Stress Test "Negotiations"

When is a stress test not a stress test? If you said when the most "adverse" scenario in the stress test is not as bad as current economic conditions, you would be correct. If you said that the regulators relied on the bankers to report on their firms' financial health using the same models that failed to alert the banks to the impending financial apocalypse, you would also be correct. And if you said when the bankers negotiate with the regulators over how much capital they need to raise due to the stress tests, you would be triply correct. From the Wall Street Journal:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.

At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.

At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.

The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.
Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.

A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.

"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.

This is exactly backwards. Throughout this sham of a process, regulators have bent over backwards, making sure not to offend bankers' sensibilities. Whether bankers are happy with the results of the stress tests is irrelevant - what matter is whether the numbers are accurate. Why would anyone have confidence in these numbers if banks lobbied for them? (Saying that what they were doing was not lobbying is a dead giveaway that they were).

This final nugget from the WSJ piece reveals the underlying problem with the stress tests - the regulators confused the ends and means. From the WSJ:

With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.

The purpose of stress tests should be to reduce opacity. Increased confidence should be a byproduct of this increased transparency. Lying about banks' balance sheets to create a short-term confidence boom in the banks simply puts off the problem, as the administration hopes the banks can earn themselves back to health. And if the banks are still insolvent six months from now? Will we finally get some sort of pre-packaged bankruptcy for systemically important financial firms? Or will we get Tim Geithner to come back and tell us everything is still fine...the banks just need another $500 billion or so.