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Stress Tests and the Failure of Reassurance

The headlines about stress tests released Thursday seemed sort of reassuring, after all the concern about the banking system going under. Ten banks need more

Mitchel Nash
Last updated: Jul 31, 2020 | May 08, 2009

The headlines about stress tests released Thursday seemed sort of reassuring, after all the concern about the banking system going under. Ten banks need more capital but the others are safe. Federal Reserve Chairman Ben Bernanke made a point of declaring that none are insolvent. Everyone should breathe easier.

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.

Mitchel Nash | Mitchel works for a high-tech telecommunication firm as a software engineer with vast experience and management skills. The company creates and provides technologies that help service providers provide high-quality voice and data services over broadband access networks while maximizing their network infrastructure investment. He is in charge of the production of the company's management software products as a senior software engineer. Mitchel has a B.Sc. in Computer Sciences from Tel-Aviv Jaffa Academic College.


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