Bank Stress Tests: Full of Sound and Fury…

Even with the stress tests completed, the Obama Administration lacks an exit strategy for its deepening involvement in supporting these banks.

What the administration needs to do is give the American people a road map for getting out of the business of owning banks. However, instead of a roadmap, the Administration keeps digging more potholes. Secretary Geithner’s recent remarks, in which he suggested imposing additional requirements before letting banks repay their TARP obligations, raise serious questions regarding the administration’s desire to actually exit the current situation. Treasury should reconsider its position and not only allow banks to repay, but encourage them to do so. The quicker we get these institutions out from under the government, the quicker our financial markets will get moving again.

As the witching hour of 5 pm on the East Coast approaches, when the Treasury will release both aggregate and individual stress test results, the overwhelming feeling in Washington and on Wall Street is one of closure: finally the circus can come to an end. In terms of the actual results, details of which have been leaking for days, the stress tests come close to telling us absolutely nothing we did not already know.

One purpose of the stress tests was to determine if the 19 bank holding companies could withstand “higher losses than generally expected.” However, what started out as extreme economic projections are beginning to look like the consensus forecast. For instance, the stress tests assume a base case level of unemployment of 8.9 percent for 2010, and an extreme “stress” level case of 10.3 percent for 2010. There’s a good chance that we’ll reach that extreme; what the new extreme is, one can only guess, but what we do know is that the banks have not been tested for it.

While the aggregate results have yet to be released, it is a good bet that they will fall somewhere within the range of exactly just how much TARP funds Treasury has left. We can expect Treasury to announce capital shortfalls of just over $100 billion, while the real shortfalls are likely to be in excess of $200 billion. Treasury is understandably reluctant to go back to Congress for additional TARP funds, so it will likely do its best to stretch its existing resources.

One way of stretching those resources is converting preferred equity holdings into common stock. How this is to be done, and what kind of voting rights Treasury will have is yet to be seen. As Treasury has repeatedly said it will not let any of these banks fail, shifting the government’s holding from preferred to common equity is little more than an accounting game that fails to address the underlying economic realities at many of these institutions.