It’s kind of easy to take pleasure in all this and think the banks are being hoisted on their own petard, but it’s all bad for the economy for the mortgage market to be in such turmoil, to not know whether the right to foreclose will be enforceable. It’s a great deal of uncertainty and makes it much harder for private investors to get back into the mortgage market. It will probably make home buyers more uncertain because there’ll be a lot of mortgage holders who are not going to be paying their mortgages or be foreclosed upon.

I don’t think any member of Congress has been more critical of the Obama administration to do more about foreclosures. I introduced the cram-down legislation, I’ve written pieces saying TARP funds should be used to buy mortgages and modify them. I’ve been very vocal that the housing sector is an enormous part of our ongoing financial pain. But this does not accomplish the solution to the mortgage problem. It’s hard even to see how it ends. But I’ve got to think it creates more uncertainty about the health of the banks. [Treasury] Secretary [Timothy] Geithner testified before the Financial Services Committee a few weeks ago and I asked him whether this legislation had been taken into account in the stress tests, and he said he wasn’t sure. At the least, we now have resolution authority that we can take out for a spin.

But there are increasing worries that the scale of the scandal and the fallout on the financial markets might impact the stability of the financial system, necessitating some form of government intervention.

But in the financial blogosphere, many aren’t feeling much better about the banking system today. They think some of the stress tests’ worst-case scenarios were too optimistic, especially regarding commercial real estate. And they fear the results will give the government cover to hold back on more aggressive action, both on the banking system and on financial regulatory reform.

Paul Krugman, skeptical from the beginning, worries the results only confirm a strategy of muddling through the crisis:

The odds are that the financial system won’t function normally until the crucial players get much stronger financially than they are now. Yet the Obama administration has decided not to do anything dramatic to recapitalize the banks.

Can the economy recover even with weak banks? Maybe. Banks won’t be expanding credit any time soon, but government-backed lenders have stepped in to fill the gap. The Federal Reserve has expanded its credit by $1.2 trillion over the past year; Fannie Mae and Freddie Mac have become the principal sources of mortgage finance. So maybe we can let the economy fix the banks instead of the other way around.

But there are many things that could go wrong.

It’s not at all clear that credit from the Fed, Fannie and Freddie can fully substitute for a healthy banking system. If it can’t, the muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.

Roger Ehrenberg at Information Arbitrage says a monster in the closet regarding the financial system still keeps him up at night:

The Administration and Congress have clearly taken the path of least resistance. Wiping out of the stockholders and unsecured bondholders of our largest financial institutions would have been a political nightmare, but it would have enabled the market to purge the excesses that our system has wrought over the past decade. An emphasis on generating comprehensive data and full transparency around toxic asset portfolios would have also helped in the process, creating a much clearer picture of ultimate ownership and a basis for working out the problem credits (and counterparties). This wouldn’t have produced nightmares, it would have yielded wakeful pain followed by catharsis and and way forward. The path taken looks and feels good today, but potential troubles lurk just below the surface.

And the Wall Street Journal gives the tests a B-minus:

To give a sustained boost to investor confidence, the tests needed demonstrable rigor. They achieved that up to a point. While worst-case loss rates look tough, certain loan portfolios — in particular commercial real estate — at some banks seem to have gotten off lightly. Meanwhile, the tests’ numbers for underlying earnings — which are needed to offset soaring credit losses — could turn out to be optimistic in some cases.

And FT’s Alphaville has a complete roundup of other reactions. As Krugman says, let the muddling through begin.

Traditionally, leaks to the press come from officials trying to curry favor with journalists, who will treat them favorably in the future. (See Woodward, Bob.) But that’s kind of hard to see as a motive in the case of the relevant economic officials here — possible, or maybe it’s people on the political side of the White House, but it doesn’t feel right.

Alternatively, there’s Yves Smith’s version: these are all trial balloons to see how outsiders will react to different stress reports.

But that just adds to the bad feeling about all this. Even Brad DeLong, who has been relatively sympathetic to the administration here, is disturbed by the idea that regulators are negotiating with the banks about the test results. Now it seems as if the report’s contents may also be dictated by what, based on the response to leaks, the informed public is willing to swallow. (”Would you believe it if we say Citi is fine? OK, what if we say they need $5 billion? Not enough? How about 10?”)

It does make you wonder if the fix is in, even before the results of the stress tests are out.

Executives at both banks are objecting to the preliminary findings, which emerged from the government’s scrutiny of 19 large financial institutions. The two banks are planning to respond with detailed rebuttals, these people said, with Bank of America’s appeal expected by Tuesday.

The findings suggest that government officials are using the stress tests to send a tough message to struggling banks. Bank of America and Citigroup have been the highest-profile problem children in recent months, but it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.

Regional banks that made a lot of commercial real estate loans also are in trouble, The Journal reports.

It looks like the coming battle over the financial system will be about defining the difference between a “stressed” bank and a totally insolvent one — if it even exists.

The paper, part of a federal effort to restore public confidence in banks by gauging their capital strength, doesn’t reveal which banks need capital or specify their total shortfall. The Fed used qualitative terms such as “some” and “more,” typical of other central bank documents.

Clearly, the Fed is avoiding specifics at this point. Until we get more than this, it will be hard to determine how geniune the Fed’s promise of transparency is going to be. Another report is expected May 4.

The story cites “people familiar with the matter” who say the Fed asked the banks to keep mum.

The Fed wants to ensure that the report cards don’t leak during earnings conference calls scheduled for this month. Such a scenario might push stock prices lower for banks perceived as weak and interfere with the government’s plan to release the results in an orderly fashion later this month.

The stress tests are being used to determine how well banks will be able to weather the recession. Some of the analysts interviewed by Bloomberg agreed with the Fed’s approach, saying the stress tests could distract from earnings results, and have the potential to overly influence the stock market.

That may well be true. But the lack of transparency surrounding the government’s rescue efforts already has created a suspicion and mistrust, and concern that things are really much worse than what’s being reported. Banks being ordered to stay quiet on stress tests will only add to this.

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