Page 37 - Accelerating out of the Great Recession

ACCELERATING OUT OF THE GREAT RECESSION

Not surprisingly, given these rosy assumptions, all the banks
passed. Indeed, based on these results, only $75 billion of addi-
tional capital apparently would be required to restore the health
of the system, and nearly all of that could be raised privately.
The trillion-dollar capital shortfall mysteriously disappeared.
However, it was not just the wrong macroeconomic assump-
tions that drove this result. First, the U.S. government’s effort
was seriously understaffed. The total number of regulators
engaged on the stress tests was smaller than the number of
auditors who typically would perform a routine audit for any
one of these institutions.
Second, it turns out that the scenarios were actually negotiated
among different segments of the U.S. government that had
vested interests in the outcome. And the banks, too, negotiated
their own stress-test results: they were allowed to use their own
asset-valuation models—the very same models that had led them
into the current situation. Securities were valued using not mark-
to-market but mark-to-model, which is more easily manipulated.
The Treasury broadened its definition of capital to lower the cap-
ital needs. And leverage requirements were set at 25:1, which is
substantially higher than most independent observers would have
proposed as the correct leverage level for the U.S. banking system.
In short, they—the government, in collaboration with the
financial institutions—took a very optimistic view. The primary
purpose of the exercise was to reassure a jittery market worried
about the debt-laden government’s ability to stabilize the finan-
cial system. It worked. The markets were reassured, believing that
additional intervention would be necessary only if the conditions
deteriorated further. Unfortunately, the exercise left fundamental
issues unaddressed. The governments chose not to force through

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