The stress tests are simply a confidence trick, which cannot possibly provide a realistic picture of banks’ underlying financial health.

Why? One cannot conduct a meaningful stress test without reviewing (sampling) the underlying loan files, and it seems likely that the purchasers of securitized instruments (not just mortgages) do not even have the loan file data. Moreover, loss ratios vary enormously depending on the issuer, so even a bank that originates (or has purchased a bank that originates) similar products cannot simply take its own loss rate and extrapolate it to measure the risk on the value of securitized credit instruments.

There are insufficient numbers of examiners to conduct a proper audit of the banks’ finances, and most lack the expertise to deal with exotic derivatives structures which are at the core of today’s financial fragility, not the loan exposures. There have been no comments, for example, about the derivatives exposures at the big capital markets players, namely Citi and Bank of America. As commentator Yves Smith notes, even if a bank as big as Wells Fargo, a very big bank but in traditional retail and wholesale businesses, were to prove terminally impaired, it might be costly to resolve, but procedurally it would not be pathbreaking.

And to what end are we conducting these “stress tests”? Is the objective to reform the financial system, or re-establish the status quo ante? As Professor Jamie Galbraith notes, “The [stress test] program is based around the assumption that the assets will recover values. But when you look at the stress tests, they seem to have been largely designed as a statistical exercise relating the valuation of different classes of assets, which the banks hold in different proportions, depending on institutions, to the performance of the economy.

The deeper problem with those assets is that they are, in the case of subprime mortgage securities, based upon documentation that is in many cases missing, contains misrepresentation and fraud on the face of the documents. Those are securities which are intrinsically unsafe, which will default at very high rates, which should never have been securitized in the first place and should not be treated as though they were financial assets.” That means, as Galbraith notes, that no amount of government money will help these assets recover unless we were somehow able to miraculous re-establish the extreme conditions of financial excess that prevailed in the middle of this decade. This is neither possible, nor desirable.
Having companies look viable as the result of massive, and seeming open-ended subsidies does not say much about how they’d be faring ex-life-support. Even JP Morgan would find it difficult to remain viable today in the absence of the panoply of financial guarantees via the FDIC that underwrites the entire system. And even worse are the distortions thrown up by this.

Here in Colorado, we’ve spoken to management of local banks, which, through no fault of their own, are now paying substantially higher FDIC insurance premiums to pay for the reckless business strategies pursued by the likes of Citi. It is akin to making a non-smoker pay increased insurance fees because most of her colleagues are 4-pack-a-day-smokers. We’ve seen that large scale banking with score based credit paradigms has fared badly.Yet these companies are being subsidized to the detriment of smaller regional and local players who are closer to their communities and can incorporate local knowledge into their credit decisions.