Treasury's Stress Test is Not a Plan at All

Editor's Note: I've had to break today's market coverage into two parts due to a need to provide some clarity on what the administration is planning to do with the nearly-insolvent banking sector. This entry will cover that issue, while the usual post - after 4:00 pm - will cover the day's market activity.

We've been hearing about Treasury Secretary Tim Geithner's "stress test" for the nation's largest banks in shrouded tones for over a week. Finally, late yesterday, some details of the plan emerged - in an exclusive interview with Jim Lehrer on the PBS Newshour - and elsewhere.

What the stress test will entail is having the banks examine their ability to function under a variety of very broad circumstances - first, a "moderate" scenario, in which unemployment

This commentary, by Adam S. Posen, Dep. Director, Peterson Institute for International Economics, lays out some guidelines which the Obama administration is conveniently avoiding.

And here's Paul Krugman opining in the New York Times that nationalization - in other words, having the federal government take over some banks, clean them up and resell the new, functioning, properly-capitalized entities to private investors.

Geithner and the Obama administration isn't listening, despite Krugman having won the Nobel Prize for Economics and other, similarly spot-on economists and commentators urging the government to make the appropriate hard choices, as opposed to the current piecemeal approach which hasn't - and isn't likely to - work.

The assumptions in the stress testing offers banks to look at two different sets of scenarios, a baseline and an extreme, or worst case outlook.

Under the baseline scenario, unemployment is at 8.4% in 2009 and 8.8% in 2010, housing prices decline by 14% in 2009 and another 4% in 2010, and the nation's Gross Domestic Product (GDP) falls by 2.0% in 2009 and rises by 2.1% in 2010.

In the worst case set-up, the assumptions are that unemployment reaches 8.9% in 2009 and 10.3 in 2010, housing prices fall 22% in 2009 and another 7% in 2010, and the nation's GDP falls by 3.3% in 2009 and gains 0.5% in 2010.

The banks will have about six weeks to report back to Geithner with either a confirmation that they're "OK" or a request for more funding from the government. That it will take six weeks to complete what is essentially nothing more than the testing of a theoretical set of circumstances against real world assets and liabilities suggests that the entire plan is nothing more than a politically-motivated cover-up for the banking giants which actually control the government.

This Bloomberg article suggests that the "worst case" scenarios laid out by the government are not severe enough, and that the banks will not not then be looking at what possibly lies ahead for the US economy.

The assessments may indeed be less severe than what's ahead, though the housing price assumptions appear somewhat on the money. Suppose GDP falls by 5% this year and another 2% next? What if unemployment hits 10.2% this year? Then the stress tests won't be testing the banks for reality and the entire plan will fail, meaning we will be sunk into a deeper recession for a longer time by supporting zombie banks which are at the heart of the problem.

In Geithner's interview with Lehrer, a the Treasury Secretary voiced a number of interesting comments, including, on the solvency of the banks involved:

"These banks now have very substantial amounts of capital relative to what you would have seen in the US economy going into previous recessions."

In other words, Geithner seems to be wanting to tell us that the banks are sound, despite what's been reported concerning trillions of dollars worth of bad loans, even more toxic credit default swaps and continuing credit-creation issues.

Geithner would have us believe that all of these pre-existing conditions have suddenly, magically, vanished. It's not a believable scenario.

On "nationalization", Geithner opined, "it's the wrong strategy for the country and an unnecessary strategy." Again, Geithner would have us believe that what's always worked for smaller, insolvent institutions, that being take-over by FDIC, recapitalization and an eventual return to a functioning entity on the other side, is not acceptable for the largest banks in the nation.

This is the kind of thinking which inspires skepticism in the banking system and the government's remedies. This approach would allow the likes of John Mack, Lloyd Blankfien, Vikram Pandit and Kenneth Lewis to continue to run their failed institutions - the same ones which caused the crisis in the first place - with only a limited amount of scrutiny and accountability.

This would allow the same excesses in the securitization of loans and largely unsupervised lending and investing activity to continue, while failing to address the toxic loans and swaps at the root of the problem.

There will be no accountability for what's already occurred, no civil or criminal charges brought against the bank and finance executives whose institutions already have benefited from taxpayer capital infusions. The same executives who nearly brought the world's financial system to its knees will remain at the controls of their now-defunct banks.

Naturally, the banks have lined the coffers of both the Obama administration and all members of congress with campaign contributions, so there will be no opposition from any government official - elected or otherwise - to this plan whatsoever.

The stress test and Geithner financial band-aid plan should be recognized for exactly what it is: further denial of the root of the crisis and a sure recipe for disaster.