At one bank in Alabama, the problem is a construction bust. At two in Ohio, the trouble is real estate. And in San Francisco, at Wells Fargo, the worry is credit cards ”” a staggering 26 percent of that bank’s card loans, federal regulators have concluded, might go bad if the economy takes a turn for the worse.

The stress tests released by the Obama administration Thursday painted a broad montage of the troubles in the nation’s banking industry and, for the first time, drew a stark dividing line through the new landscape of American finance.

On one side are institutions like JPMorgan Chase and Goldman Sachs, which regulators deemed stronger than their peers ”” perhaps strong enough to repay billions of bailout dollars and wriggle free of government control.

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The relatively modest size of the hole discovered by regulators carrying out the tests, which were based on an “adverse” economic scenario, led to both applause from investors who believe the worst is over and skepticism among those who think the examination wasn’t rigorous enough.

“The fears of nationalization or of failure have more or less disappeared, and now what we’re getting is details of how banks are going to fill in their capital deficiencies,” said Eric Kuby, chief investment officer at North Star Investment Management in Chicago.

The doubters believe the banks will need much more of a capital cushion than stipulated by the regulators, as the U.S. jobless rate soars and the housing market and economy takes time to pull out of a funk, driving up credit losses.

“I’m a skeptic. I don’t see this as a genuine audit. They have been playing the marketing game strongly lately,” said Robert Andres, president of Andres Capital Management in Philadelphia.

Read it all.

6 The administration seems to bounce back and forth between emphasizing building a strong capital base and helping BHC[Bank Holding Company]’s get rid of toxic assets. I think the capital cushion is more important.
7 $34 B more for Bank of America is a big number.
8 I continue to be confused about why the administration is so confident they will not need to ask Congress for more TARP money, especially if they intend to use a lot of cash to prevent GM from liquidating.

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The habit of assessing a president’s accomplishments after his first 100 days in office goes back to the first administration of Franklin D. Roosevelt. In his first 100 days, Roosevelt laid the foundations for the New Deal. It’s an impossible standard to meet, says former Federal Reserve vice chairman Alan Blinder.

“I often say that Roosevelt cursed future presidents with the 100 days concept. … It’s just too short,” Blinder says.

In normal times, new presidents can’t hope to match Roosevelt’s accomplishments. In that regard, Obama has an advantage. These aren’t normal times. In fact, they’re the most challenging economic times since the Great Depression. So challenging, says Douglas Holtz-Eakin, John McCain’s former top economic adviser, that Obama began to influence economic policy even before he was inaugurated.

“This is the longest first hundred days, at least in my lifetime,” Holtz-Eakin says. “President Obama actually became the leader right after his election.”

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The U.S. Treasury and financial regulators are clashing with each other over how to disclose results from the stress tests of 19 U.S. banks, with some officials concerned at potential damage to weaker institutions.

With a May 4 deadline approaching, there is no set plan for how much information to release, how to categorize the results or who should make the announcements, people familiar with the matter said. While the Office of the Comptroller of the Currency and other regulators want few details about the assessments to be publicized, the Treasury is pushing for broader disclosure.

The disarray highlights what threatens to be a lose-lose situation for Treasury Secretary Timothy Geithner: If all the banks pass, the tests’ credibility will be questioned, and if some banks get failing grades and are forced to accept more government capital and oversight, they may be punished by investors and customers.

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As a Peruvian educated by British and American teachers, I learned never to embark on a major task without first “doing the math.” No more of that Latino “happy go lucky, trust your gut and say three Hail Marys” approach to life.

Without measurement, my teachers advised, I wouldn’t be able to identify and disentangle the very reality before my eyes. By doing the math, I would see order and coherence, the way things were organized; invisible relationships would come into view, and right behind order would come meaning, followed by confidence. Thanks to my Anglo-Saxon education, I learned the lesson: You cannot manage what you have not previously measured.

