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.

Shiller: Against Market Fundamentalism

Far too often, debates devolve into black-and-white affairs, with strawmen on both sides taking a pummeling. Robert Shiller's latest piece in the Wall Street Journal takes on this type of Manichean thinking, as he adopts the Herculean task of convincing economic conservatives that not all financial regulation is bad. From the WSJ:

The principal long-term result of the current financial crisis should be improved financial regulation. After the immediate crisis is over, we need to restructure our fragmented system. This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

This is not as radical as it sounds, for while many observers equate U.S.-style capitalism with unconstrained free markets, the story is more complicated. Americans have long understood that for the economy to work well, government must play an important supporting role. They've also long understood the important role that self-regulatory organizations (SROs), such as trade associations and exchanges, play in cooperation with government regulation.

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators as guiding hands in a healthy, productive free-enterprise system. History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes....

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. While the sports of baseball and football haven't changed much in the last century, the economy has -- and American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

You might think this is an uncontroversial point. Unfortunately, it is not. What was that about Dark Ages again?

Sanity From the Wall Street Journal?

We're not in Kansas anymore. Someone aside from a token liberal is making sense in the Wall Street Journal's opinion pages. Hedge funder Paul Singer takes to Fox News Dead Tree Version, opining that

While many of Mr. Obama's ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

How did this get by the Journal's editors? No mention of the CRA? Or Fannie and Freddie? And an acknowledgement that crazy levels of leverage, non-existent risk management, and perverse short-term bonus incentives were the key factors in this crisis - it's so...reality-based. What's next, admitting that this is the greatest financial crisis since the Great Depression? Maybe not - but we can hope.

Someone Might Want to Tell the Wall Street Journal There Was a Credit Bubble, Not Just a Housing Bubble

So, according to Daniel Henninger, we're just suffering from a housing bubble that requires relatively minor fixes. Indeed, Henninger seems so skeptical about the chaos in our financial system and markets, that he puts quotes around the phrase "the greatest financial crisis since the Depression" (if he can name a financial crisis since the Great Depression worse than this one, he neglects to mention it). According to Henninger

The housing bubble that floated into view in 2007 is turning into the blob that ate the world. Real-estate mortgages and their derivative securities are a significant problem. That discrete problem, however, has been pumped up to an historic "crisis of capitalism."

Capitalism didn't tank the U.S. economy. Overbuilt housing did. Overbuilt housing tanked the economies of the U.K. and Ireland and Spain. If little else, we've learned that artificially cheap housing sets loose limitless moral hazard.

Um...what? Maybe he didn't notice that aside from the housing bubble, there was a more generalized credit bubble. Credit cards, auto loans, home equity loans, private equity LBOs, increased financial leverage - they were all symptoms of a massive credit bubble. Housing was the most pernicious part of this bubble, since it was the collateral so many people used to secure loans, and so many banks held so many securitized mortgages on their balance sheets, but it was hardly the only aspect of this crisis. Although give him credit - at least Henninger is actually proposing new regulations in the housing market as part of the fix, instead of just saying Merry Christmas.

AIG Bonus Outrage=Fascism?

We have a winner for most hyperbolic defense of AIG: Holman Jenkins of the Wall Street Journal. While many Very Serious People in the establishment media have taken to print and the airwaves to lecture the public on how pointless, unproductive, and even counterproductive rage over the retention bonuses paid to AIG's Financial Products employees (some of whom no longer even work at AIG), Holman Jenkins is the first to nearly break Godwin's Law. At the conclusion of his jeremiad chronicling the veritable slings and arrows of outrageous fortune befalling AIGFP's employees, Jenkins informs us that Andrew Cuomo's investigation into AIG reminds us that "It can happen here." This is a reference to Sinclair Lewis' 1935 work It Can't Happen Here, imagining a fascist takover of the United States at the hands of a charismatic Huey Long-style pol. So anger over the employees of a bankrupt company on government life support receiving millions of dollars of bonuses in taxpayer money is the first step on the road to serfdom? Will Andrew Cuomo ask President Obama to set up FEMA concentration camps in the AIG building? And could the right wing be any more detached from reality?

