A Shot Of Confidence

Another day, another new leak about those stress tests due for release on Thursday.

The results of the bank stress tests to be released by the Obama administration this week are expected to include more detailed information about individual banks — assessing specific parts of their loan portfolios — than many analysts have been expecting.

Using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear [...]

The administration is expected to make the case that the needs of the troubled banks can be met with the bailout funds that Congress has already approved. That would be a departure from what administration officials were saying as recently as March and evidently reflects the recent improvement in banks’ conditions.

“None of these banks are insolvent,” said a senior government official, who did not want to be identified before the public release of the test results.

The official added: “These are manageable losses.”

The problem at this point is that the grade-grubbing from the banking industry has destroyed the credibility of these tests, making them really useless and making the insistence of solvency hollow. The stress tests also focus on the wrong liabilities.

There is another way the stress tests fall short. As was revealed earlier, the tests are focusing on bank loan exposures. Ahem. The real risk to the system is not in not-too-difficult to value (and sell) loans, but in the complex dreck and derivatives exposures at the big capital markets players, namely Citi and Bank of America. Even if a bank as big as Wells Fargo, a very big bank but in traditional retail and wholesale businesses, were to prove terminally impaired, it might be costly to resolve, but procedurally it would not be pathbreaking.

It's the capital markets firms that pose the real systemic risk. The powers that be still have yet to develop procedures for an orderly resolution. The reason being that their large trading books depend on ongoing credit from counterparties; if a firm is put into receivership or bankruptcy, a counterparty can't continue to trade with it (otherwise, it gets downgraded. So when a big trading firm gets into trouble, counterparties are fast to shut off credit, putting the firm, a la Bear, into a death spiral. Indeed, we've been saying since the Bear collapse that the first orders of business should have been an intrusive and thorough assessment of the big credit intermediaries and the creation of a special resolution regime should anyone go asunder. How many months have passed? And tell me, how much progress have we made?

Given that even the modest recommendations from the stress tests face resistance from the banksters, and that they don't even focus on the proper liabilities, I really don't know their purpose. Other than to give everyone a shot of confidence. I guess we're going to build an empire on a base of sand again.