So imagine how I have felt watching my role models go to war over weapons of mass destruction that they never actually assessed, or now, watching them wage a losing war against derivatives….

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During World War I, Americans were exhorted to buy Liberty Bonds to help their soldiers on the front.

Now, it seems, they will be asked to come to the aid of their banks ”” with the added inducement of possibly making some money for themselves.

As part of its sweeping plan to purge banks of troublesome assets, the Obama administration is encouraging several large investment companies to create the financial-crisis equivalent of war bonds: bailout funds.

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The pricing of the toxic assets of the banks is in line with the pricing of other risky assets. There is no evidence that prices of credit instruments are now reflecting fire sales or distress selling. The evidence, if anything, suggests that the prices are actually on the high side. This means that the liquidity rationale of the Keynesians has no basis in fact.

The findings are sure to be contested in the literature, as most research is. In the end, they will prove robust. They will hold up.

The debate on bank bailouts is broader than economics. It goes to a question of justice. Should one group, taxpayers, be forced to pay for the mistakes of another group, bankers? It goes to a question of freedom versus socialism and fascism. Should banks operate in a profit and loss system and bear the losses that they incur, or should they not, in which case the financial system becomes more socialist and fascist? Even before addressing these questions, if the Keynesian policy does not do what it is claimed, then in economic terms the Keynesian case falls.
The government and FED claim that the financial system lacks liquidity. They say that there is a market pricing defect or failure. This, they say, is why the bad loans (toxic assets) held by the banks are worth more than the prices that they are fetching in the market. These prices, they claim, are fire sale prices. The remedy, they call for and implement, is for the Treasury and FED to supply the banks with liquidity, i.e., bail them out. Thus, the government and the FED are directing trillions of taxpayer dollars to shore up weak banks by buying their bad loans rather than overseeing a judicial-like process of re-organizing the banks and cleaning out these loans in established bankruptcy-like procedures.

The Austrian position is that the financial system does not lack liquidity. The bad loans were overpriced to begin with, largely because the FED and government engineered a speculative bubble. The bubble burst. The loans were repriced in the market. The loans are now worth what they are bringing in the market. Thus, the government has no liquidity justification for bailing out the banks. The government’s economic rationale has no merit. Many banks are insolvent. On the economic merits, they should be allowed to fail, not bailed out.

This may seem arcane but it really does matter. Read it all–KSH.

Mr. Obama is betting that the totality of economic policies his team and the Federal Reserve have put in place will act, like radiation therapy, to halt the spread and reduce the size of the cancerous tumors eating away at our financial system ”” and stimulate enough new growth and optimism so that Phase II will be small enough to get past Congress and the public.

As Treasury Secretary Timothy Geithner told ABC News, “If we get to that point” ”” where more funds are needed ”” “we’ll go to the Congress and make the strongest case possible and help them understand why this will be cheaper over the long run to move aggressively.”

Have no doubt, Phase II is coming. At best, it will require hundreds of billions of dollars more, at worst more than a trillion, to deal with more bad loans and toxic assets weakening the economy ”” problems that Phase I can’t fully absorb. Because unemployment is still rising ”” ensuring that the initial spate of mortgage defaults, which came from loans to people who could never repay, will be followed by another spate of defaults from those who could repay but now can’t because the deteriorating economy has stripped them of their jobs, their businesses or their credit lines.

Read it all.

Listen to it all from NPR. Note especially what he says about the so-called “Geithner plan” to rescue the banks. At some point it is going to dawn on more people that significant questions need to be asked about this plan and whether it is the right approach, since so many thoughtful industry participants and observers do not think so. But maybe that is just yours truly, since I am worried about the plan–KSH

In September 2005, Timothy Geithner made one of his most visible moves as a supervisor of the U.S. banking system. He summoned the nation’s top financial firms and their regulators to streamline an antiquated system that threatened Wall Street’s boom.

