Forget About Another Stress Test…Let’s Fix the Banks and the Credit Markets

Posted by Michael A. Kamperman on June 9, 2009

Today Elizabeth Warren spoke truth and said we need to redo the stress test of the banks because the economy is already worse than the worst case assumptions used in the stress test.  She also called for making public the criteria used in the stress test.  This strong rebuke of Treasury’s stress test comes from none other than the Chairperson of the Congressional oversight panel for the $700 billion TARP fund.  We all know the worst case assumption for unemployment in 2009 used in the test was 8.9%.  By the end of May the unemployment rate had already reached 9.4%, and the consensus opinion is that unemployment rates in the U.S. are still rising.  But why bother with another exercise that doesn’t fix anything.  This time, let’s focus on helping the banks to heal so that we have lending banks and not zombie banks.

The first step in this process is to go back to the drawing board and establish a “bad bank.”  Every bank in the U.S. should be required to move their troubled securities and troubled in-house real estate loans to the “bad bank.”  The banks should receive a cash loan from the “bad bank” backed by the troubled assets as collateral.  The federal government should not issue more debt to fund the “bad bank.”  Instead, the federal government should print money to fund the “bad bank.”  Each bank should be allowed to transfer their troubled assets to the “bad bank” based on the 2008 year-end carrying value of those assets.  The banks will be given a very long time to repay the “bad bank.”  The banks will have cash to lend to the economy and earn an economic profit to help pay back the “bad bank.”  Importantly, all of the cash-flow from the troubled assets will go directly to the “bad bank” to pay back principal and interest.  If the cashflow from the assets do not fully pay the loan the banks will be on the hook for the difference.  The interest rate charged should be a variable rate based on the current Fed Funds rate.  The banks will ultimately bear the economic gains or losses from the troubled assets they pledge as collateral to the “bad bank.”  The FDIC will still have the authority to close a troubled institution, even if it has a loan at the “bad bank.”  And, there should be a complete moratorium on the sale of foreclosed real estate held by the “bad bank.”  Vacant real estate can be leased out by a property manager, but not sold, for as long as the economy remains in a deflationary depression.  This arrangement allows banks to buy the time they need, and it will give the economy better access to affordable credit.

Other steps will need to be taken to fix the credit markets.  Specifically, the U.S. government will need to guarantee jumbo-mortgage-backed securities and auto-backed securities.  Without an improvement in the credit markets there will be no real recovery in the broader economy.  The time for waiting for things to get better on their own is over.  The time for more gimmicks is also over.  If the economy doesn’t turn up soon, then the enthusiasm for green shoots in the markets will fade and everything will take another leg down ala 1931.  Elizabeth Warren and her Congressional oversight committee are right to say more needs to be done.  However, this time let’s do it right.