After the Stress Tests

Financial institutions are in a rush to exit the government’s $700 billion rescue operation, but policymakers need to consider the consequences of hasty repayments, writes David Min.

People exit the Financial Square building  following the Goldman Sachs shareholders meeting on May 8, 2009 in New York. The Federal Reserve and the Treasury Department officially released the results of the bank stress tests, and several recipients of the government's $700 billion financial rescue package want to exit the program, with Goldman Sachs Group Inc. expected to lead the way. (AP / Louis Lanzano)
People exit the Financial Square building following the Goldman Sachs shareholders meeting on May 8, 2009 in New York. The Federal Reserve and the Treasury Department officially released the results of the bank stress tests, and several recipients of the government's $700 billion financial rescue package want to exit the program, with Goldman Sachs Group Inc. expected to lead the way. (AP / Louis Lanzano)

It’s only been a week since the Federal Reserve and the Treasury Department officially released the results of the bank stress tests, and already several recipients of the government’s $700 billion financial rescue package want to exit the program, with Goldman Sachs Group Inc. expected to lead the way. The stress tests concluded that the U.S. banking system needed a relatively paltry $75 billion in additional capital to protect against the “worst-case” economic downturn, but this doesn’t necessarily mean that the healthiest of the stress-tested banks are ready to stand on their own.

Even assuming that the results of the stress tests are based on a “credible” worst-case scenario—which many dispute—it is still worth considering what the next steps should be before the banks given a clean bill of health by the stress tests are allowed to opt out of the more rigorous oversight requirements of participating in the $700 billion Troubled Asset Relief Program. Policymakers probably need to do so soon, too, given the desire of Goldman Sachs, J.P. Morgan Chase &Co., BB&T, and US Bankcorp, among others, to return the government’s investments in their preferred shares.

Here are three considerations that officials at Treasury, other government agencies, the Fed, and Congress should make before deciding whether any of the recipients of TARP funds should be permitted to exit the program. First of all, the Treasury and the Fed should be keenly aware of potential negative developments in the broader credit markets, in the event that the critics of the stress tests are correct. The Obama administration must not remain beholden to its stress test results—and the policies tied to them—even in the face of contrary evidence.

Second, banks that are deemed healthy enough to opt out of the more onerous TARP oversight rules should also be forced out of the various government subsidies that are directing huge amounts of taxpayer money to banks in the hopes of keeping them liquid and profitable. If a bank is healthy enough to survive without extraordinary government oversight, then that bank should also be able to survive without extraordinary government subsidies, including funds from the $12 trillion alphabet soup of Fed, Treasury, and Federal Deposit Insurance Corporation programs designed to keep the banking system solvent.

Finally, Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke should articulate a vision for unwinding these extraordinary financial stability programs, which have effectively endowed the financial system with enormous subsidies and a strongly implied government backing. If the banking system is as healthy as the stress tests are indicating, then the Obama administration should consider shrinking its various bank subsidies, including the Public-Private Investment Program (designed to relieve the banks of toxic financial assets using hefty government subsidies) and Term Asset-Backed Lending Facility (designed to jumpstart key secondary markets in financial assets such as car loans, small business loans, and real estate loans).

These three conditions, which we explore in further detail below, will require some policy analysis before implementation can occur. Fortunately, even if the stress tests are overstating the health of the financial system, the current relative calm is as good a time as any for Geithner and Bernanke to begin thinking about how they might pull back government subsidies that provide financial institutions with taxpayer-subsidized profits alongside explicit government guarantees, jeopardizing the federal balance sheet in addition to directing scarce resources toward Wall Street and away from Main Street.

Keeping a watchful eye on the stress-test results

The stress tests results were publicly released last week. These “carefully designed, credible” test results found a total capital shortfall of $75 billion among the 19 largest financial institutions against the “worst-case” economic scenario. These relatively positive findings were greeted enthusiastically by the stock markets, which recorded major gains the week of the stress tests.

But while the markets may have reacted positively to the stress tests, many prominent experts did not. Nobel Prize-winning economists Joseph Stiglitz and Paul Krugman, prominent economist Nouriel Roubini, widely read pundit Arianna Huffington, and popular financial blogger Barry Ritholtz are all among those who have publicly criticized the stress tests as “not very stressful” or “fudge tests.” These are all observers who, it is worth pointing out, were well ahead of their peers in recognizing the credit crisis early on.

Treasury itself explained the better-than-expected stress test results as the product of an improved economic and market outlook alongside bank efforts to raise capital ahead of the release of the stress test results. And to be fair to the Obama administration, there are some pretty heavy hitters that support the stress test results as well. Financial guru George Soros recently stated his belief that the downward economic cycle appeared to be ending, and Goldman Sachs chief economist Jan Hatzius predicted that banks could earn enough money over the next two years to cover their remaining credit losses.

Criticisms of the stress test notwithstanding, if we assume that the stress tests do in fact represent a credible worst-case scenario, then the financial system appears to be in much better shape than had originally been thought. Treasury and the Fed should be applauded for their efforts. But this successful interlude should not be a moment to abandon vigilance. In the coming months, we can expect to see major credit losses in the areas of commercial real estate and credit cards (although the full extent of these losses may not be known for much longer, due to the recent Financial Accounting Standards Board decision to allow firms additional leeway in avoiding loss recognition on hard-to-value assets). These losses in turn could blow a hole through the “worst-case” scenarios of the stress tests. Some have even pointed to municipal bonds, long considered one of the most ultraconservative types of investment, as a potential source of enormous losses for the banking system.