Billions of dollars worth of financial instruments known as credit derivatives were being traded daily, as banks and investors worldwide tried to protect against losses on increasingly complex and risky financial bets. But the buying and selling of these exotic instruments was stuck in a pencil-and-paper era. Geithner, then head of the Federal Reserve Bank of New York, pressed 14 major financial firms to build an electronic network that would cut backlogs and make the market easier to monitor.

Geithner’s summit, held at the New York Fed’s fortress-like headquarters near Wall Street, was a success. By fall 2006, the new system had all but eliminated the logjam, helping derivatives trade more efficiently. One financial industry newsletter honored Geithner as part of a “Dream Team” for his leadership of the effort.

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Check it out.

Ironically, the moral hazard created by the Geithner plan is similar to the incentivizing of risky mortgage investments by the government’s backing of Fannie Mae and Freddie Mac, which played a major role in causing the financial crisis in the first place, as economists Peter Wallison and Charles Calomiris describe in this paper. Wallison deserves some credit for warning about this danger back in 2005.

Both parties deserve blame for the policy of federal backing for dubious mortgages and investments. Certainly, President Bush didn’t help matters when he, in his own words, “use[d] the mighty muscle of the federal government” to promote the issuing of risky mortgages.

Barack Obama, however, promised to break with the failed policies of the past, and often criticizes those who he claims advocate “the same failed ideas that got us into this mess in the first place.” Ironically, he has now embraced some of the worst of those ideas himself.

Read it all and follow the links as well.

That’s what “Market to Mother Nature” accounting is all about. It begins with the premise that the distinction between the G-20 and the Copenhagen climate change negotiations is totally artificial. They are just flip sides of the same global problem ”” how we as a world keep raising standards of living for more and more people in ways that will not, as a byproduct, have both the Market and Mother Nature producing huge amounts of toxic assets.

The old system, which has reached its financial and environmental limits, worked like this: We built more and more stores in America to sell more and more stuff, which was made in more and more Chinese factories powered by more and more coal that earned more and more dollars to buy more and more U.S. T-bills that got recycled back to America in the form of cheap credit to build more and more stores and more and more houses that gave rise to more and more Chinese factories. …

This system was a powerful engine of wealth creation and lifted millions out of poverty, but it relied upon the risks to the Market and to Mother Nature being underpriced and to profits being privatized in good times and losses socialized in bad times. This capitalist engine doesn’t need to be discarded; it needs some fixes. For starters, we need to get back to basics ”” accountable lending, prudent saving, reasonable leverage and, most important, more engineering of goods than just financial products.

Read it all.

Here is the real plan that now seems odds on to succeed.

The Plan: Dump $500 billion of toxic assets on to unsuspecting taxpayers via a public-private partnership in which 93% of the losses are born by the taxpayer.

—Mish in his latest analysis of the Geithner “plan”

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause””Lehman was small relative to Citigroup or Bank of America””is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider…

To break this cycle, the government must force the banks to acknowledge the scale of their problems….

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U.S. Treasury Secretary Timothy Geithner said some financial institutions will need substantial government aid, while warning against any attempt to tax investors who join a federal program to buy tainted assets from banks.

“Some banks are going to need some large amounts of assistance,” Geithner said today on the ABC News program “This Week.” The terms of a $500 billion public-private program to aid banks “cannot change” for investors or they’ll lose confidence in the plan, he said on NBC’s “Meet the Press.”

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Take a look.

Now, Goldman Sachs, for example. Their chief financial officer said he had no material economic exposure to AIG. So why weren’t they forced to take a discount?

GEITHNER: George, we came into this crisis as a country without the tools necessary to contain the damage of a financial crisis like this. In a case of a large, complex institution like AIG, the government has no ability, had no meaningful ability to come in early to help contain the fire, contain the damage, prevent the spread of that fire. Restructure the firm, change contracts where necessary, and helped make sure that the financial system gets through this…

STEPHANOPOULOS: But it would have been the right thing to do, right?

