Relief from the Stress Tests

US Treasury secretary Timothy Geithner told the country last week that the banks are essentially OK, based on his stress tests
of the country's 19 largest banks. Geithner's call may not seem quite
right. After all, the bad case in the stress tests assumed that
unemployment would average 8.9% for all of 2009, and we just hit that last week. But there's no reason not to take the Treasury secretary at his word.

So,
we are told that the banks have the means necessary to get through the
downturn. In that case, why should we spend hundreds of billions of
taxpayer dollars to keep these healthy institutions afloat?

As
long as the banks were on their death beds there was a plausible
argument that taxpayer dollars were needed to keep the financial system
from collapsing. But if the banks now have a clean bill of health from
the Treasury, then it's time for the banks to stop relying on taxpayer
handouts.

First and foremost, this should mean the end of the Public Private Investment Partnership (PPIP) programme that was designed to clear the toxic assets from the banks' books.
PPIP involved a massive subsidy to the banks since it provided enormous
leverage to buyers of toxic assets, while assigning them very little
risk.

The basic story was that if an investor put up a million
dollars, the government would put up $13m. The investor would have the
opportunity to profit on $7m of this investment (her $1m, plus $6m of
the government's money), but could not lose more than $1m. The
government would profit or lose on the other $7m that it put up
directly.

Even assuming that there was no gaming of the PPIP
(banks could pay third parties to bid up the price of their assets),
this incentive structure would lead investors to bid far more for toxic
assets than they would in a free market. The result would likely be
that many investors would incur large losses with the taxpayers'
dollars.

If the banks were hopeless zombies, perhaps there
would be an argument for this sort of subsidy from taxpayers to clear
the books and allow the banks to start lending again. But, if Geithner
is telling us that the banks are healthy, can't we just let them sell
their loans in the market like anyone else? What's the argument for
special bank welfare now?

Of course the bank welfare goes well
beyond PPIP. The banks have the authority to issue hundreds of billions
of dollars of bonds that come with an explicit guarantee from the
Federal Deposit Insurance Corporation (FDIC). This is a substantial
interest rate subsidy, especially for the more risky banks. The savings
from a government guarantee can easily be 4 percentage points of
interest. If a bank has borrowed $30bn under this programme (which is
the case with the largest banks), this amounts to a taxpayer gift of
$1.2bn a year.

In addition to the FDIC guarantees, the banks also
benefit from a variety of special lending facilities established by the
Federal Reserve Board. These lending facilities allow banks to borrow
in secret and possibly pay substantially lower interest rates to borrow
the same amount in the private sector.

The Fed currently has
close to $2tn in outstanding loans (a large portion of these loans are
to non-financial companies) that were issued through these special
facilities. If the banks are really OK, then it should be time to shut
down these special channels and allow the banks to again rely on market
financing.

Finally, it should be time to shut the AIG
window. Many of the largest banks, including Goldman Sachs and JP
Morgan, had bought derivatives from AIG's financial products' division.
If AIG had been allowed to collapse last fall, then most of these
derivatives would be essentially worthless. However, the government
stepped in and decided to honour in full AIG's obligations.

This
commitment from the government was very helpful to the banks. Goldman
Sachs in particular did very well, pocketing $12.9bn (approximately 4.3
million S-Chip kid years) on derivatives that might have been worthless
without the government's helping hand. If the banks are OK, then how
about letting them bear the consequences of their bad investment
decisions rather than foisting the cost of their mistakes on the rest
of us.

In short, we should take the stress test results as good
news. Based on what Geithner has told news, the bailouts should be
over. It's time for the banks to stand on their own two feet and to get
their hands out of our pockets.