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Sunday, February 15, 2009


Published: February 14, 2009

Fair Game
The Worst Misstep: Geithner Added to the Doubt
Geithner was not especially articulate, his critics said, and he provided only an outline of an outline, not the detailed blueprint people anticipated and wanted.

To a degree, one of Mr. Geithner’s biggest problems was not of his own making. His boss, President Obama, had fanned expectations for his debut as Mr. Fix-It, leaving the impression that it would be boffo. It wasn’t.

Why is anyone surprised that Mr. Geithner’s Financial Stability Plan lacked details? We are still in sugar-coating mode — yes, we have a problem, government officials contend. But they can handle it. Don’t you sweat the details, dear taxpayers.

To be sure, Mr. Geithner is in something of a box. If he were to lay out precisely how he plans to save the financial system, he might actually telegraph to the public that the problem is more dire than they suspect. Being vague might be less scary. Unfortunately, market participants have lost their patience with vague. Uncertainty, for investors anyway, can be worse than simply acknowledging genuinely grim circumstances.

Treasury’s fuzziness, of course, also provides an opening for corporate lobbyists to step into the vacuum and bend the program to suit their needs. Taxpayers, on the other hand, don’t have lobbyists arguing on their behalf.

Many of the questions arising from Mr. Geithner’s bailout haiku involve the matter of the so-called stress tests that he said the government would use to analyze the nation’s banks. The tests are to determine which banks have the best shot at survival and therefore merit taxpayer money. No sense throwing taxpayer funds at zombies.

But Mr. Geithner did not detail what his stress tests would measure. “We want their balance sheets cleaner and stronger,” he said. “And we are going to help this process by providing a new program of capital support for those institutions which need it.”

Any measurement of bank health would most likely require answering two questions: What is the equity that the bank has on hand and how much earnings power does the institution have to make it through the economic downturn?

Measuring equity positions at banks today is easy, if unsettling. During the credit boom, banks used excessive amounts of debt to juice their returns. This was especially so at the largest institutions, and it has left many banks in a very deep hole now that they may not have the cash or the earnings power to pay down all that debt.

Identifying banks that have the wherewithal to earn their way out of that hole is far more complex because it involves knowing where the economy will be in six months or a year. If you assume that we will emerge from the recession soon, the stress test might generate one result; a graver economic outlook would produce an entirely different projection of a bank’s potential for survival.

(And let’s face it, do you think the economy is going to rebound anytime soon?)

Let’s consider a hypothetical stress test. Say a bank has $120 in assets of which $100 are loans. That means its tangible equity to assets ratio is 1.2 — a very weak position. If those loans had to be marked down because the market was troubled, reducing their value to $85, the bank would have a negative equity-to-assets position (homeowners who have mortgages that are greater than the market value of their homes know exactly how this feels).

Faced with that situation, anyone trying to determine whether a bank should be saved would then have to assess whether the firm has enough earnings mojo — or an ability to raise more money — in order to wait out the current economic malaise. The longer the malaise lasts, the more earnings potential or extra capital a bank would need to survive.

Private investors are not going to be willing to put money into an institution whose business model is broken and whose profit power is limited. Investors in the stock market have already run their own stress tests on the banks and have found many of them lacking — hence the free fall in the share prices of many banks.

On the bright side, lots of small banks that focused on good, old-fashioned lending are considerably better off than their big and formerly powerful brethren created in the merger mania of the last decade.

So here’s a strong first step: the Treasury Department needs to hire out-of-work bankers to conduct what investors call a “burndown analysis” of banks’ financial positions. This is what private investors do as they go foraging for gems hidden amid the wreckage in the banking system.

A burndown analysis, because it is a worst-case exercise, typically requires very pessimistic estimates for loan performance early on and higher-than-average loss estimates for loans in later years. A bank’s prospects also derive primarily from its deposits, not its loan book, in such an assessment. To reiterate: Any examination of a troubled financial institution needs to determine what its assets are truly worth, how much can it earn and how much capital it needs to operate at a profit.

THERE is no silver bullet to end this crisis, and Mr. Geithner was correct when he said it was going to take time to work our way out of it.

But it will also require transparent, rigorous analysis; candor with the public and investors; and a recognition that lots of debt heaped upon a pile of dubious assets has created a financial nightmare — it’s no more complicated than that.

Worst of all, none of this had to happen. Regulators should have been more vigilant.

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