What, me stressed?

While foraging for bagels this morning in one of Washington’s schmancier chow lines I ran into an old friend this morning who is a very successful real estate developer. He was having breakfast with the chairman of one of America’s largest banks. Not surprisingly, the conversation turned to the stress test results. (I find discussing the economy before I eat is an effective diet technique.) A few highlights from this widely-respected banker’s animated, often rueful comments, although I’m not sure “highlights” is precisely the right word:

• We knew there was a problem brewing when we got the first tests results back and they got the arithmetic wrong. They had their numerators where their denominators were supposed to be. It was a rocky start.

• I wish that the public could hear the full nature of our conversations with Treasury. Geithner and others go to the public and talk about all they are doing to increase liquidity but behind the scenes the real people we work with every day are putting up road blocks to lending, saying you can’t do this or you can’t do that.

• Of course, this stress test would have been better if the results had been kept private and that was the original goal. But it just wasn’t realistic and that’s why we’ve already seen so many leaks.

• The original problem we had was with real estate, bad loans, and our banking system. We have effectively done nothing to address the underlying real estate problem thus far. Spending a trillion dollars on new infrastructure is not going to do that. Some banks, like Citi, have not accounted for their bad debt as conservatively as others, like ours, have.

• We are still not accounting for the problems that have yet to come.  Commercial real estate and consumer credit are big systemic risks that are still out there and have not been effectively addressed or even accounted for.

• Treasury does not seem to yet understand the difference between commercial banks and investment banks. All we are doing is working to protect the interests of Wall Street investment banking types and not address the underlying issues or make the changes that need to be made.

I’ve heard the warning about commercial real estate several times recently, noting that there are at least tens of billions in potentially bad loans out there that will be coming home to roost in the next year or so. This major U.S. banker was clearly not a happy camper and was deeply skeptical that the administration really has its arms around the problem in U.S. financial markets yet. The real estate developer with whom he was speaking said, “Welcome to 1928. The big problems and down turns are out there a year or two ahead of us.” 

It’s hard to know what to make of such pessimism except that the sources were certainly credible enough to demand a good hearing. I’m not sure this stress test is going to achieve its original intentions which were, presumably, to get to the truth about the financial health of America’s biggest financial institutions. There are too many variables and the roll-out of the stress test has been as fraught with so many hiccups and delays that it is reminiscent of many a hollywood flop. You don’t postpone the release of your May blockbuster because you are confident it is going to do well. When the early reviews from critics who should be in the administration’s pocket, like Warren Buffet, are so mixed, it is hard to be too optimistic. In the best case, the stress tests briefly reassure the markets.  But as the banker with whom I was talking this morning noted, when some of these banks need money, “who is going to want to invest alongside the U.S. government who can change the rules unfavorably at any moment” and as he also noted, “we won’t know what’s right or wrong about these stress tests for months or years.”

In other words, the government hands out its grades now…and consistent with its other economic efforts count on at least a little grade inflation…but the markets won’t offer the final and binding grade until quite some time from now.

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