GEITHNER: If we had the legal authority, that’s what we would have done. But without that legal authority, we had no good choices. We were caught between these terrible choices of letting Lehman fail — and you saw the catastrophic damage that caused to the financial system — or coming in and putting huge amounts of taxpayer dollars at risk, like we did at AIG, to keep the thing going, unwind it slowly at less damage to the ultimate economy and taxpayer.

Read it carefully and read it all.

After experiencing a few emerging-market crises, I get the sense of watching the same movie over and over. All too often, a tragic part of that movie is the failure of the countries’ policymakers to hear the loud cries of canaries in the coal mine. Before running up further outsized budget deficits, should we not heed the markets that now see a 10 percent probability that the U.S. government will default on its sovereign debt in the next five years? And should we not be paying close attention to the Chinese central bank governor’s musings that he does not feel comfortable with the $1 trillion of U.S. government debt that the Chinese central bank already owns, let alone adding to those holdings?

In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to “get their house in order” — without the slightest thought that the United States might fare no better when facing a major economic crisis. Now, I fear time is running out for our own policymakers to mend their ways and offer real leadership to extricate the United States from its worst economic calamity since the 1930s. If we insist on improvising and not facing our real problems, we might soon lose our status as a country to be emulated and join the ranks of those nations we have patronized for so long.

Read it all.

You wake up in the morning and once again the financial weather report calls for the Apocalypse followed by brief showers of despair. Seeking a ray of hope, you turn on the television and settle in to watch a Capitol Hill hearing. There in the hot seat is the man who holds the entire U.S. economy in his hands. And he looks like Harry Potter….

We do need strong leadership. The world is in chaos. There are riots from Greece to China. Iceland has collapsed, and Mexico teeters on the edge. Pakistan is broke, melting down and awash in nukes. Yes, the stock market soared with Geithner’s toxic asset plan, but didn’t he and Obama dismiss Wall Street’s response when the first version of the bank bailout landed with a thud last month? Don’t we hate Wall Street? Obama and Geithner subsidize hedge funds on Monday and come back with heavy regulations on Thursday. What gives?

Gradually it becomes clear. This is not just a global economic crisis. It’s a global leadership crisis. Obama is still finding his footing, Gordon Brown is on his way out, Hugo Chávez is nuts and Wall Street management is larcenous. Isn’t there someone somewhere with decent values, a firm hand on the tiller and at least one big new idea? Where have all the leaders gone?

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An interesting array of editorial opinion on the subject.

Update: in yesterday’s Financial Times Jeffrey Sachs did not like the plan:

The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers.

The banks could be saved without saving their shareholders ”“ a better deal for taxpayers and without the moral hazard of rescuing shareholders from the banks’ bad bets. Most simply, the government could provide loans to buy the toxic assets on a recourse basis, therefore without the hidden subsidy. Alternatively, the plan could give the taxpayers an equity stake in the banks in return for cleaning their balance sheets. In cases of insolvency, the government could take over the bank, the much dreaded nationalisation, albeit temporary. At the end of the Bush administration, Congress voted for the $700bn (€517bn, £479bn) troubled asset relief programme (Tarp) on the assurance the taxpayer would get fair value for money (for example, by taking equity stakes in the rescued banks). The new plan does not offer that.

The Obama administration will detail on Thursday a wide-ranging plan to overhaul financial regulation by subjecting hedge funds and traders of exotic financial instruments, now among the biggest and most freewheeling players on Wall Street, to potentially strict new government supervision, officials said.

The Treasury secretary, Timothy F. Geithner, will outline the broad revamping of the regulatory system, which goes further than expected, in a hearing on Thursday. He is expected to say that the new rules are necessary to prevent a repeat of the excesses that nearly wrecked the global financial system and plunged the economy into a recession.

