Geithner's Stress Test Sham

Charles Ommanney / Getty Imagse Wall Street's fiscal report cards came out Thursday afternoon. Frank Partnoy argues they prove only one thing: the government will go to any lengths to prop up the nation's worthless banks.

There are two problems with the financial “stress tests,” the results of which have been leaking all week like pools of subprime mortgages. First, they weren’t stressful. Second, they weren’t tests. Treasury Secretary Timothy Geithner praised the results in advance of their release, saying they “will help lift this fog of uncertainty over the financial system, and I think the results will be, on balance, reassuring.” He might as well have asked bank shareholders whether they, like Mrs. Lincoln, enjoyed the play.

The stress tests results don’t reveal that the banks are healthy, or even alive. Some commentators have called the banks zombies, but effigies might be the better metaphor. Banks shares have value because they are bets on government intervention. Without that, they would be worth zero.

The truth, as many experts have maintained, is that the leading banks are insolvent, and have been so for more than a year. Subprime mortgage bets killed them, as any real stress tests—or, better yet, autopsies—would show. If this week’s stress test results reassure investors, as the leaks seem to have so far, it's because the results illustrate how far the administration will go to prop up the banks, not because they show the banks are healthy.If Bank of America needs another $34 billion of capital based on this test, it is in serious trouble. The same is true for Citigroup, Wells Fargo, and others. These test results don’t lift fog; they add to it. They cloud the truth about the banks so that investors will not see them as walking dead.

Not many people have seen the actual stress test. It's all of one-and-a-half pages—it’s about as intimidating as a 1040-EZ tax form. Each of the banks filled out two of these forms, one for a “baseline” scenario and one for an “adverse” scenario.

How stressful are these two scenarios? Not very. The “baseline” scenario assumes the economy will shrink by two percent in 2009, but make up that loss in 2010. It assumes unemployment will remain below nine percent, and that housing prices will decline just four percent next year. In other words, the “baseline” looks more sunny than stressful.

It isn’t good news if many banks need capital under this scenario. Indeed, the leaked information about the test results, and several banks’ need for capital—at least seven of the nineteen—nearly contradicts the first sentence of the Federal Reserve’s white paper on the stress tests, which said: “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” Is that statement still true? Was it ever?

The “adverse” scenario also is optimistic, and the Federal Reserve has admitted as much. According to its white paper, “the more adverse alternative is not, and is not intended to be a ‘worst case’ scenario.” Instead, the banks have been tested under only a “sort of bad” scenario. But focusing on “sort of bad” scenarios was precisely what got the banks into this mess originally. If the banks had calculated or considered disclosing “worst case” scenario analysis of their subprime mortgage bets, they wouldn’t likely have made those bets originally.

Apparently, the banks can’t handle the truth about the worst case. But their aversion shouldn’t stop the government from giving a real, stressful test. Even cardiac patients who can’t perform an increased grade treadmill stress test are given vasodilators to simulate the effects of exercise.

The absence of stress is related to the other problem illustrated by the recent leaks: these weren’t real tests. It is now apparent that the banks got to grade their own exams, and to use a tilted scale. They calculated their own “loss estimates,” subject to limited government scrutiny, and only had to disclose estimated losses for two years, because the Federal Reserve concluded that this limited horizon “seems likely” to capture a large portion of the losses.