterday a paper was released that was supposed to show the methods used for the tests. The paper revealed few details.

“The market may be disappointed by the lack of details, as there is not much new in the report, but at the margin, it does sound as if regulators will give each company a real review, rather than a rubber stamp of approval,” said Paul Miller, an analyst with FBR Capital Markets in Arlington, Virginia.

This was the kindest remark that I have seen about the report. One analyst said that the only significant numbers in the report were those that told you what page you were on in the 21 page report.

The full report is supposed to be released to the public during the week of May 4th. In the meantime the markets will probably be extremely volatile as leaks and rumors about the results of the test find their way into public view.

The tragic thing in all of this is that the banks and government have not faced up to the fact that the big money center banks are still sitting on trillions of dollars of toxic assets. The hope is that over time the real estate markets will recover and that when held to maturity the value of the securities secured by the real estate will be at par.

This hope does not take into account how quickly vacant homes, shopping malls, and office space deteriorate once left vacant. Not only does the weather have its effect on poorly maintained structures but vandals quickly move in a strip the facilities of anything of value. The banks have just been overwhelmed by the numbers of distressed foreclosed real estate properties now showing up on their books as non performing assets. In addition, they have been swamped by the number of borrowers who are walking away from homes with under water mortgages.

The stress tests have likely understated the size of these unprecedented problems. Securities may be revalued by the banks from mark to market to mark to model by the use of accounting trickery but eventually the true value of these “assets” will surface. Assets now valued by banks at from 80% to 95% of par may eventually prove to be nearly worthless.

Now whether banks pass or fail the present stress tests that day of reckoning will produce some genuine stress within the financial system.

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