IE 11 is not supported. For an optimal experience visit our site on another browser.

Bank ‘stress test’ draws fire from critics

As Treasury officials wrap up their “stress test” for the U.S. financial system, some critics are giving the entire process a failing grade.

The Treasury’s “stress test” for the U.S. financial system sounded like a good idea at the time. But as officials wrap up and begin disclosing the results, some critics are giving the entire process a failing grade.

Treasury officials say the comprehensive analysis of the assets on the books of 19 of the largest U.S. banks will help identify which institutions are at the greatest risk of failure if the recession deepens. By applying scenarios that simulate the impact of, say, a higher unemployment rate on mortgage defaults, the government is hoping to target aid to the banks that need it most. The test results could force banks deemed at risk to set aside more capital to cover future losses.

The idea is flawed, critics say, and the exercise has done little to shore up battered bank balance sheets and investors' confidence.

“The stress tests are, at best, a waste of time,” said Mike Holland, who heads the investment firm he founded. "At worst, they're misleading and testing the wrong things. The idea of using some level of unemployment to say whether Citigroup is not as strong as JP Morgan to me is laughable. And therefore I will be glad when this process is over."

Bank regulators are hoping to quell concerns about the stress test by releasing details Friday of how they’re being performed and offering guidance on how the results should be interpreted. The final results are expected to be made public May 4.

Investors will be looking closely at the Treasury's assumptions. Given the complexity of the mortgage-backed assets the computer models are analyzing, there is already skepticism about how any model can forecast and identify potential problems.

“I would argue — as others have — that a lot of (banks') models have been badly flawed in the last few years anyway, which is why they're in the mess they're in,” said Yra Harris, a currency trader with Praxis Trading.

It’s also not clear just how “stressful” the Treasury’s models are. Critics says it's as if your doctor tried to gauge the health of your heart by setting a treadmill to a leisurely stroll.

Even if the test is vigorous, they argue, it doesn’t guarantee that the road ahead won’t turn out to be steeper than expected or subject to falling rocks.

There’s little doubt U.S. banks face some serious stress ahead. On Tuesday, the International Monetary Fund estimated that U.S. financial institutions could suffer $2.7 trillion in losses from the global credit crisis, nearly double its projection six months ago. U.S. banks have written down about $510 billion in assets, putting them about halfway through the process of loan loss recognition, according to the IMF. Another $550 billion in write-downs is expected over the next two years.

Announced in February, the stress test was supposed to give the government a head start in case another financial panic threatened a large financial institution. When the last panic hit in September 2008, Treasury officials vowed “no more Lehman weekends” referring to a series of sleepless marathon sessions with armies of lawyers, which in one case ended with the collapse of the investment banking firm Lehman Bros.

Instead, they would subject the biggest banks to a thorough exam and apply some preventive medicine before one of them keeled over. By forcing the biggest banks to swap special “preferred” stock for billions in government cash, the Treasury installed a backstop on banks' books. That special stock could be converted with the click of a mouse into common stock, instantly shoring up the capital base of any bank that strayed too close to  insolvency.

The next step was to get the patients on a treadmill and determine just how healthy they are.

That’s when things got complicated.

Since the process was announced, the financial winds have shifted in favor of troubled banks. The Fed’s aggressive moves to flood the financial system with cash have forced short-term interest rates to zero. Although the volume of bank lending is down, the loans that are being made are extremely profitable. If you borrow at zero and lend it out at 5 percent, it’s not hard to make piles of cash.

Some banks say they don’t need the government money and never did. Those banks are eager to give the money back and get the government out of their board rooms.

But others still need the government lifeline. The question now is, which ones? That’s where the government has backed itself into a corner, critics say.

The original plan was to restore investor confidence so private investors would begin buying bank stocks again and let the government get out of banking. But if the Treasury now discloses a list of “bad” banks, it could doom them to failure if investors shun them in favor of “good banks” and depositors move their money elsewhere.

If the Treasury is vague about the stress test results, it will be hard to generate confidence among investors, depositors and customers. It's as if someone offered you 10 glasses of water with a warning that one of them is poison, but won’t say which one it is. You’ll lose your thirst in short order.

The banking giants aren’t the only ones facing further pressure from bad loans. Several large regional banks reporting first-quarter profits this week warned that they see continued loan losses coming this year. There are also signs that loans backed by commercial real estate, which usually lag problems in residential mortgages, may soon bring a new round of defaults and loan losses.

The stress test also offers no guidance on the risk banks face from the rest of the highly interconnected global banking system. Some overseas banks could be in far worse shape than the U.S. banks that get the lowest stress test scores. German banks are riddled with some $1 trillion of illiquid or toxic assets; government officials there are still working on a plan to shore up those banks. But it’s not expected to be in place until at least July.

Treasury officials have said repeatedly that the $700 billion bank bailout fund has helped contain a financial fire that threatened to become an inferno. But if the ill winds of the recession whip up the flames again, the Treasury’s fire hoses may run dry. After wide criticism of former Treasury Secretary Henry Paulson’s handling of the $700 billion bailout, there’s little support on Capitol Hill to refill the nearly depleted bailout fund. As of this week, the TARP balance is down to $110 billion.

“The stress test was done to prove to the public that the banks are in good shape, because the government simply cannot come up with more money to put into the banks,” said Richard Bove, a bank analyst at Rochdale Securities. “I think the net effect of it is a sham. It is a political game. And I think that what they have now done is backed themselves into a corner because they have to say which banks are not doing well.”