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The Obama administration program to address the fragility of the banking system is based on a two major initiatives. First, it has proposed the Geithner- Summers Plan to buy subprime securitized assets from the banks. The toxic assets plan deals with less that 40 percent of the balance sheet of the banks that is in marketable securities. It does not deal with the 60 percent of the balance sheets of US banks that are loans and are not marked to market. Further, it will take six months to get the program in motion. The plan elicited deserved criticism from reputable analysts, including Paul Krugman in his NYT column. As Krugman points out in his column this plan is the third variant of an old plan to lift the value of toxic assets. The plan meets Einstein’s definition of madness: continuing to do the same thing, hoping for a different outcome. Jeff Sachs (FT, March 23), Joseph Stiglitz (NYT, April 1) and Peyton Young (FT, April 1) added their concerns that the plan nationalizes losses and privatizes profits.

The second part of the administration program is the now famous stress test of the nation’s largest banks. The other dimensions of the Geithner plan are the loan-purchase program run by the FDIC, the Treasury securities-purchase component of the PPIP is supplemented by the expanded Fed TALF program, and the various programs aimed at lowering rates in the conforming mortgage market.

This article argues that the Obama Administration is in denial regarding the problems in the financial system. The losses in the banking system are not an “unknown unknown”. As shown below, the stress test calculations can be conducted by any informed analyst, and the losses are known with a reasonable degree with approximation. The stress test is simply a “smoke screen” designed to postpone the inevitable moment when the administration has to deal with the well known and severe problems in the banking system.

As with the subprime crisis, there is a collective reluctance to review and analyze the information available and timidity in addressing the obvious problems. The FDIC Quarterly Banking Profile is a quarterly publication that provides the earliest comprehensive summary of financial results for all FDIC-insured institutions. An informed review of the balance sheet of the banking system as of December 31, 2008 shows that Tier 1 capital is $1,296 billion, of which only $1 trillion tangible equity, while the rest of Tier 1 is goodwill, and other intangibles. The loans outstanding are $7,873 billion. The report also informs that the Reserve Coverage Ratio (noncurrent loans to loan losses reserves) has declined from over 220% in 2005 to slightly under 80% in 2008. Further, at this stage the loan losses reserves for the average outstanding loan are slightly over 2 cents on the dollar. Economists at Goldman Sachs estimated recently that banks were valuing their mortgages at about 91 cents on the dollar (Showdown Seen Between Banks and Regulators, NYT, April 10, 2009).

A charitable stress test of the balance sheet uses the following conservative assumptions: Increasing the level of nonperforming loans to 8%, which was the level of non-performing loans during the 1991-2 recession; and establishing a modest coverage ratio of 100%. Without going into the gory details of my calculations, the Tier 1 capital shortfall is $753 billion under those very liberal assumptions. $630 billion (8%) in non performing loans is a very benign estimate. McKinsey - as well as others, such as Goldman Sachs - estimates that US banks may currently hold as much as $2 trillion of impaired assets. (A better way to fix the banks (The McKinsey Quarterly February 2009 Lowell Bryan and Toos Daruvala)). In the new Global Financial Stability Report the IMF is expected to estimate the potential losses of U.S.-originated credit assets held by banks and others at $2.8 trillion. With more conservative assumptions, including non performing loans comparable to the 1982 recession, and a coverage ratio of 200%, the shortfall of capital is north of $1.5 trillion.

The banking system is severely undercapitalized, with numerous insolvent banks. Clearly a more robust banking system requires far more capital and a robust loan loss reserve adding to the capital cushion. Until the trillion plus of impaired assets are removed and the banking system is recapitalized, credit flows will be restricted. In this context, it is puzzling why the administration is tinkering at the fringes with programs designed to enrich Wall Street. Geithner and Summers need to address the banking problems square-on.

Source: Geithner and Summers Need to Address the Banking Problems Square-on