The plan, which would require congressional approval, would give the government vast new powers over “systemically important” banks and other financial institutions that are so big that their collapse would jeopardize the economy as a whole.

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The good news from our historical study of eight centuries of international financial crises is that, so far, they have all ended. And we confidently predict this one will end, too. We are just not quite so sure it will be nearly as soon as the chirpy forecasts coming from policymakers around the globe. The U.S. administration, for example, is now predicting that growth will renew in the latter part of this year and continue at a brisk pace of 4 percent for several years thereafter. Is this a fact-based forecast or wishful thinking?

A careful look at the international evidence on severe banking crises suggests a far more cautious assessment. The recessions that follow in the wake of big financial crises tend to last far longer than normal downturns, and to cause considerably more damage. If the United States follows the norm of recent crises, as it has until now, output may take four years to return to its pre-crisis level. Unemployment will continue to rise for three more years, reaching 11”“12 percent in 2011.

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…[DONALD MARRON] I hope the government has set it up that, once it gets going, they can change the terms, as the market gets more comfortable, as more confidence this thing is actually going to work, isn’t as concerned about what the Congress is going to do as they are in the case of TALF.

So this is getting things going. There needs to be flexibility in the future. I’m assuming Tim Geithner and Larry Summers have thought that through. So once we get it started, we can make sure it becomes a positive continuing force and not some kind of a windfall.

JEFFREY BROWN: Well, Mr. Krugman, go ahead. Argue back. That’s the argument is, you need to attract investors, so…

PAUL KRUGMAN: I don’t think that’s the issue, really. I mean, there’s a lot of people who’ve got money parked in the banks. The problem is that people — it’s the banks as institutions that are the issue, not whether people are willing to buy these particular assets.

In a way, we’d like to make the whole story of these assets go away. The only reason that they’re there, the only reason it’s an issue is because the banks have lost so much money that they are not effective at their job of passing funds from one end of the economy to the other.

This is not going to change that. I mean, it’s going to make some of the stuff sell for a slightly better price, but the banks are still going to be deep underwater, at least the troubled ones are going to be. It’s going to convey some windfall benefits to people who are holding some of this paper who are not actually crucial financial intermediaries.

Read it all. I am on the Paul Krugman side of the argument, believing this treats symptoms rather than the disease. I would love to be wrong–KSH.

An infographic that flowcharts the nearly $12 Trillion allocated in government progams affecting the financial services industry.

In all the uproar over AIG, the most important lesson has been ignored. AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG’s outstanding positions without abrogating any contracts.

CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating.

Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect.

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The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document.

The government at present has the authority to seize only banks.

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The long awaited details of Geithner’s “plan” for dealing with bad bank assets is finally out. Githener’s plan is disingenuous at best. If people want to be outraged at something, it should be over Geithner’s plan.

Read it carefully and read it all.

Meanwhile, there is little prospect that Congress will do what is necessary to bring spending and borrowing down to levels that do not trigger inflation. Politicians just don’t worry as much about inflation as about catering to their multiple constituencies. So the Treasury will have more trillions in IOUs to peddle.

But its best customers just might be unenthusiastic about adding significantly to their holdings. Wen already owns trillions in Treasury bills that are depreciating in value. Besides, China’s mounting needs for infrastructure and an improved safety net will sop up funds once used to buy American securities. Japan, another large customer, is now running a current-account deficit, and so it won’t have as many dollars to recycle. Nor will Middle East buyers, no longer receiving a flood of dollars from $140-a-barrel oil. Little wonder that Larry Lindsey, former economic adviser to President George W Bush, says he “cannot figure out what combination of foreign buyers is going to acquire . . . [the] debt” that Obama’s plans will generate.

Which leaves Americans and the Fed as customers. Even if they save more, domestic consumers can’t absorb all the Treasury bonds that will be on offer. And if the Fed keeps buying, it will pour fuel on the inflationary fires.

Read it all.