Stress testing stressing me out…

Via Barry Ritholtz, I think I need to read David Reilly more.  I love his column on the possible trainwreck known as stress-testing for the banks:

Maybe it should come as no surprise that President Joe Cool’s administration has a laid-back view of bank stress.

Investors expected the government to be a bit more intense in tests of the nation’s biggest banks. After all, if nightmare scenarios were appropriate in urging passage of a $787 billion stimulus package, they should be appropriate now to gauge a bank’s ability to withstand losses.

Sadly, that’s not the case, at least according to the stress-test criteria laid out by the Treasury Department and bank regulators Wednesday.

That is bad news for investors, taxpayers and the economy. The longer we keep trying to avoid the reality of banks’ dire straits, the longer the financial crisis will stretch.

The lack of sufficient stress in the tests is especially surprising since a big lesson of the past two years is that the worst can happen, and then some. In times like these, the government and investors need to play “What If?” even when it involves some outlandish possibilities.

The failure to do such worst-case planning, even after plenty of red flags, probably made the after-shocks to the financial system from the collapse of Lehman Brothers Holdings Inc. far worse than they should have been.

Perhaps the biggest lesson, though, is that banks, like plenty of other companies, will get drunk on their own Kool-Aid. And regulators are supposed to be the ones who abstain.

President “Joe Cool” preaches to the masses that action must be taken and they will take the necessary action.  In response, the administration asks the banks,the same banks whose idiotic business and lending decisions would have rendered these banks insolvent if not for Uncle Sam, to test themselves and give them ample latitude to set the assumptions that they use.

Although the article will point out that regulators will “check” the results of the bank’s stress testing, the Administration is leaving it up to the banks to conduct the tests and set the appropriate stress levels and given that regulators haven’t historically pushed too hard in this area, I don’t expect them to.   

As much as the little Hayek sitting on my shoulder tells me that bank management would have better knowledge of this and should be allowed to set the standards for themselves, given that these banks are in this position because of having little to no knowledge about the enormous risks they were taking, I’m likely to think that the Treasury Department could have easily set up its own stress-test criteria, especially since we’re experiencing the mother of all stress tests as we speak.  Personally, I think that any stress test that does not involve using this environment as a data point is useless.

So Citigroup Inc., which didn’t even know it had a $25 billion off-balance-sheet exposure to toxic debt until that blew up in its face, will assess its own off-balance-sheet exposures. Government at work is truly a thing to behold.

That’s not to mention that Citigroup, along with peers such as Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co., have incentives to see that the tests don’t induce too much agita.

Otherwise, they will have to tap into the new Capital Assistance Program unveiled by Treasury on Wednesday. Under that program, banks lacking sufficient capital would sell the government new convertible preferred stock that must be converted into common stock after seven years if it isn’t bought back.

Whatever happens, it’s better to figure this out sooner rather than later and I believe that ignoring reality does not get us there.  Maybe I’ll be proven wrong.

As a final note, it’s worth putting a statment I saw on Obsidian Wings (written by Eric Martin) into perspective given the above:

The moral being: the federal government can work, if run by qualified people. Pointing to Bush’s obvious, predictable failures as evidence of how the federal government would perform under any stewardship is a bit silly.

Maybe pointing to Bush’s failures is a bit silly since there are at least 50 billion reasons to suggest that other administrations have had their share of regulatory failures or shortcomings.  The moral of the story is that people who want to believe that federal government “can work if it is only run by qualified individuals” best get themselves smart to the fact that the very people who are subject to the oversight/authority of the regulatory agencies are going to exert tremendous influence on those agencies.  This process is not a new one and spans both Democrat and Republican administrations.   One need not subscribe to a particular set of political beliefs to observe this reality in action.  “Change I Won’t Believe In” is a belief that this practice will be reversed anytime soon.