Stress Test: Obama's Rosy Scenario

Now it's official. Prosperity is right around the corner. We have heard
the good news from both Wall Street and Washington. President Obama is
careful not to use those very words, since this is what Herbert Hoover
kept telling Americans during the country's ugly, post-1929 slide into
the Great Depression. But the Obama administration sees "green shoots"
sprouting all around and it offers hard evidence in the long-anticipated
results of its "stress tests" for major banks. Good news! Nobody is
insolvent. Some major names need to raise more capital--a not exactly
trivial $75 billion more--but not to worry. They can all weather the
storm, with a little more aid from Uncle Sam.

he stock market turned bullish in anticipation, and so has Federal Reserve
chairman Ben Bernanke. With few qualifiers, the Fed chairman announced a
recovery is likely in the second half of the year. Well, maybe not for
employment, but that's a lagging indicator and financial markets always
lead the way. If these forecasts are true, the celebrated "stress tests"
are an anticlimax. Things already are on the mend in the banking system.
When the $800 billion economic stimulus spending fully kicks in, the
animal spirits will also return to the real economy of producers and
consumers. There will be "a chicken in every pot," as Herbert Hoover
used to say.

Barack Obama's wholesome optimism is doubtless sincere, and so was
Herbert Hoover's. But in Hoover's day, people did not believe him. They
could see for themselves it wasn't true. In time, Americans came to
revile Hoover for his repetitious happy talk.

President Obama is now flirting with the same fate. He and his
lieutenants, much like the Bush administration before them, are
convinced that the nation's crisis can essentially be reversed by
restoring "confidence" among investors, producers and buyers. So they
talk up every budding blossom as proof. So did Hoover.

Reality is unlikely to cooperate, because the core of this crisis is not
psychological. It is about real breakdown and real loss--trillions of
dollars lost to the collapsing financial values, thousands of businesses
and banks deeply damaged by collapsing balance sheets and markets.
Wishing does not necessarily make it so. Talking up the economy
prematurely may actually yield an opposite result--deepening cynicism
and mistrust, a sense that the authorities do not know what they are
talking about or, even worse, are concealing the truth.

More bearish analysts look beyond the good talk and they see deepening
troubles for the banking system. While Obama's technocrats captured the
big headlines with their encouraging "stress test" results, a private
firm produced its own "stress test" on the very same day and it told an
opposite story. The Institutional Risk Analytics Bank Monitor produces
quarterly reports for investors on the health of individual banks and
the system as a whole. IRA has gained enormous prestige in financial
markets during the last few years because it has consistently been far
ahead of government regulators and economists in warning about big
trouble ahead.

Contrary to the government's claims, IRA's analysis is not brightening.
IRA crunches the internal numbers that all banks report to the FDIC. It
finds "a dramatic climb in the stress in the US banking industry." More
and more financial institutions, large and small, are losing stability
or capital cushions as net incomes turned turned negative for 1,575 of
them. IRA's Bank Stress Index jumped from 1.8 at the end of 2008 to 5.57
in the first quarter of 2009.

"Our overall observation is that US policy makers may very well have
been distracted by focusing on 19 large stress test banks designed to
save Wall Street and the world's central bank bondholders, this while a
trend is emerging of going concern viability crash taking shape under
the radar," IRA explained. That is a polite way of saying Treasury
Secretary Tim Geithner and Obama's economic guru, Larry Summers, are so
fixated on trying to save their old Wall Street colleagues they do not
seem to recognize the deterioration underway broadly in banking. The
trend, as IRA has noted in the past, is that "US banks have been
migrating down the quality slope taking an average of nine months to
complete the journey from A to F on the stress scale." That trend
accelerated in the first quarter, the Bank Monitor said.

What happens typically to some healthy banks, IRA explained, is they
encounter business failures and loan losses, then move to curtain their
lending and reduce risks. But that step perforce reduces their incomes
too. "This is a rare diet to try to live on in these times," IRA
observed. "The bank, which makes its living wage from interest it
collects from its lending engine, slowly starves." When operating costs
exceed declining earnings, banks typically try to pump up their income
from service fees--"a move that only serves to increase customer
reluctance and mistrust." This retracting credit system is the classic
pattern in recession and has now reached a more threatening stage. Sick
banks stop lending. Where is the government intervention to reverse
that? This president rejected the activist approach.

"We may have wasted valuable time trying to save Wall Street at the cost
of Main Street," IRA's Christopher Whalen warns. "...Has the time come
to shift the policy focus away from the things that we love, namely big
zombie banks, to tackle those things that are truly hurting us?"

I am not a banking expert. I cannot say if IRA is right or not. What I
do know is that, up until now, this private firm of bank analysts has
been way more right than the government in Washington.