Time for Some New Stress Tests for {SCUMBAG}Banks

By SIMON JOHNSON

Simon Johnson, the former chief economist at the International Monetary Fund, is a co-author of “13 Bankers.”

How much damage to the financial system should we expect from what is now commonly called the foreclosure morass, the developing scandal involving document robo-signing (and robo-dockets), completely messed up mortgage paperwork and highly publicized inquiries into accusations of systematic and deliberate misbehavior by banks?

The damage to banks’ reputation is immeasurable. They have undermined property rights — the ability to establish clear title is a founding idea of the American republic. They have mistreated customers in a completely unacceptable manner. If people doubted the need for a new consumer protection agency dealing with financial products — and the importance of having a clear-thinking reformer like Elizabeth Warren at its head — they have presumably been silenced by recent events. (If you need to get up to speed on the basics of this issue, see this series of posts by Mike Konczal.)

But what is the cost in terms of additional likely losses to big banks? The likely size and nature of these are leading to exactly the kind of systemic risks that the Financial Stability Oversight Council was recently established to anticipate and deal with.

It is hard to know how the precise numbers for losses will end up; so much uncertainty remains about the basic parameters of the foreclosure problem. A lot of smart people are looking for ways to sue the big banks — in particular to force them to take back (at face value) securities that were issued based on some underlying degree of deception.

This is a fast-evolving situation in which every day brings potentially significant news, but our baseline view is that the losses are in the range of $50 billion to $100 billion — that is, these are “new” losses not yet recognized by banks. (Our downside possibility, with perhaps a 10 percent probability, is that the losses are much larger.) Most of this is so-called putbacks to the banks from Fannie Mae and Freddie Mac, meaning that the banks are forced to take back onto their books the underlying securities (and absorb the associated losses) if there was significant misrepresentation in the original documentation.

In almost all cases, these additional losses will remain an order of magnitude smaller than the trillions of dollars in credit losses that brought down the global financial system in 2008-9. Still, these latest losses are not helpful to confidence in big banks, and the continuing uncertainty, which is entirely the banks’ fault, will make their managements more cautious about extending new credit.

Capital is the buffer that banks hold against losses, and banks really do not want to raise more capital under current conditions. Their executives’ fear about potentially having insufficient capital will further undermine loan availability, even for creditworthy borrowers. This is exactly what the economic recovery does not need.

In addition, Bank of America is a particular worry, because its capital position is already precarious, and any downgrade by rating agencies will push it into dangerous territory. To the extent the market believes that the government does not stand fully or immediately behind Bank of America (a view expressed by Morgan Stanley analysts in a note this week), we should expect pressures reminiscent of fall 2008.

We also learned this week of sizable additional potential exposure from the lawsuit filed by the Federal Reserve Bank of New York, Pimco and BlackRock — seeking to force Bank of America to buy back bad mortgages packaged into $47 billion of mortgage-backed securities issued by Countrywide.

The best approach would be a fresh set of stress tests, resulting in the requirement that Bank of America and perhaps other banks need to raise a specified dollar amount of capital (not hit a particular capital-asset ratio, as that would just result in further dumping of assets), and reassuring the market that other banks have sufficient capital, including under the augmented Basel III requirements. (For a primer on capital requirements and the thinking that underlies the approach we are recommending, see a post I wrote with Peter Boone on Oct. 7.)

Created by the Dodd-Frank financial regulatory act, the Financial Stability Oversight Council has plenty of power to order and organize such stress tests. In fact, because of the powers granted to the council under the Kanjorski Amendment, the country’s top regulators have a complete menu of choices available in terms of what they can require banks to do in order to reduce risks to the system (up to and including pre-emptively breaking up big troubled banks).

The foreclosure morass clearly poses systemic risk, both through its general effects on uncertainty about losses and because any manifest weakness at one big bank could spread — in some obvious ways and in some unanticipated ways — through the rest of the system.

In addition, the stress tests of 2009 (known as the Supervisory Capital Assessment Program) did not consider the possibility of large losses arising from the litigation now surrounding mortgage-backed securities. When Representative Brad Miller, Democrat of North Carolina, asked Treasury Secretary Timothy F. Geithner about this at a House Financial Services Committee hearing on Sept. 22, the exchange went like this:

MILLER, asking about possible breach of contract in securitized mortgages: Was potential liability on these theories taken into account at all in the stress test? I mean, the securitizers, who presumably would be the defendants in any litigation, are the 19 biggest banks that got the stress tests. Was their potential liability taken into account at all in the stress tests a year ago?

GEITHNER: I don’t think so.

Mr. Geithner also said he would take this question up in more detail with his colleagues at the Federal Reserve, which administered the 2009 stress tests. The exchange can be heard in full online, with the Miller-Geithner exchange at about the 42-minute mark.

The only fair, reasonable, and safe way to handle this situation is to order a fresh round of stress tests for all systemically important financial institutions. The stress case should consider not just the current dismal macroeconomic prognosis (and the potential for another slip back into recession) but also the downside with regard to litigation losses.

If the Financial Stability Oversight Council refuses to act decisively in this regard, a vital piece of the Dodd-Frank financial reforms will have failed.