It is clear that the dangers warned of by the many credible critics still remain, and should real-world events prove to rebut the basic assumptions of the stress tests, the Obama administration should have a Plan B to fall back on. Should the real economy continue to decline or credit defaults continue to rise, policymakers should be ready to revisit the results of the stress tests, and change course if necessary. This process should be public and transparent to ensure the continued confidence of investors and depositors in our financial system.

Cutting the purse strings for banks that opt out of TARP

According to media reports, JP Morgan, Goldman Sachs, BB&T, and U.S. Bancorp, among others, are seeking to repay the TARP funds they received under TARP’s Capital Assistance Program in order to end the additional oversight requirements for TARP recipients. These include stringent reporting requirements, restrictions on the use of funds, a prohibition on mergers or acquisitions, and caps on executive compensation.

Under current rules, banks must meet three requirements to repay the TARP preferred shares and get out of the TARP oversight regime. First, they must raise senior unsecured long-term debt in the private markets without a guarantee from the Federal Deposit Insurance Corp. Second, they must purchase back the warrants they issued to the government at a fair market price. Third, they must be deemed “well capitalized” by their primary bank regulator.

While news of banks being healthy enough to leave the TARP program is a welcome sign, such repayment should only be allowed pursuant to one additional requirement: Any banks opting out of the TARP regime also opt out of the various Fed, Treasury, and FDIC programs that have been providing them with easy profits subsidized by the taxpayer. The federal government has committed over $12 trillion in an alphabet soup of guarantees, subsidies, investments, and cheap financing, most of which is not money from the Troubled Asset Relief Program, providing the financial system a major shot in the arm in the hopes that major surgery can be avoided.

If the stress tests have shown that certain banks are now healthy, and the inoculation has been effective, then we need to start figuring out how to wean them off of these government subsidies before they become addicted to them. If banks are “earning their way” out of their losses based on extraordinary government subsidies, then those banks should not also be allowed to opt out of the government oversight that goes with it.

At a bare minimum, banks seeking to repay TARP funds should be barred from participation in the FDIC’s Temporary Liquidity Guarantee Program (which extends the FDIC guarantee from deposits to senior unsecured debt), and the Fed’s Term Auction Facility (which allows bank holding companies to borrow money cheaply, secured by distressed assets such as toxic mortgage-backed securities) and Term Securities Lending Facility (which allows investment banks to borrow money from the Fed just like commercial banks can). These institutions should also be barred from participating as sellers in the forthcoming Public Private Investment Program, which was designed to provide taxpayer-subsidized financing to help struggling financial firms get toxic assets off their balance sheets.

As a simple rule, financial firms that opt out of the special oversight provisions created to provide regulators with more power during these extraordinary times must demonstrate that they are able to thrive without the benefit of government subsidies that were created to deal with our extraordinary circumstances.

Contemplating a day when the banking sector doesn’t rely on subsidies

Given the relatively positive results from the stress tests, the Obama administration should begin to plot the eventual unwinding of the various guarantees, subsidies, and investments that have been put in place on an ad hoc basis to try to prop up the struggling credit markets. How will these programs, which after all provide an enormous benefit to a large number of powerful financial institutions, be withdrawn? Under what time frame? It is critical that Treasury, the Fed, and the FDIC begin to think about this, given the enormous risk these $12 trillion in commitments pose to the federal balance sheet.

Treasury and the Fed ought to also consider scaling down the Public-Private Investment Program and nix its plans to expand TALF to include legacy securities, or those financial assets created during the credit boom as opposed to new financial assets created during the current economic recession. As discussed previously in a piece written by CAP Vice President for Economic Policy Michael Ettlinger and myself, PPIP is a $1 trillion program designed to deal with the problem of troubled bank balance sheets by providing cheap and abundant government-subsidized debt financing to private investment funds to purchase troubled assets—the premise being that these investors can pay a higher price for these troubled assets because of the free leverage being provided by PPIP. While there has been some debate over whether PPIP will work, it seems undisputed that it will provide a major subsidy to investors and perhaps to the banks selling these troubled assets as well.

An important part of the PPIP is the expansion of TALF to include “legacy securities.” TALF was originally designed as a $1 trillion program to provide liquidity for struggling debt securities markets, including commercial real estate and consumer loans. But with the release of PPIP came the announcement that TALF would be expanded to include the purchase of so-called “legacy” securities, another term for troubled mortgage-backed securities and other asset-backed securities. In other words, TALF would be used to help buy up toxic assets from the balance sheets of struggling financial firms. Like PPIP, TALF relies on government-provided debt financing to provide cheap leverage financing, which can then be used to justify higher prices for these toxic assets. And like PPIP, TALF’s ultimate efficacy is a matter of debate, but its subsidy to investors is not.

If the banking system is as healthy as the Obama administration and many investors appear to believe, then it is worth considering how and to what extent PPIP and TALF’s expansion to legacy securities—which collectively total $2 trillion in potential funds and were developed during the worst part of the credit crisis—should be scaled down. If the banking system, which admittedly even under the rosiest scenario has a long way to go before returning to normalcy, is healthier than expected, then we should consider shrinking TALF and PPIP accordingly so as not to unduly burden taxpayers and enrich hedge funds and banks, as well as the strained federal balance sheet.

Ultimately, events in the real world will determine whether or not the encouraging stress tests results are credible. Since the Obama administration is putting its reputation on the line with these stress tests results and the relatively sunny picture they paint of our financial system, they should begin proceeding along these lines, considering what the future might look like following this great credit downturn.

David Min is Associate Director for Financial Markets Policy at the Center for American Progress. To read more about the Center’s financial policy recommendations please go to the Markets and Regulation page of our website.

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