They Say It Like It's a Bad Thing

According to the Wall Street Journal, "the exodus" out of finance is in full force. As politicians have tried to attach more strings to bailout packages to appease angry voters, and anemic (if that) earnings have drastically cut into Wall Street bonuses, more and more bankers are leaving the business. What a shock - investment bankers were only it for the money. But the Wall Street Journal says this as if it were bad. It is not. Just as there was massive misallocation of capital into bubbles over the last decade and a half, there has been massive misallocation of human capital into banking. If our best and brightest physicists and MBAs turn their attention to solving real problems rather than inventing new ways to pile leverage on top of itself, I think our society will manage to keep going. We might even prosper again, as opposed to merely creating an illusion of wealth. Indeed, the sooner we can turn our top minds towards developing green tech or making healthcare more efficient, and away from mastering market manipulation, as Jim Cramer explains below, the better we will be.

Greenspan: Don't Blame Me; Blame China

Alan Greenspan takes to the pages of the Wall Street Journal today to defend whatever is left of his tarnished legacy. His message: the housing bubble wasn't my fault; it was China's. Of course, there is a savings glut, and it certainly contributed to the credit and asset bubbles in large part. But doesn't this miss the point? Greenspan could have raised short-term interest rates to higher levels; if the 2004 hikes did not bring down long-term mortgage rates, Greenspan should have continued to raise rates (if he was truly worried about the housing bubble). It strains credulity that there was nothing the Fed could have done to pop the bubble. Doing so obviously would have meant sending a weak economy into recession - likely even a fairly nasty one - but in retrospect, it would have been better. It's easy to fall into hindsight bias, but Greenspan's own understanding of the role of the Fed as designated driver surely prevented him from taking action that at the time seemed reasonable.

Dean Baker does a good job laying out the case for the Fed targeting asset price stability in addition to its historically understood role of managing inflation. Alan Greenspan, are you listening?

Ken Lewis: We're Not Insolvent! We Promise!

Ken Lewis takes to the Wall Street Journal to tell us to pay no attention to that man behind the curtain.

Lewis assures us that "the vast majority of banks will weather this storm" and that nationalization is misguided, because its "announcement would undermine confidence in the financial system and send shudders through the investment community."

Undermine confidence in the financial system? Really? As Paul Krugman would ask, what's the weather like on his planet? Trillions of dollars of credit losses worldwide has destroyed confidence in the financial system. Paying billions of dollars for the right to absorb Countrywide and Merrill Lynch's billions of dollars of losses has crippled confidence in Lewis's BoA. Nationalization only raises the specter that creditors won't be made whole. That could create a renewed panic among holders of unsecured bank debt, but if there's an orderly process it should be a tractable problem. At this point, nationalization might be the only way to convince the public that banks are actually healthy.

So nice try Ken. But you're not distracting anyone from the real question at hand: why do you still have a job?

Robert Barro: Stock Market Crashes Are Bad

So get this: stock market crashes are bad. Don't believe me? Well don't take my word for it - listen to Harvard professor Robert Barro, who recently studied the correlation between stock market crashes and depressions (defined as at least a 10% drop in GDP or consumption). Barro's conclusion:

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in U.S., represent a serious threat.

I'm glad Robert Barro is here to tell us these things. Really, I am. But here's a tip: his study might actually be meaningful if he included debt levels as a variable. Debt deflation - a d-process - is the real culprit when it comes to depressions. As Irving Fisher described, when assets used as collateral for loans undergo price deflation, economies can fall into a downward spiral of deleveraging, leading to further falls in asset prices, and then even more deleveraging, as the two processes feed on each other in a negative feedback loop. I suspect if Barro redid his study and considered debt levels as well that the odds of today's crisis spiraling down into a depression would be significantly higher than the 20% figure he gave. I doubt he would compare our current situation to the crashes in 1974 and 2001. What does it say about the state of academic economics that "stock market crashes are bad" passes for insight from a professor at our nation's top university? Dark Ages, indeed.