I rarely have the radio on in the middle of the day. But yesterday on the Bloomberg Radio Hays Advantage, Kathleen’s guest was David M. Jones Sr. Dr. Jones is a professional economist and consultant and the principal in DMJ Advisors. He holds a Masters and a PhD (presumably in economics) from the esteemed University of Pennsylvania. He was speaking with Ms. Hays on the subject of financial reform and the role of the Federal Reserve.
Departures from Reality
Dr. Jones argued for the centrality of the Fed as chief financial regulator since they had garnered enormous expertise in banking practices in the current crisis. That is a pretty remarkable statement, as the Fed purportedly had a major bank regulatory role BEFORE the crisis. When events exploded, the Fed was clearly part of the problem. They in fact had condoned shoddy lending practices and therefore contributed to the consequences we face now. (As examples, the Bear Stearns-J.P Morgan forced merger, the Lehman and AIG insolvencies). On this issue, I guess we should all be glad if the Fed at least has learned that lesson. But have they? Dr. Jones then lauded the government for the 2009 “stress tests” of the nineteen major banks. These tests have purportedly restored confidence in our financial system. Jones maintains that these “rigorous” tests demonstrate the reaffirmed solvency of the banks.
Stress Tests and Public Relations
Dr. Jones is wrong because the stress tests were not valid, but in fact were a public relations stunt. Independent economists and bloggers such as Michael Shedlock, Karl Denninger and Martin Weiss felt the tests were at best deceptive and at worst fraudulent. Instead of demonstrating the financial worthiness of the banks, the terms of the “stress tests” exposed fundamental weaknesses in these banks’ financial health. Let’s look at some of the criteria, assumptions and methodologies the government utilized to assess solvency.
- Worst case scenario too optimistic – The government assumed that at worst losses would not exceed $950b by the end of 2010. Projected bank losses far exceeded that worst case. The IMF projects a range of loss of 2.4 – $4.1 trillion; Karl Denninger projects residential mortgage losses at 2.5 trillion, and Nouriel Roubini’s loss estimates are in excess of $1.8 trillion.
- The “Take Home Test” – Using two alternative macroeconomic scenarios, the government required the banks to estimate their potential losses on loans, securities and trading positions, as well as pre-provision net revenue and the resources available from the allowance for loan and lease losses. Karl Denninger in The Scam of the “Stress Test” commented:
They asked the banks, they did not send in a team of examiners to look at the books independently. So the base data that was ingested into this process in fact came from the banks themselves, not from independent, outside examination. As a consequence it is fair to ask where the valuations came from and how they are supported, including the models and other information used to develop these figures.
This data is not disclosed.
Second, some of the data points and “expected losses” are comical. For example, the banks are expected under the “more adverse” situation to believe that prime mortgage losses will not exceed 4%, and ALT-A (liar loans and Option ARMs) will not exceed 13%. HELOC loss (most of which is unsecured!) is expected not to exceed 11%.
- Bank Permission to Massage and Change Results – Some banks did not like the results, so they lobbied for methodology and outcome changes. Karl Denninger again reports:
Some major banks managed to wrest concessions from the government in closed-door negotiations over their “stress tests” that helped them put the best face on their results, financial analysts, industry officials and sources said.
So in essence the entities being examined became the architects of their own examination. In what universe do we do that? Do we allow school students to write their own tests? The resulting continued wave of residential delinquencies, foreclosures, losses on second mortgages (home equity lines) and commercial real estate demonstrate that the stress tests were flawed. In fact, utilizing 2010 data from FDIC losses in bank seizures, Mr. Denninger estimated losses at just 4 major banks (Bank America, Wells Fargo, Citicorp and JP Morgan Chase) to be in the range of $1.5 to $3 trillion. See All You Need to Know About Bank Balance -Sheet Fraud
Sometimes the Truth Appears
Yesterday, Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, blasted the current large bank regulatory regime. See Kansas City Fed’s Hoenig Endorses Volcker. The top 20 banks have a grossly unfair economic advantage by way of explicit government loan guarantees. Without these guarantees the top 20 would need $210 billion more in new equity, or would need to shrink their lending activities by $3 trillion. How does this need for capital square with the confidence building stress tests?
Dr. Jones is a sad example of economists who slavishly follow the government line of thought. Dr. Jones should be asking some tough questions: why do we need $23 trillion of government guarantees for our financial system to be solvent? Why are short term interest rates still set at zero for our top banks? Why have we been in a state of financial emergency since 2008 if the economy is recovering? Were the stress tests a scam to help the banks raise cheap capital? Given the Fed’s past poor regulatory performance why give them more plaudits and power?
Perhaps the Administration and the Federal Reserve have done a better job at capturing prominent economists and our news media than regulating the banks - of course, all to the taxpayer’s detriment.
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- Extend, Pretend and Crash?
- Surfing the Financial Crisis
- Who Pays?
- It Doesn’t Matter Until It Matters
- The Tragedy of the Commons Part II: Modern Finance and BP
Tags: Bloomberg, Citicorp, Dr. David M. Jones, Hays Advantage, JP Morgan Chase, Karl Denninger, Martin Weiss, Michael Shedlock, Sr., stress tests, Thomas Hoenig, Wells Fargo
