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Blog: How America Fell in Love with Stress Tests

05-13 17:54 Caijing

Rosy news about major U.S. banks and their stress tests helped boost market sentiments, proving the value of 'jawboning.'


By Bob Dowling

(Caijing.com.cn) When announcing plans February 10 to 'stress test' America's largest banks for financial safety, U.S. Treasury Secretary Timothy Geithner was nearly hooted out of the Treasury's ornate briefing room. With investors on edge about the potential for another financial shock, and by releasing few details, Geithner generated an overwhelmingly negative reaction, leading Americans to assume these stress tests would only show how much additional bad news was yet to come.

Three months passed, and now Geithner looks like a hero. The final results of the stress tests announced May 6 did indeed show that, in the worst case, America's 19 largest banks could still see up to US$ 600 billion in mostly real estate loans going bad. But that news had been managed through weeks of controlled leaks to the press that left an impression that even the most troubled financial players such as Citibank and Bank of America could find the necessary capital to 'buffer' their positions based on a worst-case scenario.

So main questions in the days before the final results were not whether big banks could fail (the government had already shown it wouldn't allow that) but whether the biggest of the troubled banks — thoroughly hated by voters -- could raise enough capital from investors, and whether they would look for taxpayer money as well. The banks immediately responded that they could go it alone. The strongest players, such as Goldman Sachs, repeated their desire to pay back Treasury loans as soon as possible.

Even if President Barack Obama were conducting with a baton, he couldn't have orchestrated this masterpiece any better. Yes, the total amount involved in worst-case bad loans might be huge, but the biggest banks could handle it. That was exactly the message the White House wanted to send to the markets. Stocks rallied for an eighth week. Geithner turned the dreaded tests into a psychological weapon. In the old days, talking to markets with carefully crafted numbers was called 'jawboning,' and it was used mainly by the Federal Reserve chairman to influence market psychology without taking direct Fed action. At times, it was a cheap fix.

But now, with short term interest rates near zero, the Fed is out of bullets. It can only announce that it will buy up ever-more bad assets to help the banks, using its over-weighted balance sheet instead of monetary finesse. So Obama's Treasury is jawboning the market with its scripted stress test results, even citing US$ 599 billion in bad loans rather than US$ 600 billion to suggest precision. The intent is simple: Convince enough investors that the absolute worst is past, and they should continue to buy stocks and drive the rally higher.

That it worked is good for the United States, the global economy and especially the big banks, because rising bank share prices revalue capital, making it easier for America's most troubled 'too big to fail' institutions to reach their government mandated capital targets. Besides avoiding a downward surprise, 10 banks that will have to raise more capital said they would sell securities to private investors and would not have to rely on more bailout loans.

For market commentators, the stress test exercise set a benchmark. It was seen as an attempt by the government to draw a line in the sand, declaring the crisis over. Nobody really cared about its precision. A day after the results were announced, The Wall Street Journal reported that, far from scientific, the results were really about negotiation. The original, much larger projections for losses and capital needs were reduced after intense objections from the 10 worst-off banks. Call it a financial or political compromise, Washington was ready to cut the deal to put the past behind for the banks. And the plan worked.

That meant other things had to be ignored. What was not highlighted was the degree of stress on the overall banking system. The 19 tested banks represent about two-thirds of U.S. deposits and about 50 percent of all loans. No one knows in detail the condition of many regional and local banks also holding large amounts of real estate loans. If those banks get in trouble, it's presumed the government will close and merge them with healthier banks. Over time, the number of American banks could shrink significantly from the current 7,000.

Optimistic investors also seemed to favor the government's outlook for a median case -- suggesting banks profits will rise – rather than worst-case forecasts suggesting weak earning in a weak economy. Bad news on job losses, for example, was shrugged off. Actually, the net loss of 599,000 jobs in April was hailed as good news because it was below the number of jobs lost in March. The fact that the government hired 66,000 temporary workers in April didn't seem important.

Politically, what the stress test handling proved is that the Obama Administration is getting skilled at selling the positive without appearing to be directly spinning good news. That approach can work if the public continues to see improvements in their lives, meaning that jobs, credit and home ownership come back. But to a number of doubters who claw through the numbers, it all seems too easy to be true.

Take the banks. The profit forecast is 'overall optimistic,' says U.S. economist Ed Yardeni. It suggests banks that only earned US$ 82 billion in 2007 and lost US$ 12 billion in 2008 will have operating earnings of US$ 400 billion for 2009 before accounting for losses. With many economists still projecting an unemployment rate above 10 percent for 2010, and with the level of bad loans rising, a large number of real estate foreclosures could be ahead. Those force banks to book losses.

In the same week as the stress test results were released, the U.S. real estate compiler Zillow.com reported that nearly one-third of Americans owe more on their mortgages than their homes are worth. No one knows how many may simply walk away.

But when good news prevails, none of that seems important. Internationally, Wall Street is praising China's US$ 585 billion stimulus program and touting a rally in emerging markets as two examples of how a global recovery is underway.

'This may be a giant global suckers rally, as some unrepentant doomsayers claim. Or it may be that all the monetary and fiscal easing is working to revive global economic activity,' says Yardeni.

With investors looking for the best, Washington and Wall Street seem to have turned the scary stress test into a tail wagging puppy — at least for now.

Robert Dowling is the editorial advisor to Caijing's annual English edition and former managing editor of BusinessWeek International.

All opinions expressed in this blog are those of  the author alone and do not necessarily reflect the views of Caijing Magazine.

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